Letters of Intent

Pankaj Raval (00:00)
Hello and welcome back to Letters of Intent. My name is Pankaj Raval. I'm the founder of Carbon Law Group and I'm co-host today, Sahil Chaudry. Sahil, how are

Sahil (00:08)
I'm doing great. I'm Sahil Chaudry, corporate attorney here at Carbon Law Group. And today, are talking

Pankaj Raval (00:14)
talking deals and these are actually smaller deals we're talking about today. We're talking about those deals that we help a lot of clients with. are the one to $10 million acquisitions. So if you're looking to buy a business of maybe starting one from scratch, but maybe buying an ongoing business or what they call a going concern, this is an episode for you. You're going to learn a lot about the do's and don'ts and things to look out for. And we're really excited to get into it.

today we're gonna cover three major topics. The first one is what you're really buying when you acquire a business, the liabilities you didn't know you bought, and then assets versus exposure, the hidden side of acquisitions. Those are the kind of the three main topics we're gonna cover today. And I'm gonna be talking to Sahil who deals lot with these kind of acquisitions, in this space, the kind of SMB, small, medium-sized business space, to see are we looking out for? What do we need to think about when you're buying a

or when you're a business. So Sahil, I'm going to turn it over to you. So your first question is, the first things a potential acquirer should look out for when they're buying a What's that first step they should be thinking about if they said, hey, I want to buy a

Sahil (01:12)
So when we do and we're talking with someone who wants to buy a business, the first question I ask them is, is this an asset purchase or is this a stock purchase? And those are two very different things. In one case, you are taking the assets out of a and you putting them in a different container. a separate company. That's not the original company. And the other option is you do a stock purchase where

you're purchasing the stock in that company and that means you're inheriting the assets, but that also means you're inheriting the liabilities.

Pankaj Raval (01:43)
Absolutely. So interesting. so there's two types of acquisitions essentially we're looking at. There's asset and stock. Is one better than the other? Or do you always want to go with the asset because it sounds like, yeah, you don't get the liabilities or are there reasons to go with a stock sale?

Sahil (01:56)
It really depends because, and that's something I think clients hate to hear from a lawyer, is it really depends. it's true. In this case, very true.

Pankaj Raval (02:02)
but it's true. This is not TikTok.

We're talking about real deals. This is not something that can be summed up in 60 seconds. So you're right. It does depend.

Sahil (02:10)
⁓

Yeah, but let's walk through what would make you decide to go with one or the other. So if it's an asset sale, that means that there are certain key assets that you can use and you don't need the corporate entity in order to continue using them. So that is true most of the time, actually. let's say

somebody has product like some new kind of phone and that phone has a patent. You can buy the phone, you can buy the patent, or you can have the patent transferred. You can have the IP transferred and you could sell that. Now, on the other hand, let's say you are buying into a factory and that factory has vendor contracts and it takes months to get registered in a buyer system. Let's say, for example, the garment industry,

when you're registered as a vendor with Ross or Burlington or Nordstrom TJ Maxx, that can take months or years to earn that trust to be registered as a vendor. There's a whole vendor history associated with that. So for you to then yourself get back in touch with that buyer and try to sell the same product, it's going to be very difficult because there's a whole process of earning the trust of a company to be registered in their system. So that's an example where

you might not wanna go the asset purchase route. You wanna go the company route. But there are a few things you really need to look at. If you're gonna go the company route, you are going to need to look at a few different things that are key in a diligence purchase. And let me comment at least on one more reason you would wanna go with a company purchase, stock purchase rather than an asset sale, goodwill.

Sometimes a company has goodwill on the market and you want their name, you want that company. Sometimes they have key employees that are part of that company and you want to inherit those. So the more you need to inherit...

of a company that you're buying the bigger reason you have to go with a stock purchase. If you can isolate key assets and sell those on your own and you have your own team and your own infrastructure to do that, that cuts more in favor of an asset purchase.

Pankaj Raval (04:09)
Interesting, interesting. So yeah, you talk about goodwill. So what's goodwill in the business? You said maybe the name like what else would you consider goodwill?

Sahil (04:16)
Well, so it could be the name of the business is primary, which you could say, okay, fine. Well, we could isolate the name as a trademark and then we can license that or sell that to the new company. That's one element of it. There's also probably team, which doesn't traditionally fall into the category of goodwill, but I just want to highlight that because if you have employment contracts with key employees, key people who have built the company from the ground up,

those are intangible human relationships that you can't just absorb through a trademark. If you have key salespeople who have great relationships, let's say you have a pharmaceutical company, you've got pharmaceutical salespeople who are usually very key to bringing in money and really nurturing relationships out in the marketplace, very difficult to replace.

You want to look at Goodwill as, yes, Goodwill is the name and sometimes a company will have multiple brands as well. So you could maybe take a brand name, but does that mean you're getting the company behind the brand, which is something that a lot of people look for as well. Goodwill is the currency, the social currency you've generated through your company. And when you buy into the company, you're more likely to be able to inherit and leverage that.

Pankaj Raval (05:24)
interesting. Yeah, I mean, that's something we deal with a lot here is, trademarks and talk about discussion about goodwill when acquiring a company and, because we do a lot with IP, that should be a big part of people's transactions when they're thinking about acquiring a business. How are you acquiring an IP? Whether it's through a holding entity where you buy stock or you acquire 100 % stock, or is it through, an asset transfer and assignment? These are all very critical elements you got to look at.

And oftentimes, the the devil's in the details. A lot of this stuff, right. Even with diligence, I found over the years that people shy away from a stock sale because they hear, you know, all the liabilities that could come along with it. But, as you mentioned, there's a lot of important advantages of that stock sale especially given the industry. Like you said, if there's a lot of compliance, regulatory issues, maybe a liquor license, right. If we're about restaurants or, restaurants or bars.

really depends on the industry. I would say that like every industry has its own approach. So when you're if you think about buying a business, it's very different to talk about a SaaS acquisition versus a restaurant acquisition, right? There's so many you got to look at. a listener today thinking about, I want to treat it all the same. It's not the We've done med spas, we've done health care, we've done hotels, we've done a variety of things, but they're all very different. And you got to understand the nuances of

some of them are very smaller acquirers don't want to invest in diligence. But really, that's where you uncover a lot of the stuff. with your experience going through different deals, helping a lot of different clients with these acquisitions, walk us through the journey. happens first from the start, maybe LOI or even before that, to the final closing? Walk us through what that looks like.

Sahil (06:53)
Yeah, well, we usually do start with an LOI. That's the first thing we want to build. And we spoke about that on a previous episode, those are the questions you want to hammer out early on to know that you're on the same page. Those are things like price. Those are things like a diligence period, escrow as well as

reps and warranties, key reps and warranties, indemnifications, who's involved in the transaction, broker's fees. Key elements of the deal, also what survives the closing of the deal in terms of, for example, if you're doing a purchase that involves real estate, oftentimes the buyer is gonna expect that the seller retains some kind of liability for environmental obligations. Those are key places you need to negotiate. And

what kind of financing? Is this an all cash deal? Is this seller financed? Is a deal that's contingent on financing? Does the bank need to pre-approve this kind of deal in order for it to go forward? So those are some key areas. The other thing is what's actually being purchased. Let's say, for example, we're talking about a hotel franchise. That means we're talking about, is the flag going to carry over? Are there termination fees involved with that?

What kind of service contracts does the current company have? Let's say it's a restaurant. Another thing that you're going to want to look at would be what kind they have, what kind of trademarks, IP they have. And so there are many key assets that you want to identify. And one of the key points that you want to highlight on an LOI will be the diligence period. And I think

this is one of the most important parts of the deal because this is where you uncover where the bodies are buried. And I want to highlight a few of the bodies that can be buried. we always are looking we talked about hospitality and restaurants, labor compliance. You will often find that companies unknowingly or knowingly are violating California labor law and a lot of those penalties run retroactively. You can't even

Pankaj Raval (08:23)
right.

Sahil (08:41)
correct them in terms of any kind of forgiveness going you could be exposing yourself to labor claims. We want to talk about liens and litigation. There are often times a restaurant looks like it's doing phenomenally, but it could also be powered completely by debt. that debt can stack up over and over

bleeds into the profit. And so you want to know what kind of margin you're getting when you're buying into a business. The other area, there lawsuits that you would be inheriting if you were to purchase this company? The other thing is you want to look at the balance sheets and specifically the EBITDA. Oftentimes in small businesses, you're going to have owners who are putting their cars on their company card.

family's on the health plan. You have a lot of expenses that are not necessarily true business expenses if someone else were to buy into the business. And so typically you're gonna separate those out as costs so that a buyer would look at that and know actually what the true profit margin is here because you add those expenses, you often will see that a business might be more profitable than

it originally seemed. So EBITDA is something that's gonna be very critical as well. And of course the IP. Think about IP like real estate, if real estate's a component as well. Any kind of ownership requires a clean chain of title. And so that's a critical piece. That means chain of title when we're looking at securities, when we're looking at real estate, and when we're looking at IP.

And the other element I wanna comment on here are cap tables. Most small businesses have a mess of cap tables because people have been handing out equity, they don't know if they've given someone a share or a profits interest or a unit or a percentage. People like to talk in percentages, but is that fully diluted or are these based on pre-money valuations, post-money

Is this fully diluted or not diluted? People are just talking in numbers that they don't really understand in terms of what kind of ownership interests are being assigned. And so you want to look at everyone's ownership interests. What are the claims to ownership? How have incentive options been outlined? Have they been awarded? Those are some key components there in terms of ownership. would say securities, IP, labor.

Pankaj Raval (10:55)
Yeah, that was so good. Yeah, that's so important to think about all those you raised great points about all the different elements you got to look at analyze your chain of title, you do people do people actually own what they're selling their you what they're saying they're selling, right? There's so much diligence, especially today with so much fraud out there. I think this even becomes so much more important, right? Sahil like, there's so many people who are, I feel like, so cavalier with just lying today, that I think

Sahil (11:18)
Yeah,

Pankaj Raval (11:19)
more than ever, you need better diligence, you need to be very careful, question everything right and the importance of understanding that every deal is different, right and people sometimes think, oh, I've got a template diligence checklist, or I've got this from chat GPT, it told me what to look out for. But every deal is different, right? Like, we're right now selling a hotel, we're working on a hotel transaction where the hotel may be closed down, maybe shut down.

That's a very different analysis and than it is where they're selling it to another operator. Right. So what does that mean? Right. How do you handle that? And those are unique issues you need someone to guide you through and think about and help you think about because, there's there's so many nuances here to every deal that you want to make sure you uncover. Because, if you especially if you're putting in a lot of money, if you're putting in millions of dollars,

into buying a business, you want to make sure that you're getting what you bargained for and something that can really help you make money. Because sometimes if there's more costs that arise that you didn't expect, that could really change the economics of the deal make it a bad deal.

Sahil (12:18)
Pankaj, I think when you're looking at diligence, if I had to flag two critical issues, I think we would be talking about contracts and IP. the equities, that's a given because if you're doing

a stock sale, then absolutely you need to make sure chain of title is clear with the equities you're buying. But out beyond that, I think with the deal itself, I think when it comes to the assets you're purchasing, contracts and IP, making sure that those are properly documented and you're getting what you're paying for, I think those are the two most What do you think about? Like when you're looking at a deal, what are kind of the most important

⁓ elements that you would

Pankaj Raval (12:56)
Yeah, I think looking at the contracts IP, but like even then, higher level is like, is this person positioned to make the they ready to make the deal? If we're selling a business, does the buyer have the money? Right. I could do the POF. And if we're buying a business, does this person, what they're representing, is that actually what it is? Right. You want to kick the tires? Right. Think about buying a car. You want to test drive it. You want to look under the

got to do all that with a business. I think just verifying that person fact what they say they have before deep into the deal. Because sooner can identify the problems, the sooner you can make a decision and the more money you'll save and be able to move on to the next deal that is the right deal for you. And I think that's one thing I like to tell clients. We are counsel for deal makers and risk takers, but not every deal is a good deal. And we want to make sure we

from getting into deals that are bad deals for them. And that's the thing, like when we're paid by the hour, as opposed to a broker or something like we're not incentivized to get the deal closed. We're incentivized to get you the best advice possible for you to make the best deal. And I also a big difference between hiring a lawyer and trusting a broker or another advisor who's compensated just a fee for a closing. And sure, there may be success

lawyers get on some of these larger deals. But again, we are really incentivized by making sure, and it depends on what side we're on too, where a success fee makes sense. If it's in terms of offering you just really practical, honest advice, we're the ones that have ethical obligations and also legal obligations and financial obligations just to make sure that you're getting the best advice possible for that deal.

Sahil (14:24)
I also noticed that a lot of people when they're doing a deal try to railroad each other with some very sweet but dangerous language. So I noticed a lot of times when we're working on a deal, people will say things like, well, it's about trust or we're like family or, you hear all of this very kind of,

Pankaj Raval (14:33)
Mm-hmm.

Sahil (14:43)
misleading language where people like oftentimes I can feel sometimes our clients are feeling pressured to say yes or they start to feel bad about like asking a question is wrong. Like, I shouldn't even push on this or shouldn't even ask on this is somebody I've known for so long. That happens often where let's say, this is maybe less in the context of someone buying a business and more when someone is investing in a business, but

Pankaj Raval (14:45)
Yeah.

Yeah.

Yes,

Sahil (15:05)
people saying, well, I've known this person for so long, we're gonna do this together. And I just want, for all of our listeners to know that you have every right to ask every question. And the other person has, the right to give you the answer they wanna give you and then you can evaluate what the answer is, but it's not wrong. It's not, I really hate this. I feel like there are some business people who take advantage of

Pankaj Raval (15:16)
Yeah, yeah.

Sahil (15:29)
other people's good nature and say, well, you know what, this is about trust. And you don't trust me, we shouldn't do this deal. And I think for us, we would say, if someone talks like that, you shouldn't do this deal because those tactics usually mean somebody's lying and the numbers should speak for themselves and the business should make sense. I feel like very often we're trying to keep people out of situations that don't make sense because

Pankaj Raval (15:31)
Yes.

Yeah, yeah.

No, I agree. Yeah.

Sahil (15:54)
they're getting pulled in by a reason that's not rational, a reason that's not business. It's like status or or some kind that doesn't have to do with the rational basis of the deal. And what we're here to do is pour cold water on everything and just say, does this make sense? And you have every right to ask if it makes sense.

Pankaj Raval (16:09)
Yes, yes, yes.

Yes, absolutely. You bring up such a good point, Sahil, because I think it's easy to overlook. And honestly, it's human nature. It's almost impossible to especially smart people think, oh, they know what's best. But honestly, when you're too close to a deal, when you're too close to the other side, where you're friendly with them and you guys have a good rapport. You kind of let your guard down and you need a third party to come in and ask hard questions.

Sahil (16:33)
Yeah.

Yes.

Pankaj Raval (16:36)
because

maybe you're not comfortable now because you guys have a good rapport. I'll be the first to admit that probably that happens to me sometimes, I have example, like I'm having someone build cabinets in my or closets in my house. He gave me this contract. He's like, yeah, I'll bring over the contract. He gave me this thing and I was like handwritten garbage. And I'm like, I was advising myself as a lawyer, like nothing, like useless. He just wrote down like the five things he's gonna do, but I'm like, okay, how, what is it gonna look like?

Sahil (16:55)
Yeah.

Yeah.

Pankaj Raval (16:59)
And

I realized I wouldn't because I've been talking to this guy for a while I'm like, okay, how much trust do I want to put in this guy versus how much do I want to document? I went back a little bit, but I didn't want to over do it because at end of the there is a balance there. And you also have to look at the amount of risk you're taking But yeah, those are things that come up all the time. So like this is I'm talking about closets

which is a few thousand dollars versus multimillion dollar business where you want to take a little bit more precaution, right? Like, it's not going to break me if he doesn't do the best job and I have to deal with it. But, I'm also looking at his reputation, his skill, he's done closets for my, my in-laws. So like, I know, he's actually trustworthy, but there's, still a balance there, right? So I think you have to be really careful when you're too close to the deal too. And it kind of lulls you into complacency.

When there's bigger deals, you've got to go through the process the steps of diligence to make sure you don't overlook anything.

Sahil (17:52)
I'm thinking about a deal Pankaj, that we both worked on where the buyer asked for an extension on the diligence period. And we advised our client just to ask for a nominal fee in exchange for extending the diligence period, which would have been a huge concession from our part because there was actually, what we should have asked for would have been

a much larger number in order to extend the diligence. And even then, were thinking, okay, well, we've had no activity so far in terms of questions regarding the diligence, and we have no assurance that this person is actually going to buy. And so in the the...

client felt comfortable enough with the buyer and the buyer said, hey, don't you trust me? definitely want to do this deal. This means so much to me. I really want to do this deal. I've just been traveling and I've been busy, which I hate the traveling excuse. You have Wi-Fi on the plane today. You have access to your device. Oh, I'll get to it once I'm back from traveling. This is not the 1980s. It's not anymore.

Pankaj Raval (18:44)
Yeah. Yeah, exactly. Exactly.

Yeah, seriously.

Seriously.

Sahil (18:56)
Just get on your

phone or get on your laptop, wherever you are in the world, it doesn't matter. It's a silly excuse today. But anyway, this person was making all kinds of excuses, kept saying, well, don't you trust me? Don't you trust me? Now do extend the diligence period. And then at the end of that period, the person backs out, not because they felt like they were being disrespected because they were asked for an additional fee for on diligence.

but because they got denied by the bank for the money. So, in that case, this is why we advise clients to, hey, stick to your guns on things like this. Talk is cheap. People will say anything that's in their self-interest and they're really not looking out for you. So, you know, when it comes to a deal, you want it, when you build out the deal terms, the words on the contract, the words on the page,

Pankaj Raval (19:35)
Yeah. Yeah. Yeah.

Sahil (19:44)
are meant to protect you because we're human beings, we have emotions. You know what it reminds me of? You know in the Odyssey when Odysseus is passing through the sirens on boat? So, you know, he's been told that they're so temp, that the sound of their voice is so tempting that the boat will crash against the rocks. That's what Pankaj and I are here for. We tie your hands to the mast, make sure you don't sail into the rocks because

Pankaj Raval (19:47)
Yes.

Yes. Yes.

Yeah, yeah, yeah. Yeah.

Sahil (20:12)
We're all human beings. We all have that weakness of, we want to be caring, we want to be kind. But there are certain times where you need to stick to the words on the page because they're there for a reason. They are your protection.

Pankaj Raval (20:13)
Yeah, exactly.

Absolutely.

going to tie you to the mast if necessary to protect you. Yes, to protect you. so I think that's a great place to end. I think this has really been really helpful. kind of crash course on the things to think about when buying a business. So listening, we really appreciate you guys listening, your continued support. I think we're probably over 50 episodes now and we're going to continue to do

Sahil (20:25)
Mast, yeah. And that way we can sail through it and get back to it.

Pankaj Raval (20:45)
We'd love to hear back from you. We love to hear insights and comments any war stories and people anyone wants to share. If you have thoughts, to be a guest on the podcast, please let us know. We always love to hear from people doing these kind of deals who have been in the trenches. And we'd love to hear other perspectives. So until next time, we really appreciate you all in listening to us and continue to support us. And we will be on next week,

with another episode of Letters of Intent, Wednesdays at 7 a.m. It drops. Until then, happy deal