George M. Taylor, III, Burr & Forman
Most of the focus on the purchase and sale of dealerships is on closing the transaction. Both purchaser and seller are less likely to give thought to what happens post-closing. While closing is the big event, the seller and purchaser are linked together for an indefinite period of time after closing, during which pro-rations not handled at closing are resolved, bills are forwarded to the seller for payment, and issues like post-closing manufacturer payments are handled.
Also lingering after closing are a host of representations and warranties given by the seller, which specifically survive closing. Some survive indefinitely, and some for a lesser period. Both seller and purchaser should give thought to whom or what is still around after closing to respond to claims for indemnity and other claims under the purchase agreements.
Most dealership transactions are asset sales, which means that technically the seller is not the owner of the business but the corporate entity that acted as its operator. Also, since most dealerships are pass-through entities of one sort or another (“S” corporations, limited liability companies, etc.), there is no tax on funds that are distributed to the shareholders.
Naturally, dealership owners will start to lean on their CFO’s the day after closing to get the funds distributed to the shareholders. Aside from the prudent decision to leave enough money in the entity to pay expected post-closing expenses, virtually all funds in the corporate entity tend to be distributed to the shareholders at the earliest possible moment. This course is much appreciated by the shareholders but can cause some anxiety on the part of the purchaser – and to lawyers on both sides of the transaction.
Why, you may ask, does the purchaser have any interest in the distribution of the seller funds to the shareholders? The reason is that the selling entity still has ongoing responsibilities under the purchase agreement. Should something arise (such as a lawsuit for pre-closing activities of the seller that somehow ensnares the purchaser), the purchaser will want to go straight to the seller to demand indemnity. This could include not only payment of any damages resulting to the purchaser, but also the obligation to appear and defend the action.
Fortunately, corporate laws offer some comfort by providing that if the shareholders strip all funds from the entity and leave it with insufficient capital to meet its obligations, creditors of that entity can pursue the proceeds that were distributed to its shareholders. However, suits to pursue shareholder distributions can be difficult and drawn-out. For example, the shareholders can argue that because no litigation was present at the time of the distribution, the entity was left with sufficient funds to conduct its business. There are burdens of proof that must be met and the whole process can be less than satisfactory.
Lawyers representing purchasers are well aware of this issue and have several tools at their disposal to address the concern. The most acceptable of these to the seller is to restrict the ability of the selling entity to make distributions to its shareholders for a predetermined time or, to require that the selling entity maintain a certain net worth. While the concept makes sense, it is difficult for a purchaser to monitor compliance, and if the covenant is breached, the purchaser faces the same sort of challenges as with use of the corporate laws to pursue shareholders.
The more frequent approach is to use one of two devices: the post-closing escrow holdback or the personal guarantee. The post-closing escrow holdback is exactly what it sounds like – the withholding of funds that are otherwise payable to the seller from moneys distributed at closing in order to provide an escrow fund against which post-closing claims can be made. Such escrows vary in amount and timing. The most typical holdback period equates with the time frame during which most representations survive closing (a period of one to four years, depending on the laws of the state and the provisions that have been negotiated in the buy-sell agreement).
As to amount, numbers vary widely. The most recent Deal Points Study, a survey of major transactions by the Mergers & Acquisitions Committee of the American Bar Association, a group in which I participate, indicates that in the transactions surveyed, most post-closing holdbacks represent less than 10 percent of the purchase price, with the largest single category being 32 percent of the deals in which the holdback is 3 percent or less.
However, the study is not specific to dealership sales and involves many sizable corporate acquisitions and mergers, none of which give guidance to car deals. Based on my experience with holdbacks, they tend to fall into dollar ranges frequently equating to an amount between15 percent to 20 percent of the blue-sky figure. However, in smaller deals it might be in the $500,000 to $1,000,000 range, no matter the blue-sky figure. Smaller transactions pose a particular challenge in computing reasonable amounts.
The personal guarantee is frequently used to avoid the need for a post-closing escrow holdback. Simply put, the majority shareholder guarantees all the obligations of the selling entity so that if there is a claim post-closing, the shareholder must come forward with the funds to satisfy it. This has the advantage of getting all the funds into the hands of shareholders immediately and avoids the need to hire an escrow agent to hold post-closing funds.
However, many dealers have fought long and hard with financial institutions throughout their careers to avoid personal guarantees, and this is no different for a post-closing guarantee. The decision about whether to issue a personal guarantee might also be dependent on other aspects of the transaction, such as whether there is an overall liability cap on the seller’s obligations, the degree to which the seller is confident in its operations and a host of other negotiating issues.
The point is that the request for some post-closing comfort is a reasonable request frequently put forward by dealership buyers. The seller’s response depends on negotiating power, the specifics of the transaction and the seller’s own tolerance for risk. As one who has seen this issue play out in many differing ways, I am carefully avoiding a statement about how it ought to be resolved. I will close by simply stating that the issue of post-closing liabilities must be addressed to the satisfaction of both sides if a deal is to move forward.
George M. Taylor is the chair of Burr & Forman’s Corporate Section, which consists of the Corporate and Tax Practice Group, the Banking and Real Estate Practice Group, and the Creditors’ Rights and Bankruptcy Practice Group, encompassing lawyers from the entire five-state footprint of the firm. He can be reached at (205) 458-5254 or gtaylor@burr.com.
