Understanding Closing
We’ve made it! After weeks or months and back and forth, conversations, reading upon reading upon reading disclosure documents, hammering out deal terms, and writing an amazing agreement that facilitates a smooth transfer of business from seller to buyer with each side’s post sale interests protected, we’re finally here! The marathon is over. It’s time for Closing!
But as joyous a moment as this is, it leads to a whole new set of concerns and a few negotiations. What exactly are the mechanics of closing? How do we actually get this thing across the finish line? Let’s find out together.
What Is Closing?
Buying or selling a business has three primary phases: (1) letter of intent, (2) due diligence, and (3) final agreement. These are just the primary phases. We can divide each of these phases into several substages. (Hint, hint, future blogs on the way.)
Closing is the last substage of the last phase of a business purchase. Closing is where agreements are made final and binding, and the parties finally make a complete exchange of promises or performance. The exchange of promises or performance is the purpose of any contract.
Closing is not unique to business sales. The concept applies equally in other transactions like certain supply or production agreements, real estate matters, and other deals. Closing may occur in any transaction where there is an exchange of deliverables at the finalization of the agreement.
Signing an agreement is not necessarily the same as closing it.
The Timing of Closing
Closing is not just a formality. It’s a chance to secure important rights, create opportunities, and subtly shift the balance of the risk of loss. We accomplish these through the timing of closing. The timing is just as important as closing itself. Generally, there are two timing windows we can use for closing. We can “sign and close” or we can “sign then close”.
Sign and Close
Sign and close means exactly what it sounds like. Buyer and seller sign the purchase agreement, which is effective and completes the transaction at the moment both parties have signed. The signing of the agreement and closing of the transaction occur simultaneously. This is the critical aspect of a signed and close agreement. Once signed the deal is done. This means that every detail of the agreement needs to be fully negotiated before the parties sign it.
A sign and close closing arrangement can be preferable for some parties. It has at least the appearance of simpler transaction. “Sign on the dotted line and I’ll hand you the keys” can feel much simpler than “Sign here and we’ll talk again in three months.”
Beyond feeling simpler, a sign and close can in fact be simpler. This is because a sign and close forces the parties to conduct their complete deal process for the purchase agreement to become final. In a sign-and-close transaction, the purchase agreement will reflect all the various negotiations and due diligence the parties have engaged in. At the moment of signing (and closing) each party knows everything they intended to know about the deal and has done everything they needed to do to complete the deal. Due diligence is complete, financing is secured, and all conditions to closing have been met. There are no issues left for the parties to resolve.
With a sign and close, if either party doesn’t like something about the deal at any point prior to closing, either one can walk away. Due diligence reveals something we don’t like; buyer can walk. The buyer is insisting on seller financing instead of obtaining a loan from a bank; the seller can walk. A better deal comes along, either can walk. This freedom to exit is a double-edged sword. It’s a benefit for each side, but that means it also is a risk for each side. The other party can leave the conversation at any time, as they aren’t bound to anything.
Sign and close carries the benefit of freezing the transaction and its risk of loss at the moment of signing. At that point, each party has (theoretically and hopefully) completed thorough due diligence and has a strong understanding of the transaction. The more time goes by before closing, the greater the risk that something changes. Maybe a critical asset is damaged. Maybe a material adverse change occurs.
When we sign and close, we are trying to mitigate the risk of uncertainties in the business that could happen between now and some unknown point in the future. The future is in the buyer’s hands, and the seller has no more ability to adversely impact that future for the buyer.
To recap: A sign and close closing makes the parties complete the entire deal, know everything there is to know, and do everything there is to do by the time to promises to purchase are final, freezing the risk of loss at that moment and allowing each party to move forward cleanly and separately. With a sign and close, either party can leave the deal at any time.
Sign and close can be preferable where business owners prefer things to be “simple”. As one might expect given the appearance of simplicity, sign and close closings are more common with the sale of smaller businesses. But simplicity for the sake of simplicity is often not a worthwhile goal. Chasing “simple” can expose you to more significant risks.
Sign Then Close
Sign then close is the opposite closing style. Buyer and seller sign the purchase agreement, but with a twist. The agreement is binding and effective once signed but the transaction is not yet complete. Instead closing will occur on a future date. At signing the parties have not completed the deal. Instead, they’ve only agreed that they will complete the deal in the future.
Sign then close is the more complex of the two approaches. With a sign-then-close arrangement, the parties secure the deal without completing it. This allows them to continue negotiations and due diligence while knowing that the deal won’t evaporate out from under them. This can give each side, or one side more than the other, security. One might feel compelled to agree to an “okay” deal under a sign and close because they don’t want to lose the opportunity knowing that it could potentially leave. Sign then close recognizes that each side makes a great undertaking of time and expense in conducting all the measures involved in a deal and gives them the security that they spend this time and money without having the rug pulled.
Sign then close also affords the parties protection in the very common situation where the deal requires actions or information that is beyond the control of the parties. These externalities greatly impact whether a deal may move forward. Externalities are present in most deals. If you buy or sell a business through an asset purchase structure, third parties absolutely can impact your deal.
For example, generally, a person may not unilaterally assign the rights or obligations of a contract. The assignment requires the consent of the contract counterparty, though a unilateral right may have been negotiated upfront. If you buy a business in an asset purchase structure without these third-party consents, you may find yourself having no clients or premises to work from if the seller’s clients or landlord don’t consent to the assignment. A sign-then-close arrangement allows the parties to lock in material deal points like the purchase price, the representations, and warranties based on the due diligence, and then have time to secure these third-party consents and approvals.
These consents often take longer than expected. Your seller’s landlord isn’t benefitting from this transaction the same way the seller is. And having a new tenant they don’t know poses a risk to them. Accordingly, the seller’s landlord is likely to take their sweet time reviewing the situation before consenting to the assignment of the lease. Further, a sophisticated third party may refuse to consider consent under a sign and close arrangement. Since nothing is binding until closing, the third party may feel they can’t consent because they don’t definitively know what they’re consenting to until there’s a binding agreement for the transaction.
Sign-then-close arrangements can also be used where a party wants to or needs to lock in the deal before there’s time to fully know all uncertain issues and resolve all matters beyond the parties’ control. This is a riskier use of a sign than a close. If you’re thinking of using a sign then close in this way, you need to take care to evaluate the upside that you’re trying to lock in against the downside if there are unknowns or things you can’t control. Communicate clearly with your lawyer, so they can draft appropriate provisions to protect you from these downside risks.
When we sign and then close, we are trying to mitigate the risk of losing out on the entire deal. We do this by creating a binding promise for the main deal points. We then create various outs that allow either or both parties to terminate the binding contract if something unknown that a party was relying on turns out to be unreliable. These can take the form of closing conditions, purchase price adjustments, and other tools.
To recap: A sign then close closing allows the parties to secure the benefit of the transaction (the binding promise that they will sell or buy the business to or from the other party), while giving time to deal with unknowns and issues beyond the parties’ control.
Sign then close is the more common of the two approaches, as it allows the parties a balance of flexibility paired with the certainty that the deal will happen once the right conditions are met.
Closing
Opportunity abounds. Legal strategy is a chance to create opportunity and secure the benefits of your bargain. When you need help creating opportunities in your deals, the team at Way Law is here to help!