Michael J. Meehan writes:
In a typical purchase agreement (e.g., an asset purchase agreement or stock purchase agreement), the seller is generally required to convey the property in question “free and clear of all liens and encumbrances.” If you are an entrepreneur planning an exit, you must have a working knowledge of the concept of “encumbrances.”
In many scenarios, the concept is simple (for example, a buyer may require the payoff of an existing mortgage before purchasing an office building). But lenders can encumber your corporate property in a variety of other ways. For example, a lender may require that the assets or receivables of your business be provided as collateral for the loan. Typically, the lender will prohibit the business from selling the assets in question without the lender’s consent. Therefore, the sale of the assets results in a potential double-edged sword for you as the business owner, as you risk violating both the purchase agreement (by failing to disclose the encumbrance) and the loan agreement (by transferring the assets without permission).
Consider, for example, a start-up that takes out a line of credit in its early stages. The line of credit is secured by the company’s assets, including its receivables. Years later, the company is profitable and operating at several locations, and the owner desires to sell one location to focus on the others. She finds a buyer and is presented with an asset purchase agreement containing standard encumbrance provisions. Even though she is selling only certain assets of the business (and not the entire business), she still must disclose and address the line of credit because the assets are encumbered by that loan. Ideally, the business owner can contact the lender and obtain a waiver that permits her to sell the assets; if not, the lender may require that the credit line be reduced or paid off prior to the transfer.
Encumbrances can also arise outside of the lending context. Tax liens, code violations, property easements, lease restrictions and equipment leases are all potential issues that may need to be disclosed or addressed in response to a standard encumbrance provision.
In helping you prepare for the sale of your business, your corporate attorney will run a lien search on your company to identify encumbrances and liens. However, not all liens are properly recorded and some can be missed. Therefore, as an entrepreneur who understands the effect of encumbrances, you can minimize risks, delays or impaired valuations associated with the sale of your business by working with your attorney during the diligence period to identify and address these issues.
Michael J. Meehan is an associate in the firm’s Exton, PA office.