Buying a California business — without inheriting its problems.

The threshold decision — asset purchase vs. stock purchase#

Every California acquisition starts with one structural choice that determines almost everything else: are you buying the seller's assets, or are you buying the entity that owns the assets? The choice has substantial consequences for tax treatment, liability exposure, transferability of contracts and licenses, employee continuity, and even the closing mechanics.

Asset purchase — buyer-preferred in most California deals#

The buyer acquires specifically identified assets of the business and assumes specifically identified liabilities. Everything not listed stays with the seller. Tax benefit: buyer gets a stepped-up basis in the acquired assets, which produces depreciation and amortization deductions over future years (under IRC §1060 allocation rules). Liability benefit: buyer doesn't assume the seller's unknown or undisclosed liabilities — tort claims, tax liabilities, employee claims, environmental issues — except those expressly assumed. Friction: requires consent to assign material contracts (anything with an anti-assignment clause), re-registration of permits and licenses, and rehiring of employees with new offer letters.

Stock purchase — usually seller-preferred#

The buyer acquires the equity (stock or membership interests) of the entity that owns the business. The entity continues to exist with all its assets, contracts, licenses, and liabilities — known and unknown — now under new ownership. Tax friction for the buyer: no basis step-up in the underlying assets unless an IRC §338(h)(10) election is made (and that election has its own constraints). Liability friction for the buyer: inheriting everything, known or not, is the central risk — the buyer's protection becomes the reps and warranties plus indemnification rather than the structural exclusion that asset deals provide. Operational benefit: contracts, permits, licenses, and employee relationships continue without consent or rehiring.

The hybrid — §338(h)(10) election#

When the buyer wants the operational simplicity of a stock purchase but the tax treatment of an asset purchase, a joint §338(h)(10) election lets the parties treat the transaction as an asset sale for tax purposes while still legally transferring stock. The election is only available for S-corp targets (and certain consolidated-group C-corp targets); it requires the seller's cooperation since both parties sign the election. The election produces buyer's tax preference (basis step-up) and seller's tax friction (gain recognition on the deemed asset sale), so the price typically reflects the trade-off.

Due diligence — what actually gets investigated#

Due diligence is the buyer's investigation of what they're actually buying — before the deal closes and the seller's reps and warranties become the only protection. The work that matters most happens in the four-to-six-week window between LOI signing and definitive-agreement execution. Diligence findings often shift the price, restructure the deal, or terminate it entirely.

Legal diligence: corporate records (formation, good standing, authorized capitalization, officer/director records), material contracts (especially anti-assignment clauses for asset deals), litigation history (pending, threatened, settled), regulatory compliance, employee matters (classifications, wage-and-hour exposure, equity grants, key-employee retention risk), intellectual property (ownership, registrations, third-party licenses), real estate, environmental issues, insurance coverage.

Financial diligence: audited or reviewed financials going back 3+ years, quality-of-earnings analysis (EBITDA adjustments, one-time vs. recurring items, owner compensation normalization), working capital trends, customer concentration, supplier dependencies, accounts-receivable aging.

Commercial diligence: customer interviews (under appropriate confidentiality), market positioning, competitive landscape, product or service quality assessment, key-person dependencies, employee morale and turnover, brand and reputation.

California-specific diligence focal points: (a) ABC test classification analysis for any independent contractors who might be misclassified under Cal Labor Code §2775, (b) wage-and-hour audit (meal/rest premiums under §226.7, pay-stub compliance under §226, final-paycheck procedures under §201–§203), (c) PAGA exposure assessment, (d) CCPA / CPRA compliance for customer data, (e) Cal Civ Code §1542 release-language review in any existing settlements that may be transferred.

The Letter of Intent — what's binding, what isn't#

The Letter of Intent (LOI) is the document that gets executed once the parties have a meeting of the minds on the major terms but before due diligence is complete. The LOI is typically a mixed document — most of it non-binding (price, structure, indicative timeline) and certain provisions binding (exclusivity, confidentiality, expense allocation).

The binding provisions deserve the most negotiation attention. Exclusivity (no-shop) gives the buyer a defined window to do diligence without the seller talking to other bidders — typical durations are 30 to 90 days. Too short and the buyer can't finish diligence; too long and the seller is locked up while the buyer has every reason to slow-walk. Confidentiality binds both parties on information disclosed during diligence. Expense allocation typically requires each side to pay its own costs through closing.

Common LOI traps: (a) ambiguous price formulas that don't actually fix the price ("approximately $X subject to adjustment" creates renegotiation leverage for whichever side is unhappy), (b) overlong exclusivity periods (90 days is the practical maximum; 120+ days lets the buyer extract concessions for not killing the deal), (c) no break-up fee (which would compensate the seller if the buyer walks for non-diligence reasons), (d) overly aggressive no-shop clauses that prohibit the seller from accepting unsolicited offers (problematic for fiduciary-duty reasons in some entity types), and (e) representations that look non-binding on their face but include enough specifics that they become enforceable promises.

The definitive purchase agreement — architecture#

The definitive purchase agreement (Asset Purchase Agreement or Stock Purchase Agreement, depending on structure) is the document that actually transfers the business. Most California acquisition agreements share a structural skeleton: parties and recitals, purchase price and adjustments, representations and warranties (seller's and buyer's), covenants (interim operating and post-closing), closing conditions, indemnification, termination, and miscellaneous.

Purchase price structure is where deal terms become deal mechanics. Cash at closing, deferred consideration, earnout, equity rollover, seller-financed promissory notes, and working-capital adjustments all interact. The simplest deals are all-cash-at-closing with a working-capital target; the most complex involve multiple components with different timing, contingencies, and tax treatments.

Working capital adjustments are the single most common post-closing dispute. The mechanic: the parties agree to a target working capital level (defined precisely in the agreement); at closing, the actual working capital is estimated and the price adjusts; post-closing, the final working capital is calculated and a true-up payment moves in whichever direction the math runs. The disputes arise from definitional issues (what counts as working capital? which accounting principles apply? are normalization adjustments allowed?) and from the inherent ambiguity in mid-cycle financial statements.

Representations and warranties — the buyer's protection layer#

The seller's representations and warranties are the contractual statements about the business — what it owns, what it owes, what it's done, what condition it's in. Reps and warranties are the buyer's primary contractual protection against discovering, post-closing, that the business is different from what was represented. A breach of reps and warranties triggers indemnification claims; in extreme cases (fraud), it can trigger rescission or punitive damages.

Categories of representations#

Fundamental reps: seller has authority to sell, has good title to the assets/stock, the transaction won't violate other agreements. Fundamental reps typically survive longer than general reps (often indefinitely) and have higher (or no) caps on indemnification.

Operational reps: financial statements are accurate, no undisclosed liabilities, material contracts identified and assignable, no undisclosed litigation, IP is properly owned, employees properly classified, taxes paid, no environmental issues, compliance with laws, customer and supplier relationships described accurately.

Knowledge qualifiers: many reps are limited to the seller's actual knowledge or knowledge of specific individuals. The knowledge definition is heavily negotiated — does it mean actual knowledge only, or constructive knowledge that a reasonably diligent person in the role would have? Different definitions produce dramatically different indemnification outcomes.

Materiality qualifiers and scrapes: reps often include materiality qualifiers ("all material contracts," "no material adverse change"). Materiality scrapes in the indemnification section let the buyer ignore materiality qualifiers for purposes of calculating damages — converting "the financials were materially accurate" into a strict-liability indemnification standard. Highly buyer-favorable when fully scraped; heavily negotiated.

Indemnification, escrow, and R&W insurance#

Indemnification is the contractual mechanism for the buyer to recover from the seller when a representation turns out to be false. The architecture has several moving pieces:

Survival periods. How long after closing the reps continue to be enforceable. General reps typically survive 12–24 months; fundamental reps survive longer or indefinitely; tax and environmental reps often survive until the underlying statute of limitations runs.

Baskets and deductibles. A threshold below which the seller has no indemnification obligation. A "tipping basket" means once losses exceed the threshold, the seller indemnifies from dollar one; a "deductible basket" means the seller indemnifies only for losses above the threshold. Baskets typically range from 0.5% to 1% of purchase price.

Caps. Maximum indemnification exposure. General reps usually capped at 10–15% of purchase price; fundamental reps capped at the full purchase price or uncapped; fraud is typically uncapped.

Escrow. A portion of the purchase price held by a third-party escrow agent for the survival period, providing a funded source for indemnification claims. Typical escrow amounts: 5–10% of purchase price, with periodic releases as survival periods expire.

Representations and warranties insurance (R&W insurance). A third-party insurance product covering breach-of-rep losses. R&W insurance has become standard on California deals above $25M and is increasingly common on smaller deals. The buyer's policy (buy-side R&W) covers the buyer's losses; the seller pays a smaller indemnification cap (or none); the policy provides recovery from the insurer rather than the seller. Premiums typically run 2.5–4% of the coverage limit. R&W insurance has reshaped how mid-market California deals are structured.

Earnouts — the deal-maker and the lawsuit-generator#

An earnout is deferred consideration payable to the seller based on post-closing performance of the acquired business. The classic structure: a portion of the purchase price (typically 10–30%) is contingent on the business hitting defined performance targets over 1–3 years post-closing.

Earnouts get deals done that wouldn't close otherwise. The seller believes the business is worth $10M; the buyer believes it's worth $7M based on observable performance. The earnout bridges the gap: $7M at closing plus up to $3M based on the business hitting the seller's projections. Both sides agree to the price; the question of what the business is actually worth gets answered by what it actually produces.

Earnouts are also the single largest source of post-closing litigation in California M&A. The disputes typically cluster around four issues: (a) calculation methodology (what counts as revenue or EBITDA? how are adjustments handled?), (b) buyer's operational decisions that affect the earnout (the buyer cuts marketing spend, redirects sales effort to other acquired businesses, changes pricing — all of which suppress the earnout), (c) good-faith covenants implied or expressly stated (does the buyer have a duty to operate the business to maximize the earnout? to merely operate in good faith?), and (d) acceleration triggers (events like a subsequent sale, change in control, or material restructuring that accelerate the earnout obligation).

Well-drafted earnouts address these issues directly: precise calculation definitions, explicit covenants about operational decisions during the earnout period, clear acceleration triggers, dispute-resolution mechanics for earnout disagreements. Earnouts without these provisions become lawsuits within 18 months of closing.

Closing conditions and the gap period#

Most M&A deals have a gap between signing the definitive agreement and closing — typically 30 to 90 days, sometimes longer for regulatory approvals or third-party consents. The conditions to closing govern what has to be true at closing for the parties to be obligated to close.

Typical conditions: accuracy of representations as of closing (with materiality and MAC qualifiers), performance of pre-closing covenants, receipt of required third-party consents, regulatory approvals (HSR if applicable, FCC, state licensing transfers), no material adverse change, delivery of closing documents and disclosure schedules.

The Material Adverse Change (MAC) clause is the gap-period escape valve. If a defined material adverse change occurs to the business between signing and closing, the buyer can refuse to close. MAC definitions are heavily negotiated — what counts as material, what categories of changes are excluded (industry-wide trends, general economic conditions, war or pandemic), and what the buyer has to prove to invoke the MAC. The standard for invoking MAC in California is meaningful but not impossibly high; well-drafted MAC clauses with appropriate carve-outs survive judicial scrutiny on legitimate buyer concerns.

Post-closing — integration, transition services, and disputes#

Closing isn't the end of the transaction; it's the start of post-closing execution. The first 90 days post-closing typically involve: integration of operations (systems, processes, branding), employee onboarding (with offer letters re-issued for asset deals), customer notification (for relationships materially changed), supplier transition (for asset deals requiring consent), transition services from the seller (often 60–180 days where the seller continues to provide specific services to the buyer to ease the handover).

Non-compete and non-solicit from the seller are common post-closing seller obligations. California's general prohibition on non-competes under Cal Bus & Prof Code §16600 has a specific carve-out for sales of business goodwill under §16601 — non-competes are enforceable against the seller of a business as long as they're tied to the goodwill being sold, limited in geography and duration to what's reasonably necessary, and entered into in connection with the sale. The §16601 carve-out is one of the rare situations where California allows post-employment / post-sale non-competes.

Common post-closing disputes: working capital true-ups, earnout disagreements, breach-of-rep claims, transition-services-quality disputes, non-compete enforcement when the seller starts a competing business, and employee-poaching claims under non-solicit provisions. The acquisition agreement's dispute-resolution mechanism (court litigation, arbitration, or hybrid) governs how these disputes get resolved.

Why same-firm representation matters here#

M&A transactions are the canonical case for combined transactional-and-litigation expertise. The deal-side work has to anticipate the dispute-side work: which provisions are most likely to be litigated, which representations have the highest breach risk, which earnout formulas produce the most predictable outcomes, which indemnification mechanics actually function under stress. The dispute-side work has to read the deal documents with the awareness of how they were drafted, what was negotiated, and what the parties actually intended.

Same firm structures the deal. Same firm litigates if the deal goes sideways. That continuity matters because M&A disputes frequently turn on drafting nuances that only the drafter fully understands. The firm that drafted the earnout knows what the working-capital target was designed to achieve, why a particular materiality qualifier was added, what the indemnification cap was negotiated against. M&A litigation done by a firm seeing the agreement for the first time after closing produces dramatically different outcomes than litigation by the firm that drafted it.