Navigating Business Contract Transfers When Selling Your Business
Your business’s contracts are among its most important assets.
Supplier contracts, customer contracts, and the like give business owners a degree of certainty that they can keep costs in check, depend on having raw materials and inventory they need, and predict revenue streams.
Control and predictability are just as important to buyers because they reduce the risks inherent in a business acquisition. When it comes time to sell your business, your contracts can boost your business valuation substantially—provided the contracts can be transferred to a new owner.
Which Types of Contracts Can Be Transferred in a Business Sale?
As a general rule, most contracts can be assigned (the legal term for transferring the rights and obligations under a contract to another party) to the business buyer as long as the contract doesn’t include a provision preventing it (more on that below).
Some notable exceptions to the rule include:
- Employment contracts, in some cases
- Government contracts
- Intellectual property contracts
However, it’s important to note that even when a contract can be freely assigned to a new business owner, the transfer doesn’t indemnify the seller if the new owner doesn’t live up to the contract terms. Sellers will want to obtain legal advice to indemnify themselves from the liabilities that can arise when transferring contracts.
How the Type of Sale Affects the Transfer of Contracts
The terms of the contract usually dictate the contractual obligations of buyers and sellers. But contracts are treated somewhat differently in an asset purchase versus a stock purchase. Those differences can impact a seller’s ability to transfer contracts. It’s a good idea to consider the value of your contracts to your business when deciding whether to use an asset or stock purchase.
Contract Transfers in a Stock Sale
In a stock sale, also called a share purchase or equity sale, the buyer acquires the whole company. Any contracts the seller holds go to the new owner, just like the equipment, inventory, and all other assets. A stock purchase is a change in control of the company, but the company remains intact, and the contracts remain in place.
In short, transferring a company’s contracts can be easier when you sell the company’s stock rather than its assets.
Contract Transfers in an Asset Sale
In an asset sale, a buyer acquires the assets and liabilities of the business. Buyer and seller must agree on the assets and liabilities included in the purchase. Contracts, like any other business assets, may or may not transfer depending on what the acquiring company is willing to buy.
If you sell to a buyer who doesn’t want some or all of your contracts, you’ll have to terminate the contract. If the contract contains an early termination penalty, you’ll want the buyer to foot any bills arising from breaching the contract.
An asset sale also restricts the transfer of certain contracts, most notably employment contracts. Most contracts are agreements between two businesses, but the contracting parties of an employment contract are an individual and a business. When a business is sold, the employment contracts of the individuals working for the company usually come to an end. Buyers must assume the risk that a new contract can be forged with key employees.
How Assignment Clauses Impact Contract Transfers
As noted, sellers can freely assign contracts to a new owner if the contract doesn’t have an assignment provision or, more accurately, an anti-assignment provision. Without an assignment clause, the transfer happens automatically and doesn’t even require the other party’s (supplier, customer, etc.) approval of the contract.
Here’s an example. Let’s say you own ABC Construction Company, a business that builds roads. You arrange a sale of your business, and the contract with a gravel supplier is among the assets included in the sale. Your gravel supply contract makes no mention of what happens to the contract if the company is sold, so you and the buyer draw up a purchase agreement that includes assigning the gravel contract to the new owner. The gravel contract transfers without a wrinkle, whether the gravel supplier likes the deal or not.
But what happens if your gravel supplier has more foresight than the one above? If the contract includes an assignment clause, you might be required to get the gravel supplier’s approval to transfer the contract, or worse, you might not be able to transfer it.
An assignment provision restricts a seller’s ability to transfer ownership. Such provisions can put sellers in a bind: They risk a breach of contract lawsuit if they don’t comply, and risk a lower valuation if they can’t transfer their company’s contracts.
What Are Anti-Assignment Clauses?
The reality is most contracts place conditions on transfers. The restriction might be as simple as requiring the written consent of the other party to the original contract (after all, customers, suppliers, landlords, and the like want to have a say in the companies they do business with). At the other extreme, however, contracts can have sweeping anti-assignment clauses that prohibit assignment altogether or restrict assignment of a contract in case of a sale or change of management.
Almost all real estate leases have an anti-assignment clause to allow landlords to not only approve a new tenant but also renegotiate the lease terms.
By law, the reasons for restricting the assignment of a contract must be “reasonable,” but that doesn’t mean you won’t end up in court disputing what’s reasonable or not.
What Happens If a Contract Has an Anti-Assignment Clause?
An anti-assignment clause puts the original party to the contract back into the equation. Whereas a contract with no assignment provisions doesn’t require sellers to consult with the other party to the original contract, an anti-assignment clause requires sellers to negotiate with them in some way.
In legal terms, ironing out the rights to transfer a contract is called “novation.”
In the example above, all three parties—the seller, the buyer, and the gravel supplier—would have to reach a novation agreement to sign off on substituting the seller’s rights and obligations for a new owner.
The parties essentially form a new contract, but it isn’t that simple. The gravel supplier might not want to do business with the new owner or see the sale as an opportunity to renegotiate the contract for better terms.
Now imagine that ABC Construction has a handful of supplier contracts, all with the same anti-assignment provisions. Such contracts could delay the sale or even derail it completely.
The parties can’t novate a contract until the deal closes, so buyers can’t be sure the contract will remain in place if novation is needed. The added risk can decrease a company’s valuation.
Best Practices to Ensure Contracts Transfer Smoothly When Selling Your Business
Buyers and sellers alike should do their homework regarding managing contracts.
Carefully review contracts during due diligence. Buyers should pay careful attention to the language in existing contracts during the due diligence period. Check for anti-assignment provisions that might change the terms of the contract if the business is sold.
Negotiate contracts before you’re ready to sell. It’s a good idea for sellers to hire an attorney to review and, if needed, renegotiate contracts one to three years prior to selling. Remember that anti-assignment clauses can be novated only after a sale transaction takes place, so having a contract favorable to selling your business from the get-go can avoid problems when selling.
Anti-assignment clauses can also jeopardize the confidentiality buyers and sellers typically seek when transacting a sale. If you have to negotiate or renegotiate your company contracts while you’re trying to sell it, you’ll be bringing third parties into the mix who otherwise don’t have reason to know a sale is underway.
Understand government contract restrictions. Contracts with government agencies involve matters of public policy. As such, transferring a government contract is prohibited by law. Buyers should value government contracts accordingly, knowing the contract will have to be renewed after the sale.
Evaluate intellectual property contracts. Similarly, transferring intellectual property contracts requires the written agreement of the IP vendor. Buyers should use the due diligence period to get fully informed on the potential risk of transferring these contracts.
Selling a business is a multi-step process that needs a clear and well-thought-out exit strategy. The earlier you begin exit planning, the better prepared you and your business will be, maximizing its value. It's important to include reviewing business contracts to understand the impact they’ll have on the value of your company as you prepare it for sale. Visit the BizBuySell Valuation Learner Center for resources and information to help ensure a successful outcome.