The past few years have seen dramatic shifts for mergers and acquisitions involving automotive dealerships. It has been estimated that approximately 3% of dealerships undergo a change of ownership in an average year. In the early days of the COVID-19 pandemic, however, deal flow in this sector nearly came to a complete halt due to the nationwide lockdown and a lack of demand. By early 2021, the industry had effectively made a full recovery in spite of supply chain and inventory challenges and M&A activity in this space rebounded accordingly, with a record 383 transactions completed in 2021, and an estimated 374 transactions completed in 2022. Despite larger U.S. economy macroeconomic headwinds and leveling consumer demand, buy/sell activity in the auto dealer sector is expected to remain robust in 2023 and beyond as several prominent acquirors continue to deploy their capital and more sellers coming to market due to a variety of reasons, including estate planning and general uncertainties about the larger economy.
If you are considering buying or selling an automotive dealership, this article provides an legal overview of the major elements of a buy/sell transaction that the parties must consider and negotiate to successfully consummate a deal in this specialized industry.
1. Structuring the Sale
While there are many nuances to structuring a dealership sale transaction, the first major decision the parties will need to make is whether the transaction will be structured an asset sale or a stock sale.
- Asset Sale: In an asset sale, the dealership entity is not sold. Instead, it sells substantially all of its business assets to the buyer, including inventory, parts, contracts (including leases), WIP, owned real property, FF&E and goodwill, but excluding cash and other specifically negotiated assets. While it is a point of negotiation, the buyer also typically assumes a fairly narrow set of liabilities that are specifically identified, such as post-closing executory obligations under assumed contracts, with all other pre-closing liabilities remaining with the seller. At the closing of the deal, dealership employees are terminated by the seller and immediately hired by the buyer. In this structure, the buyer is able to cherry pick the assets and liabilities they take and receive a broad indemnification protection for any pre-closing liabilities of the business. However, because contracts and other assets are actually being transferred from one legal entity to another, an asset sale requires the parties to complete a greater volume of ancillary paperwork (e.g., contract assignments, trademark assignments, vehicle title transfers, etc.), and also typically requires the parties to obtain more third party consents, which can delay a deal.
- Stock Sale: By contrast, in a stock sale, the shareholders of the dealership entity sell the stock of the entity to the buyer. Because the buyer purchases the entity itself, buyer is indirectly acquiring all of the assets and assuming all of the liabilities of the purchased entity. Likewise, there is no need to terminate and rehire dealership employees, as they will continue to work for the same entity post-closing. Unlike in an asset sale, where the buyer can disclaim all pre-closing liabilities and seek indemnification from seller for all such liabilities, in a stock sale, the buyer’s indemnification rights are typically limited to inaccuracies in the representations and warranties given by the shareholders on the closing date, and other specifically negotiated items, such as pre-closing taxes, known material litigation or environmental liabilities. There are typically fewer third party consents required to consummate a stock sale.
Given their disparate risk allocation profiles, buyers typically favor an asset sale and sellers typically favor a stock sale. In practice (and in contrast to other industries), most auto dealer transactions are structured as asset sales. There is no legal reason for this dynamic, which appears to be driven by generally accepted industry precedent and the disparate negotiating leverage that tends to exist in this industry between buyers, who are often large and well-finance consolidators, and sellers, many of whom are smaller, family-owned businesses looking for an exit. Sellers of high value assets in a competitive process, however, can often utilize the auction sale process to their advantage to structure the transaction as a stock sale.
2. Determination of Purchase Price
As you would expect, the buyer and seller will devote significant time to negotiating the applicable purchase price for the auto dealership, which typically consists of the following items:
- The Goodwill/Blue Sky Value: Goodwill represents the premium/going concern value of the dealership over the value of its underlying assets, and is an integral part of a buyer’s offer. This is a fixed amount and is typically not subject to any adjustment.
- Value for Vehicles:
- New Vehicles: New vehicles typically include vehicles that are not registered and have never been sold to a customer, subject to a maximum mileage and potential exclusion based on model years. New vehicles are typically priced at the factory invoice cost, net of incentives, with deductions for miles and the cost of minor repairs.
- Used Vehicles: Used vehicles include all vehicles in inventory other than new vehicles. Prices are often negotiated on car-by-car basis, as part of the pre-closing inventory process.
- Service Vehicles: Service vehicles typically include loaner vehicles and vehicles that are used for test drives and other dealer/corporate purposes. Parties negotiate different pricing models for these types of vehicles. They are sometimes treated as new vehicles with additional price reduction for excess mileage. Other times, they are priced like used vehicles.
- Parts and Accessories: Parts and accessories are typically priced based on manufacturer published prices, with allowances for obsolete inventory. Parties typically hire a third party servicer to take inventory of parts and accessories immediately prior to the closing.
- Work-in-Process: Work in process is typically priced at cost (i.e., cost of labor, parts and sublet repairs), but the seller sometimes negotiates a different methodology that shares the margin of the work performed between the buyer and the seller.
- Furniture, Fixture, Equipment, other personal property: FF&E and other personal properties are typically priced based on their depreciated book value.
- Cash and Other Working Capital. Cash and other working capital items (such as A/R and A/P) are typically excluded in an asset sale. However, in a stock sale, such items need to be separately addressed. For example, the seller typically gets credit for every dollar of cash that is left in the target entity, net of any debt that is not paid off at the closing. Similarly, the net A/R typically adjusts the Purchase Price on a dollar-for-dollar basis.
3. OEM Consent and Right of First Refusal
Virtually every dealer agreement includes a “change of control” and/or “anti-assignment” clause which gives the OEM the right to block or consent to a buy/sell transaction, regardless of whether the transaction is structured as a stock or asset sale. As the dealer agreement is at the heart of the value of a dealership, a closing cannot happen from a practical standpoint then without OEM approval and significant consideration will accordingly be given to the consent process. While the seller plays an important role in obtaining this approval by leveraging its existing relationship with the OEM, ultimately, it is the buyer’s identity, reputation, financial capacity and track record that will determine the outcome – the OEM must be convinced that the dealership will continue to perform as well (or better) under the buyer’s stewardship. If the buyer is an industry insider and currently operates one or more well-performing dealerships with the same OEM, the chance of approval will increase significantly. The OEM will typically perform business due diligence on the buyer before addressing the consent request. They may also make a number of commercial demands as a condition to approving the transaction (e.g., additional capital investments, better terms, etc.). When negotiating the purchase agreement, the seller should specifically address the buyer’s obligations with respect to these types of OEM demands. Otherwise, the buyer would have a de facto option to terminate the transaction by refusing to accept any OEM demands.
The OEMs also typically have a right of first refusal (“ROFR”) on any buy-sell transaction. If exercised, the OEM or their designee (including other dealers) can purchase the dealership instead of the original buyer, on the same terms as those negotiated with the buyer. The parties have to assess the risk of the OEM’s exercising the ROFR based on their existing relationships, current market conditions (i.e.., how attractive is the brand and will the manufacturer be able to find a third party willing to purchase) and the reputation of the buyer. Practitioners have come up with creative ways to discourage a ROFR exercise, such as adding a high termination fee in favor of the buyer that gets triggered by a ROFR exercise, which fee is typically required to be borne by the replacement purchaser exercising the ROFR (in this case, the OEM itself). In the case of multi-dealership sales, the parties also often consolidate the sales into a single transaction, which allows them to take the position that any OEM exercising their ROFR must purchase all of the dealerships, providing further disincentive to exercise. As these types of legal maneuvers can harm their relationship with the OEM in question, however, the parties should carefully consider whether these strategies are justified.
4. Real Property Considerations
Securing long term access to dealership real property is critical for business operations. Buyers will want to ensure that they have access to the location for the long term because a material potion of the goodwill is specifically tied to the location.
If the dealership real estate is currently owned by the seller (or an affiliate of seller), such property may be transferred to the buyer for additional consideration, which may require a separate real estate purchase agreement. Alternatively, the seller may retain the real estate and enter into a long-term lease for the property, sometimes with a purchase option attached. Note that while an existing related party lease may be in place for the location in question, this lease will generally need to be replaced as such agreements are often not on “market” terms or are otherwise inadequate to address various risk allocation issues. Accordingly, buyers and sellers need to allow themselves sufficient time to negotiate and document these various real estate agreements.
If the dealership real property is leased from a third party, then the underlying lease will either automatically transfer to the buyer (in the case of a stock sale) or need to be assigned to the buyer (in the case of an asset sale). In either case, the buy/sell transaction will likely trigger a separate consent requirement. As with the OEM consents, the parties will have to work with each other to provide the third party landlord with assurances that buyer is a creditworthy counterparty that will continue to perform under the lease.
Because dealership properties often provide services that involve the handling of hazardous materials (such as servicing departments, underground storage tanks/fueling stations, and car washes), buyers, as well as their lenders and insurers, have heightened sensitivity with respect to environmental issues. In the course of their due diligence, buyers will typically hire environmental consultants to conduct “Phase I” investigations on each real property, which generally involves non-invasive examinations. To the extent “Phase I” reports flag items of material concern, buyers may also require “Phase II” investigation of the specific sites, which involves drilling holes into the property to collect investigative samples and other invasive examinations. A “Phase II” investigation adds significant lead time to the transaction and could trigger ongoing legal obligations for the property owner to further investigate and/or remediate the underlying issues. Because the company sale will still be pending when these investigations are completed, the seller bears the risk of uncovering a material issue that causes the buyer to abandon the transaction, leaving the seller with newly discovered remediation obligations. Consequently, it is important for the seller to limit the buyer’s ability to conduct such invasive testing and as well as negotiating legal responsibility for any problematic findings.
5. Floor Plan Financing
Auto dealers typically utilize floor plan financing to finance the purchase of their lot inventory. Floor plan financing is effectively a specialized line of credit that is secured by the vehicle inventory. In an asset sale, the seller must arrange a payoff of the financing and the transfer of the collateral to the buyer’s lender. In a stock sale, the parties have the option to maintain the current floor plan financing with the lender’s consent, or to replace it with the buyer’s floor plan financing. The collateral transfer process is both simple and time-consuming, as the representatives from both lenders physically inspect the vehicles in person. Lenders offering floor plan financing are generally familiar with the buy/sell dynamic and the parties involved, and the representatives from the old lender and the new lender typically work together to ensure a smooth transition.
Auto dealers are some of the most sophisticated and successful entrepreneurs in the modern economy. A well-run dealership with a loyal customer base can reliably generate significant profits for years, making them very attractive acquisition targets. And while profitability in this space generally fluctuates with the U.S. economy at large, for a variety of reasons, the businesses themselves trade in both good times and bad. The record number of transactions from 2021 may not be replicated in the near term, but we are likely to see consistently elevated transaction levels for the foreseeable futures, making it more important than ever that parties to a transaction in this space be aware of the number of unique legal concerns they will face as part of their deal process.