After-sale involvement can take a number of different forms, the most common of which are an employment contract and a consulting agreement. In addition, many deals require a noncompete agreement that will bar you from starting a similar business nearby for a period of time. In addition to defining your after-sale role, these agreements can serve to compensate you in connection with the sale, with tax advantages to the buyer.
It's a rare buyer who won't want you to show him or her the ropes by remaining involved with the business for a while after the sale. Often the deal won't fly unless you agree to this. At a minimum, the buyer wants to be sure that the business is indeed a going concern. In addition, buyers realize that much of the real business knowledge has never been written down, and when you leave, it will go with you unless the new owner takes steps to learn it from you. Often a significant part of the total cash you receive will be tied to your future involvement in the business.
After-sale involvement can take a number of different forms. The most common are the following:
- employment contracts;
- consulting arrangements; and
- noncompete agreements.
Your future can remain tied to your former business in other, more indirect, ways. For example, if you've agreed to finance part of the deal, or to make part of the price dependent on an earnout, you'd be well advised to keep your eyes on the business's future performance and to be ready to act if things start to unravel. In fact, if you may want to include an oversight role for yourself when defining the terms of the sale.
Employment contracts facilitate short-term involvement
When an employment contract is used in a business sale, the seller becomes an employee of the new owner. This is generally a short-term solution. Few entrepreneurs can successfully make the adjustment to taking orders as an employee once they've gotten used to calling all the shots in the business they used to own. Generally, the relationship sours and the seller leaves within a year to 18 months, sometimes causing the entire deal to unravel in the process.
One reason why you may want to agree to an employment contract is that it is virtually the only way you can continue to receive perks such as insurance, an expense account, a company car, travel to seminars and conventions in Hawaii, etc. Salary and benefit payments to or for you are business expenses (under the usual rules) for the new owner of the company, and taxed as ordinary income, subject to payroll taxes, to you.
Employment contracts are frequently used in family businesses as part of a succession plan. Where the older-generation founder really does intend to stick around for a while, and the younger-generation new owner can deal with any ego problems and make good use of the founder's advice, experience, and skills, such arrangements can make good economic sense.
Example: Just be careful that you are really functioning as an employee, to satisfy the IRS. If you do too little for your pay, the payments won't be deductible. If you continue to do everything you used to do as owner, the entire sales or succession transaction can be treated as a sham by the IRS, bringing you an endless number of tax problems.
If you do use an employment contract, make sure that it's separate from the business purchase agreement so that if the employment relationship falls apart, the entire deal won't collapse.
Consulting contracts pay you for your advice
Consulting agreements are used more frequently than employment agreements when the buyer is an unrelated third-party. Usually the buyer will agree to make specified payments at certain intervals of time, and the seller agrees to be available for consultation for a specified number of hours per month. The seller is "on call" and still gets the payments even if no services are required.
One disadvantage to these agreements is that you may need to make yourself available for consultation. A possible solution, provided the buyer is amenable to the plan, is to set up your own consulting company and have it sign the agreement, so that you can substitute other consultants if you are not available.
Payments made under consulting agreements are taxed as ordinary income to you, and are deductible by the buyer. They can serve a dual purpose of compensating you for your wisdom and also making a portion of the cash you get (which might otherwise be part of the purchase price) deductible to the buyer. The IRS is well aware of the potential for abuse in this situation, so make sure that the agreement is in writing and that any payments under consulting arrangements are within the range of fair market value, given your experience, contacts, knowledge of the business, etc.
Noncompete agreements may limit future ventures
One of the last things that a buyer wants to happen is for you to sell your company, and then turn around and start another one just up the street, taking most of your customers with you. For that reason, buyers will want you to sign a noncompete agreement as part of the deal. The agreement will state that in exchange for a specified payment, you promise not to go into a similar type of business, within a certain geographic area, for a given period of time. Sometimes the agreement will specify that you promise not to use certain confidential trade secrets, business processes, customer lists, etc. that you are transferring to the buyer.
Most sellers think of signing a noncompete agreement as a "no-brainer." They are retiring, and weren't planning to go into a similar business anyway, so why not take money for doing nothing? However, you should know that there's a sizable number of business owners who find, a couple of years down the road, that they got out of their business too early and they miss it. When they decide they want to go back into business, a noncompete agreement can stand in their way.
To be enforceable, noncompetes generally have to restrict you from starting only a business similar to the type you sold, in the same geographic area from which the former business drew customers. A noncompete agreement must be limited to a reasonable (meaning, short) length of time. State laws generally discourage such agreements and in some states, they are virtually impossible to enforce.
But noncompetes have another purpose: to convey more cash to the seller, in a form that has tax advantages for the buyer. All noncompete agreements must be written off over a 15-year period, regardless of their actual length. Since most noncompetes are for five years or less (and must be short in order to be valid), this rule makes them much less attractive. Nevertheless, they are still used in a majority of business sales.