What Is A Break Up Fee?
A break up or termination fee is a contractual penalty imposed on one party of a business deal for failing to close on the transaction. Break up fees are very rare in small business sales. Constructing and negotiating the terms of a break up fee involves hefty legal costs which neither side in most small business deals is willing to pay. Further, in lieu of a break up fee, the buyer may negotiate an exclusivity clause in the purchase agreement to guard against the seller from accepting a competing bid. The seller may require a limited break up fee via the forfeiture in whole or in part of the buyer’s deposit. Seldom do sellers impose a separate and distinct penalty on the buyer for walking away from the deal. An experienced business broker should be able to provide sound advice to both the buyer and seller in regards to when different forms of break up fees may be appropriate.
Why Deposits Are Typically Refundable
As a general rule of thumb, the buyer’s deposit in furtherance of purchase a business is fully refundable if the business sale does not go through. Purchasing a business is not like purchasing a real estate with physical assets not subject to a formal due diligence process. Since the purchase of a business is subject to or contingent upon the buyer’s successful completion of formal due diligence (investigation of the historical financials and intangible attributes of the business), it is not generally fair to penalize the buyer for walking away based on adverse results. After all, the buyer did not have access to the information discovered during formal due diligence prior to making their deposit. The best measure most business owners may employ to protect themselves from the ill effects of buyers walking away from a business deal is by shortening the buyer’s exclusivity period.
Break Up Fee for Lengthy Exclusivity Period
The typical exclusivity period after a seller accepts the buyer’s offer in a business deal (as memorialized in a Letter of Intent or purchase agreement) is generally 30-60 days. This allows the buyer enough time to complete formal due diligence and possibly assume the seller’s lease as contingencies of the deal. During the exclusivity period, the seller may not legally entertain or act upon other offers for their business. Some buyers for various reasons may request an exclusivity period of 90 days or more. Frequently, buyers seeking to purchase a business for purposes of securing an E2 Visa may require an unusually long exclusivity period in order to be assured that their E2 Visa will be approved. In such a case, it is perfectly appropriate for the seller to negotiate a break up fee (via the forfeiture of the deposit) in the event that the buyer does not close.
Break Up Fee for Unusual Formal Due Diligence
Some buyers request unusually sensitive or time consuming formal due diligence questions, which the seller may consider too risky or onerous to answer in the absence of a break up fee. The most common example is where the seller insists on meeting and even interviewing staff members of the business as a part of the formal due diligence process. Most business owners consider this formal due diligence request out of bounds for the simple reason that staff members may prematurely quit as a result of being made aware of the sale or otherwise meeting with the buyer. Likewise, allowing the buyer to meet with customers or suppliers poses the same risk of business interruption. As a result, a break up fee may be reasonable in case the buyer does not close after meeting the staff members or other types of risky and onerous formal due diligence requests.
Warranty Customer Accounts
- In the sale of certain businesses with recurring customer accounts, break up fees may be imposed on the seller based on the loss of customer accounts after the sale. The warranty on the loss of customer accounts is generally limited for a period of time and only to the extent that it is not the fault of the buyer.
- The break up fees are imposed via clawback provisions which essentially return part of the purchase price (held in escrow) to the buyer.
- This is quite common in the sale of pool routes where the recurring customer service accounts are essentially the only assets being sold.
- The buyer will insist on some measure of protection from the loss of customer accounts within 90 days or so of closing, and use clawback provisions as a way to motivate the seller to properly transition the customers to the buyer.
- Most business owners will not agree to a clawback provision since they do not wish to be held responsible for the loss of customers after a business sale.
- In some circumstances, however, giving a limited warranty for the loss of certain customer accounts may be necessary in order to convince the buyer that the customer base will largely remain intact after the sale.
- The parties may always negotiate limitations on the amount and time period of the clawback provision and establish fair mechanisms to establish whether the buyer was responsible for the loss of the account.
In business – and in life – breaking up is hard to do. The costs, time, and emotional turmoil caused by a business sale that falls through may be substantial. While break up fees and nonrefundable deposits are quite rare in the sale of most small businesses, both buyers and sellers should be aware that unusually lengthy exclusivity periods or unusually sensitive and time consuming formal due diligence requests may justify the imposition of break up fees.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.