Published in the Kitsap Peninsula Business Journal in July 2006
The IRS places a “value” on your business and taxes your surviving family members on this “value” when you die. Consequently, it becomes important for owners of businesses to know what their business is worth and learn how to “cash in” on this “nest egg” before they die. Buyers Beware! Whether you are buying or selling a business, now, or in the future, this article is designed to help Sellers “cash in” and Buyers avoid the hidden risks that are lurking for the unwary.
1) Recognize and Protect the Inherent “Value” of Your Business —
If your business comfortably supports your family, then it has “value”, even if the “assets” walk out the door every night at five o’clock! What is it worth? With the many methods of valuation, there is one rule of thumb — A purchaser wants to recoup their investment, on average, in 5 years. That is, given the average risk, they want an annual return of 20 percent. You need to put yourself into a Buyer’s “shoes” and determine the “real” annual cash flow by eliminating unnecessary expenses and other “perks” of ownership.
Then determine the Earnings Before Interest, Depreciation and Taxes, or the “EBIDT.” Then multiply this number by 5. This will give you a rough indication of “value.” Multiples range from a high of 8 or 10 times to a low of 3 times EBIDT, depending on the relative risks and other intangibles. How do you protect this “value?” One way is with Key Employee agreements on confidentiality and non-competition. In exchange for these covenants, you provide incentive compensation packages. As your business grows in “value,” everyone benefits.
2) Agree Up Front to “Key Terms” —
Buyers and Sellers need to quantify their “bottom line” and agree up front on the “Key Terms” to achieve the expected result. For example, a Seller generally prefers to sell stock rather than assets, because the profits from the stock sale are taxed at favorable capital gain rates (currently 15 percent). Buyers, though, prefer to purchase assets and allocate the bulk of the purchase price to depreciable assets, to gain the tax advantages of accelerated depreciation. Sellers prefer to allocate the purchase price to assets such as real estate or goodwill (15 percent tax rate). These issues need to be negotiated up front to avoid unpleasant surprises as the transaction unfolds.
3) Set a Realistic Purchase Price —
As unusual as this may sound, the last thing a Seller wants is a sale price that is too high. Why? Because if the Buyer is unable to service his debt, the Seller may be faced with breach of warranty claims. Also, many times, Sellers finance the sale by carrying notes from the Buyers and the Seller’s problems are compounded. Buyers need to make sure there is enough cash flow to service the debt. For Sellers, a sufficient down payment and collateral for the notes (preferably with assets outside of the Business) are important considerations. Better yet, don’t be the bank.
4) Anticipate the Best Deal Structure Given the Nature of the Assets —
Does the business have a lot of service contracts with third parties that represent an important part of the future revenues of the business? If so, will these parties agree to an assignment of these contracts to the Buyer? This is an important question in an asset sale for several reasons. First, you no longer have control of the transaction because you need the consent of these third parties. Also, it will take longer to complete the transaction and added expenses will be involved. These types of businesses generally work better as a stock sale to avoid these issues.
5) Beware of Hidden Liabilities —
Buyers of stock take on the liabilities of the entity, whether known or unknown. These can include product warranty claims, as well as suits from disgruntled employees or unhappy customers. Insurance can be helpful to provide protection from certain liabilities during these transitional periods, but generally, a Buyer must do his due diligence in this area and/or rely on an asset purchase to minimize such liabilities.
Washington state law provides for “Successor Liability” which places the burden (and liability) on Buyers to make sure Sellers have paid their Washington state tax obligations. In asset transactions, Buyers (without proper tax planning) will generally be responsible for Washington sales tax on the value of the tangible personal property purchased in the transaction. Another area of risk is when the Seller is a C corporation in an asset sale. Care must be taken to avoid a double tax. Again, allocation of the purchase price and the deal structure can be very critical.
6) Pay Attention to Intangibles —
Patents, licensing rights, covenants not-to-compete, goodwill, phone numbers, customer lists, addresses, and other customer data represent valuable intangible assets that a Buyer wants to purchase. They also are very important assets for purchase price allocation considerations.
7) Value Good Professionals —
Buying and selling a business, regardless of the size of the transaction, is very complicated and it presents challenges to the best tax, insurance, legal, and accounting professionals. A business is a moving target that is constantly changing. The trick is to structure the transaction so that there is minimal interruption in the normal operations of the business and a clear understanding of the assets and liabilities being transferred. In many cases, ownership of the business may transfer on one day, and possession may transfer several days later, after cut-off statements can be prepared. Funds can be held in escrow until these adjustments are completed and all documentation can be finalized. Also, for small transactions, consider using one attorney in a neutral role as a facilitator for document preparation and escrow services. Each party saves a lot of money in legal fees and stress levels are greatly reduced.
Buying or selling a business is generally a critical, life-altering transition for the parties involved. Pay attention to these Keys and make your transition both enjoyable and lucrative.