Selling a Business by Auction

Owners often ask, “Can I auction off my business?”  Selling by auction sounds appealing because it seems to guarantee the highest sale price.  However, some advisors reject the idea.

In this article:

• First, I will discuss the potential challenges and pitfalls of using an auction.  
• Second, I will discuss our approach to auctions and how it circumvents the pitfalls.  
• Third, I will weigh the advantages and disadvantages of implementing an auction.
• Fourth, I will discuss the types of business that are suitable for auction

In an auction for a painting, the second when the auctioneer says “sold,” a buyer and seller enter into a binding contract with the following terms:  The buyer will pay their bid by a certain date and the seller represents that the painting is legitimate.

As we parse the elements of the last sentence, we can imagine the challenges for a business sale auction:

1. Binding Contract.  In a non-auction business sale, the buyer and seller negotiate their purchase agreements in what can be costly process.  However, in an auction, all bidders must submit binding offers that fill in certain blank spaces in a non-negotiable purchase agreement.
   1. Challenge: The contract therefore must be acceptable to all bidders.  
   2. One might ask, “What if the bidders submitted non-binding offers and the full terms of the purchase agreement were left to be negotiated after the completion of the auction process?”  That is unworkable because nothing stops the winning bidder from negotiating a purchase price lower than their winning bid or requesting terms that are unacceptable to the seller.  In either case, the seller might wish to resume conversations with the second-highest bidder.  The expectation that this might occur destroys the auction process.  Therefore, if bids do not bind bidders to a purchase contract, then effectively there is no auction.

2. Payment Terms.  In a business sale, the seller usually receives payment from the buyer in multiple ways, including, for example, payment at closing, a share of future revenue, and transition consulting fees, to name just three.  The seller and each buyer will be open to a different set of payment structures.  The purchase contract should be flexible enough to accommodate all qualified parties’ payment structure constraints.  The red, green, and blue shapes in the below diagram depict the payment structures that Buyer A, Buyer B, and the seller are willing to accept.  The region containing tiny diagonal lines represents the payment structures that all three parties are willing to accept.  If the purchase agreement is not flexible enough to allow any bids within that region, then at least one of the three parties will not participate in the auction.  For example, if the agreement requires that 100% of the purchase price be paid at closing, then neither of the buyers will ll participate.

3. Representations.  The representations that the seller makes about the business for auction must be comprehensive.  They should specify practically all that the buyer would uncover during due diligence.  In the event that representations are deemed materially false by an expert, the buyer will have a right to annul the purchase agreement.

Here is how we would conduct an auction, although modifications can be made to fit the needs of a seller.

Chronology  

1. Marketing. Market the business for sale at auction and invite qualified parties to participate.
2. Contracts. Finalize all necessary sale-related agreements.
3. Auction. Auction closes.  At this point, all sale-related agreements are fully executed.
4. Deposit. Non-refundable deposit is put into escrow.
5. Due Diligence. Due diligence occurs and financing is committed.
6. Closing. Closing occurs unless one of the conditions for aborting the transaction is met.

Closing Documents

At the time of auction, all necessary agreements will be presented to the bidders in the form of binding offers from the seller’s entity and its owners.  These agreements will likely include the following (and possibly others):

• Auction process agreement
• Asset purchase agreement
• Promissory note
• Consulting agreements for the owners
• Assignment agreements for assigning certain contractual relationships
• Expert determination agreement
• Escrow agreement

Representations

Critically, the representations and warranties section of the purchase agreement will include representations whose truth or falsehood can be determined during due diligence.  These will include a comprehensive list of facts about the business, especially regarding finances.  If any of these is determined to be materially false, where “materially” would be precisely defined, then the winning bidder would have the right to call off the deal and collect a breakup fee from the company.  The size of the breakup fee would vary per representation and be proportionate to the extent to which the company should have known the veracity of the representation.  A breakup fee sounds painful, but its presence will make buyers willing to place higher bids.

The contract will determine whether representations were materially false using expert determination, as explained in the next section.

Expert Determination

We have developed a 12-page expert determination agreement by working with several attorneys and business owners.  If incorporated into any contract, this agreement provides a legally binding answer to any objective or subjective question.  It can thereby resolve most predictable disputes.  It resolves disputes at low cost, at relatively fast speed, with minimal vulnerability to the answer being overturned by litigation, and with a high level of fairness and justness.

The expert determination agreement is the linchpin:  It is the deal’s source of integrity.  It enables each party to believe that the other is acting in good faith and will keep their promises.

There are other auction types, but none is expected to generate a higher price than a Vickery auction.

If you would like to learn more about auction types, here is a good resource.