Buying or selling a business can be complex. Many variables can affect the purchase and sale. These variables will affect your decisions, whether you should make them at all and how you should begin.
There are many favorable aspects to buying an existing business such as drastic reduction in startup costs. You may be able to jump start your cash flow immediately because of existing inventory and receivables.
There are also some downsides to buying an existing business. Purchasing costs may be much higher than the cost of starting a new business because of the initial business concept, customer base, brand and other fundamental work that has already been done. Also, be aware of hidden problems associated with the business like debts the business is owed that you may not be able to collect.
It’s impossible to write a blog post that covers every issue. So this article will highlight some of the common issues that you should keep in mind.
Types of Transactions
Taxable Transactions. In taxable transactions, the seller must pay income tax to the extent the consideration exceeds the tax basis of the seller’s assets or stock. This benefits the buyer who receives a “stepped-up” (purchase price) basis in the assets or stock acquired.
Buyers often elect to structure the transaction as an asset purchase. The goal is to avoid acquiring unknown liabilities. This strategy is frequently, but not always, successful. Buyers also prefer to purchase assets only because to avoid inheriting the seller’s historic low tax basis of the assets (rather than a tax basis equal to the purchase price).
In contrast to an asset purchase and sale, corporate sellers often prefer a sale of stock. This is because a sale of assets can result in a seller paying 2 levels of income tax. First, the seller incurs a corporate tax on the transaction itself. In addition, if the seller’s corporation is dissolved after the sale, a tax may be imposed on the shareholders to the extent their portion exceeds their tax basis in the stock.
The sale of assets by an S corporation generally does not result in this double taxation, unless the S corporation was converted from a C corporation within the prior 10 years.
Tax-Free Transactions. A “sale” of stock can be tax free to the seller if the principal consideration is not money but stock in an acquiring corporation. (We refer to these transactions as “mergers”, and they can be structured in many ways.)
Tax-free transactions benefit sellers, but the buyer often suffers detriment by acquiring the seller’s (historically low) basis.
In asset sales (but not sales of stock), sales tax is generally imposed on the sale of tangible personal property unless the company being sold is a service business (where the “occasional sale” exemption may apply).
Sales tax is imposed even if the only consideration is the buyer’s assumption of liabilities. In the absence of any provision in the purchase agreement to the contrary, the seller is liable for any sales tax.
Listing Assets and Liabilities
There are different types of business purchases. A common form of business purchase involves simply purchasing the assets of an existing business. It surprises us how often a buyer will be willing to spend considerable funds on the assets and then fail to specifically identify them. In an asset sale, the assets being purchased should be carefully listed.
It isn’t enough simply to include a clause that states that the sale includes all equipment, furniture and supplies on the premises. True, this generalized approach will save you time, but just as often as not it will also lead to arguments about what was and wasn’t included.
Your agreement should also list the liabilities (if any) that the buyer is assuming, and it should clearly indicate that no other liabilities are being assumed.
Another type of business purchase involves buying the entire entity, including all shares of the company. When purchasing a business, including stock of an existing company, the buyer should carefully review the seller’s books, and should not rely on a quick review. We recommend that buyers and sellers involve their accountants in the process. This creates added expense but avoids problems.
In addition, it also is not enough to refer generally to the assets listed on the books. Instead, a list of the seller’s assets and liabilities should be created and attached to the agreement. This list should be detailed.
Valuing the Sale
Valuing a business is somewhat subjective and is always the subject of negotiation. Valuation methods include:
Earnings-based valuation. This takes into account historical financial figures, including debt payments, cash flows (past, present and projected) and revenues. Sometimes multipliers of revenues or profits are used; these vary widely from industry to industry. Also, sometimes this is calculated in a return-on-investment approach.
Market-based valuation. This is based on the sale prices of similar businesses in that geographic area. Often business brokers use this method, based on their experiences selling similar businesses in the area. (Business brokers frequently ask for 10%, but like everything else, that is negotiable.)
Asset-based valuation. This takes into account figures such as the book value and liquidation value of the business. Still, these are considered bare minimums in business appraisals and are not generally used as the sole path to an asking price.
The parties should agree on the allocation of the purchase price to various categories as part of the purchase agreement. It is often difficult to reach agreement if this is left until later – so decide it before the agreement is signed. In an asset sale, if the buyer is paying all the sales taxes, then the allocation should definitely be set to best benefit the buyer for tax purposes.
If the seller is paying some or all of any sales tax, though, then allocating more to tangible personal property will increase the seller’s sales tax amount.
Typically, the buyer wants to allocate as much of the purchase price as possible to assets with the fastest tax write-offs – that is, those with the shortest depreciation periods. For this reason, the buyer generally wants to attribute most of the price to business equipment and fixtures. Usually equipment and fixtures can be depreciated over three, five, seven or 10 years. The buyer also generally wants to assign smaller values to intangible assets, because they have a long tax write-off period, 15 years.
Goodwill may not be amortized, so a buyer emphatically will want to allocate the minimum amount to goodwill. Still, in transferring a trademark, goodwill must be specifically transferred as well or the trademark will be lost – so something must be allocated to goodwill.
Adjustments in Price Based on Performance
Buyers often limit their risk by including a performance clause in the purchase agreement. For example, a performance clause might state that if the business’s revenues drop, the buyer will receive an adjustment on the promissory note used to pay the remainder of the purchase price. Correspondingly, a seller may include a provision that increases the amount of the promissory note if the business’s revenues increase.
If you are selling a business, be sure to know your buyers. Have all of them sign a confidentiality agreement, particularly before you provide them with any proprietary information.
Covenant Not to Compete
Most buyers will almost insist that the seller to agree to not start or participate in a competing business. A sale of a business is one occasion in which Arizona will uphold a covenant not to compete. Nevertheless a specific geographic area where the business has been carried on must be specified. Payments specifically allocated to the seller’s covenant not to compete are taxed as ordinary income to the seller and are deductible by the buyer. The allocation must be reasonable in nature and amount. The buyer must amortize the payments over a 15-year period (like other intangible assets). That’s not as good as an allocation to equipment and fixtures, but is still better than a larger allocation to goodwill. In a sale of stock, generally the seller would prefer less or no allocation to a covenant not to compete (which represents ordinary income tax) and more or all to any accompanying stock sale (which is usually capital gains). Often the buyer will want the non-competition provisions to be in a separate agreement, so if there is some argument over adjustments in the purchase agreement then the non-competition agreement will still stand. The seller, of course, may well want the opposite.
Frequently the buyer wants a certain amount held back in escrow to cover any adjustments (due to changes in inventory or accounts receivable, or due to unpaid creditors) or pro-rations (such as taxes, utilities or rent) based on the closing date. The seller, of course, tries to minimize the amount of the hold-back.
Bulk Sales Laws
With sales of assets (though not sales of stock), the buyer must be wary of the Bulk Sales Law. A bulk sale, sometimes called a bulk transfer, is when a business sells all or nearly all of its inventory to a single buyer and such a sale is not part of the ordinary course of business. This type of action is often used in an attempt to dodge creditors who intend to seize such the business’s inventory; in order to protect the purchaser from claims made by creditors of the seller, the seller must usually complete an affidavit outlining its secured and unsecured creditors, which must usually be filed with a government department, such as a court office. Such procedures are outlined in the bulk sales act of most jurisdictions. If the buyer does not complete the registration process for a bulk sale, creditors of the seller may obtain a declaration that the sale was invalid against the creditors and the creditors may take possession of the goods or obtain judgment for any proceeds the buyer received from a subsequent sale.
Some States, but not all, have repealed this law. But if you are buying or selling a business in a State where the law still applies you should be aware of it. Generally, this law applies when the seller’s principal business is the sale of inventory from stock, including those who manufacture what they sell, or that of a restaurant owner; and the sale is not in the ordinary course of business; and more than half the seller’s inventory and equipment is sold. Essentially, the Bulk Sales Law makes the buyer liable to pay the debts of the selling company – although unless agreed otherwise, the buyer has the right to recover these amounts against the seller.
If the buyer is continuing the seller’s business, the buyer may be liable under a “successor liability” theory for any product-liability suits brought by pre-closing customers. It’s a good reason to have an indemnification clause running from the seller in favor of the buyer, and to check out the business’s insurance as well.
In addition to all the other due diligence that the buyer conducts, the buyer should hire an accountant to examine the seller’s books and determine if any adjustments in the purchase price are needed. This is crucial. The seller will want to have a specific time limit placed on all due diligence so that if no objection is made by the specified deadline the due diligence results are deemed satisfactory to the buyer. Buyers may want to conduct a UCC search to see if there are liens against the business. We always recommended this. We also recommend that buyers investigate a company to determine what litigation has been filed against the business. Use a service like www.lexis.com. (Often, though, the buyer will be satisfied with contract provisions that state that the seller warrants there is no litigation unless expressly listed – and that the seller will indemnify the buyer if there is any breach of this warranty.)
Buyers may want to check with the Better Business Bureau to see if any consumer complaints have been filed regarding the business. If you believe that there may be environmental issues, see if the county where the business is located has an “Environmental Health” unit – and call them to ask if there are any problems at the location.
Assignments of Leases and Contracts
If existing leases are important, the buyer should include provisions stating that closing is contingent on the landlord’s approval of the leases using the current rents and lease provisions. Similarly, if existing contracts are important, the buyer should either make sure that the contracts allow assignment or include provisions stating that closing is contingent on the other parties to the contracts agreeing to the assignment.
Licenses and Permits
The seller should represent that it has all licenses and permits needed to operate the business, and that these can all be transferred to the buyer. The buyer should investigate if there will be any fees from the issuing authorities for these transfers – or if the issuing authorities will require the buyer to qualify in some way.
In addition to many other warranties (and indemnification provisions), if intellectual property is being transferred, the buyer generally will want the seller to warrant that the seller owns the intellectual property and will indemnify the buyer for any third-party claims of infringement.
Pre-Closing and Post-Closing
For smaller transactions in particular, if the buyer needs training to operate the business, the purchase agreement should state precisely how much (in hours or days) pre-closing training and post-closing consulting will be provided by the owner and what (if any) compensation will be paid to the owner for this. (For example, this could be done as a maximum number of hours per week for a set number of weeks.)
From the seller’s point of view, the agreement should specify that this time is for training or consulting only, and not for running the business. It may also be important for the seller to limit the days and times during which training and consulting will be provided (e.g. 9:00 to 5:00, M-F) so that the buyer does not try to have the seller be present at unusual times. The seller will often want to limit how far he/she must travel, in case the new owner relocates the business.
For some entrepreneurs, buying an existing business represents less of a risk than starting a new business from scratch. While the opportunity may be less risky in some aspects, you must perform due diligence to ensure that you are fully aware of the terms of the purchase.
If you have decided to buy an existing business, you will want to be sure you are making the right choice in your new venture. Only you can determine the right business for your needs.