Deal Terms

Deal Terms Come Into Play When Structuring The Sale Of A Small Business.

 

Attention to deal terms can affect a successful sale and get beyond simply negotiating price. Benefits can accrue to both the seller and the buyer. Keep in mind too, that both legal and tax professionals should be consulted during deal term negotiations.

In short, getting 100% of the sale proceeds at closing for the seller maximizes his/her tax liability and usually results in a lower selling price. And, paying 100% of proceeds due at close opens the buyer to maximum risk of a successful transfer and continued business operational success.

So, it’s important to address the deal terms as a way to negotiate solutions to both buyer and seller to arrive at a mutual meeting place.

 

Key issues in negotiating deal terms have to do with a number of factors:

  • What is the structure of the business? LLC? Sole Proprietorship? S Corp? Partnership? C Corp?
  • What is the type of Sale? Asset? Stock?
  • What is being sold? Entire business? Partial interest? Investment? With Real Estate?
  • Is it an Installment Sale? Seller Financing?
  • Who is the buyer? Financial buyer? (Entrepreneur) Strategic Buyer? (Corporation? Equity Fund?) Family Member? (Succession)
  • What are the plans after Close? (Short Term? Intermediate? Long Term?)
  • (Consulting Agreement?  Employment Agreement? Covenant not to Compete?)
  • What is the buyer’s and seller’s personal tax situation?

 

Deal terms, financing and tax management should be addressed early in the process in order to maximize mutual benefits to buyer and seller. In an asset sale, attention to the allocation of purchase price among the different asset classes is another negotiating tool and can significantly benefit buyer and seller.

From a legal standpoint, the entity type will have different legal and tax consequences. Sole Proprietorships, LLCs, Partnerships, and S Corps are pass through entities to the owners. There are many complexities in asset sales. C Corps are not pass through entities and are handled differently. They are often stock sales as opposed to asset sales. The legal structure thus plays a significant role in determining whether the sale is an asset sale or stock sale.

Determining what is being sold can affect greatly whether the sale ought to be an asset sale or stock sale.

With an asset sale, the legal entity and tax identity do not transfer to the purchaser. The Buyer receives a stepped-up tax basis in the assets acquired equal to the FMV purchase price, the point from which new depreciation is started. Under a stock sale, the tax basis of the assets remains unchanged, and all of the tax attributes, including depreciation methods, tax year, corporate tax election, are preserved.

 

Liabilities: With an asset sale, the Buyer’s liability is limited. The Buyer is purchasing some or all of the assets and has the option to identify any liabilities they are interested in assuming. Under a stock sale, the Buyer purchases the stock of the company and assumes all liabilities (known, unknown, contingent or otherwise).

 

Contracts: Most businesses have contracts in one form or another. The most common are commercial real estate leases, contracts involving business relationships, and contracts with employees. An asset sale transaction involving the assignment of these contracts requires considerably more work and has a potentially a different outcome than a stock sale. Contracts need to be evaluated to determine if they permit an assignment without consent. Should they not permit assignment without consent, third party consent will need to be obtained. In stock sale transactions, the legal entity that is the party to the contract continues, and the general rule is that the contract remains in force between the original parties. (No consent to assignment is needed, as assignment typically does not occur). There are exceptions, as some contracts stipulate that a change in ownership of the business will be considered an assignment of the contract. If such a ‘change of control’ clause exists in the contract, the same issues will arise as with an asset transaction. Performing due diligence and having legal counsel thoroughly review all of the company’s contracts will be critical to determine the available options.

 

Covenant Not to Compete: A covenant not to compete (CNTC) is a contractual condition by which the seller promises to refrain from conducting business or professional activities of a nature similar to those of the business being sold. In a contract for the sale of a business, a reasonable value can be allocated to a ‘covenant not to compete’ which is generally enforceable provided it is reasonable and limited as to time and territory. The buyer may amortize this amount over 15 years even though the actual term of the CNTC is usually much shorter. For this reason, buyers often prefer a larger amount be allocated to tangible assets or a consulting agreement with a shorter useful life. In order to be legally binding, it is recommended that some consideration be allocated to a CNTC.

 

Independent Consultant: Depending upon the goals of the seller/buyer and the complexity of the business being sold, the seller could be retained as an independent consultant. The consulting agreement should specify the schedule of time (days or hours involved), type of training or services provided, the length of the agreement, and compensation. This is a popular structuring method, which can benefit both the buyer and seller. For example, the sales price could be lowered in exchange for a lucrative consulting contract. The buyer benefits as they pay less money up front and have the ability to deduct the payments in the year made as a business expense. The seller could benefit by receiving the compensation over a period of several years, possibly reducing the tax impact. There are additional tax related issues to the seller, pertaining to the deductibility of business expenses incurred as a consultant and potential self-employment taxes, and it is therefore recommended that proper tax counsel is obtained.

 

Seller Financing: It is rare for a privately-held business to change hands for an all-cash price. More common in small business sales would be to have a component of seller financing as part of the deal structure.  Seller financing is a mechanism where the business owner would fund the sale of their business and/or business assets with a promissory note helping the buyer finance all or a portion of the acquisition of the business and/or business assets, which is then paid back from the business’ cash flow.  This type of deal can be very flexible — the seller can adjust the payment schedule, interest rate, loan period, or any other terms to reflect the seller’s needs, business cash flow, and the buyer’s financial situation. There are several benefits to the business owner in providing seller financing: Seller financing could be a way for the owner to defer tax on the sale of the business. If the sale complies with the IRS installment method of reporting for tax purposes, capital gain taxes could be recognized when payments on the seller-financed note are received versus 100% of the gain recognized upon closing the sale.  It will be important to consult a tax professional as not all assets would qualify for deferred capital gains treatment. Typically, the assets that have depreciated beyond their original purchase price, such as real estate, are eligible for installment sales, as are intangibles (such as goodwill) that are established during the course of the business.

For some businesses, carrying back a note for some or all of the purchase price may be the only way to sell the company.  Many buyers will leverage bank financing to acquire a business and the majority of these lenders will require a component of seller financing to underwrite the loan. Seller financing, in the lender’s eyes, mitigates risk as they will have the additional confidence knowing that the seller has a vested interest in the business succeeding.   The seller, in this instance, will be providing secondary financing to the bank’s acquisition loan (i.e. subordinated debt) for the remainder of the price. In the event of a default by the buyer on the seller financing note, the seller would have a number of options for recourse and the specifics will vary per transaction based upon the involvement of a primary (1st position) lender, the extent of collateralized assets, in addition to personal guarantee’s made by the buyer. The specific rights will be detailed in the security agreement that is associated with the promissory note and can involve a number of stipulations including restricting the new owner’s sale of assets, acquisitions, and expansions until the note is paid off in addition to specifying the receipt of quarterly financial statements to enable the seller to keep tabs on the business. Having an experienced transaction attorney involved in the drafting of the promissory note will be essential.

 

Earn-outs: An earn-out provision is an excellent structuring vehicle to bridge the gap on a valuation difference between what the seller expects to receive from a sale and what the buyer thinks a business is worth. Earn-outs are contractual contingent payments in which the purchase price is stated in terms of a minimum, but the seller will be entitled to additional compensation if the business reaches certain financial benchmarks in the future. Although the benchmarks can be calculated as a percentage of sales, gross profit, net profit or other figure, an earn-out is most often based on sales (not profits) and is typically tied to increasing revenue over historical levels. An earn-out is a good way to maximize the total selling price of the business, especially if the seller is confident of future sales and the new owner’s management ability. It is not uncommon to establish a floor or ceiling for the earn-out, and in a down economy, a seller can use an earn- out provision to obtain a value closer to what the business is worth in a healthy economic climate. Earn-outs are favorable to both the buyer and seller. The seller recognizes earn-outs as payment of money predicated on the future performance of the business and is therefore in a position to potentially obtain a higher value for their business than what would be afforded in a traditional sale in the current market. Buyers, on the other hand, are attracted to earn-outs as they pay less money at the time of sale but compensate the seller based upon the future success of the business. Buyers are protected against overpaying for a business that doesn’t meet the projections or growth that the original owners expected. Furthermore, Buyer’s recognize the vested interest the earn-out creates with the seller and the shared goal in the continued success of the enterprise. Most successful earn-outs are achieved when they are limited to one or two variables based upon a solid 3-5 year sales forecast. Earn-out provisions require a greater degree of involvement by the seller, and are most often implemented in conjunction with a seller employment or consulting agreement where the seller is positioned to ensure that all of the steps are being taken to reach the goals. Furthermore, it is also important to specify in the contract the person or firm that will be responsible for managing or reviewing the books and verifying the business’s performance.

 

Asset Sale: In a small business sale, the owner is selling a collection of assets, some tangible (such as inventory, vehicles, buildings, and FFE) and some intangible (such as software, customer lists, trade names, trained assembled workforce, patents, non-compete agreements, and goodwill). Unless the entity is a C-Corp and stock is being sold, the total transaction price is allocated sequentially based on the fair market value of the acquired assets. The Tax Code shows that assets fall into 7 different categories (asset classes) based on IRC section 1060 (Form 8594), and requires that the buyer and seller adopt and maintain a consistent purchase price allocation method for tax future calculations that will determine both the buyer’s basis in the assets and the seller’s gain or loss. In most cases, the tax impact on the individual assets sold are measurably different for the buyer and seller and therefore the negotiation of the dollar amounts allocated to each of the 7 categories becomes an important element of the business transaction.

Class I –     Cash
Class II –    Marketable Securities
Class III –  Market to Market Assets & Accounts Receivable
Class IV –   Inventory
Class V –    Assets Not Otherwise Classified
Class VI –   Section 197 Intangibles other than Goodwill and Going Concern
Class VII – Goodwill and Going Concern Value (Residual)

 

Taxes: Minimizing taxes plays a major role in structuring and negotiating a business transaction. Many promising deals have fallen through because the buyer and seller couldn’t agree on how to structure the deal to minimize taxes. Typically, the seller seeks to have as much money as possible allocated to assets that would be taxed as capital gains versus assets that would be treated as ordinary income. The buyer on the other hand strives to have a larger weight allocated to assets that are currently deductible or where stepped-up assets could be depreciated quickly under IRS regulations. Particular attention should be paid to the identification and valuation of the “intangible” assets, as they can be significant in negotiating terms. While Buyers are often indifferent to an allocation between goodwill and a CNTC, because Sec. 197 allows a buyer to amortize goodwill or a CNTC over the same 15-year period, they will often prefer a larger allocation to a consulting agreement, which can be expensed in the year paid. Sellers, however, prefer goodwill going concern allocations (capital gain treatment) versus CNTC or a Consulting Agreement (ordinary income treatment).

 

 

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