Selling Your Business – Practical Tips for Sellers – Part 1: Introduction and Deal Structure

Introduction

It’s time to cash out. You’ve reached retirement age or some other point in your life where you want to sell your business. Or perhaps your business has reached a point where you can’t take it any farther on your own and a sale makes sense. Or maybe you’ve simply received a great offer. In any event, the sale of your business is probably one of the most significant events in your life, and you should understand the process before you jump in so you’re well positioned to get the best deal you can with the least amount of risk.

In this series of posts, we’ll discuss the key steps in the sales process from the seller’s perspective. We’ll lay out some of the basic concepts and try to provide some practical advice for potential sellers. Our goal will be to give readers who may be considering a sale some information and things to consider that will be helpful to you along the way. We’ll cover the following topics, and maybe a few others, offering helpful tips where we can:

  • Deal Structure – asset sales versus stock sales
  • Deal Structure – earn-outs and seller financing
  • Term Sheet Negotiation
  • Due Diligence Investigation
  • Negotiation of the Purchase Agreement, including Representations and Warranties
  • Conditions to Closing
  • Indemnification
  • Ancillary Agreements – employment, consulting, and non-competition agreements

Deal Structure – Asset Sales versus Stock Sales

Buyers of a business typically want to buy its assets, not its stock, and sellers usually prefer stock sales. Why is this so? For our purposes, we’ll use the term “stock” to refer to any equity interest in any entity (e.g., membership interests in a limited liability company, stock in a “C” or “S” corporation, or partnership interests in a general or limited partnership), and the term “stock sale” to refer to the sale of any such equity interest.

Taxes – From the buyer’s perspective, an asset sale results in the best tax benefit. The buyer’s purchase price is allocated among the purchased assets and the buyer’s tax basis will equal the purchase price, which will benefit the buyer when taking depreciation and amortization deductions as well upon a subsequent sale of any purchased assets. This is obviously a good result for the buyer. On the other hand, in a stock sale, the buyer will get basis in its stock, which can’t be amortized, but the buyer won’t necessarily get increased basis in all of the purchased assets.[1]

Contrast the foregoing tax consequences for the buyer with those of the seller. If a seller has a C corporation, then, in an asset sale, any gain will be taxed at the entity level for federal income taxes, and then a second level of tax will be imposed when the after-tax sales proceeds are distributed to the seller as dividends. On the other hand, with an S corporation or an entity taxed as a partnership, there will usually be only one level of tax in an asset sale, at the seller’s level. However, with a stock sale, there will only be one level of tax to the seller regardless of whether a C corporation or a pass-through entity is involved. State taxes differ based on the state(s) involved.

Risk – The asset purchase structure is usually better from the buyer’s perspective in terms of minimizing risk as well. With an asset purchase, the buyer does not normally become responsible for any debts or liabilities of the business (and often, unknown or contingent liabilities are the concern – think of things the buyer might not know about, such as a potential lawsuit, environmental issue, tax issue, etc.).[2] On the other hand, with a stock purchase, the purchased business will most certainly continue to be liable for all of these items. Of course, the buyer will attempt to cover these potential losses through contractual indemnification provisions from the seller, but that’s certainly not as good as having no responsibility in the first place.

From the seller’s perspective, there is less of a concern about mitigating risk through structuring the deal as an asset versus stock deal. In either case, the seller’s best tool for minimizing risk is to be diligent and thorough in its review of the representations and warranties and the associated disclosure schedules in the purchase agreement.

With this backdrop in mind, here are few tips for potential sellers to consider in the initial stage of a sale transaction:

  • First of all — and this is probably pretty obvious — address deal structure very early in the negotiation process; if you own a C corporation, for example, and the “double tax” hit will be too much to make a deal attractive enough for you, then be sure this is clear to potential buyers at the outset. I’ve seen many sellers and potential buyers “strike a deal” for a purchase and sale of the business without considering whether it should be an asset or stock deal and then the deal falls apart in term sheet negotiations.
  • For owners of C corporations, consider whether there may be personal goodwill of the owners that can be sold. In the right circumstances, a sale of personal goodwill may help tremendously with the tax bite if the right facts are present.
  • If you’re a seller and your potential buyer insists on a stock deal due to concerns over risk, consider evaluating insurance to cover breaches of representations and warranties. Perhaps such insurance could get a buyer comfortable with a stock deal when the buyer wouldn’t otherwise be. (Keep in mind that this insurance isn’t cheap.)
  • Identify any “warts” on your company as early as possible – when you get to the point of looking for a buyer, most potential issues that could be concerns for buyers are probably in place and you may not have much control over them. But to the extent you do have control, try to get things in good order. If a sale is a year or more away, identify any potential liability issues and try to address them; get books, records, and contracts in order; and consider having your law firm perform some “due diligence” (i.e., a thorough investigation) of the type that a potential buyer will be doing to help identify problems and how to solve, mitigate, or appropriately disclose them. Don’t underestimate how much time it can take to simply collect and copy all of the documents connected to your business, much less try to figure out what might be missing or inconsistent or problematic just days before a deal is scheduled to close.
  • Get your lawyer and CPA involved at an early stage of negotiations. Too frequently an owner will come to his or her lawyer and CPA with a signed term sheet (all too often copied and pasted from some dubious online source) and say, “Here is the deal we agreed on – make this happen!” If the term sheet fails to include key protections for the seller or actually includes terms extremely unfavorable to the seller and the seller was unaware of it, perhaps because he or she was focused mainly on the economic terms, it is probably too late to get more favorable terms in the purchase agreement without a lot of arm-twisting.

Consider your estate plan a few years before you decide to sell, if possible. Often, substantial wealth can be passed to future generations upon a sale while minimizing estate and gift taxes if planning is done early enough. However, it’s much harder to accomplish such results if no planning is done until the time of a sale.


Footnotes

[1] There are ways for a buyer to get around this by, for example, making a Code 338(h)(10) election for an S corporation so that the transaction is treated as an asset purchase for tax purposes, stepping up the buyer’s basis to reflect the purchase price, or making a Code 754 election for an entity taxed as a partnership to equalize a new partner’s outside and inside basis.

[2] Buyers can become responsible for liabilities under certain successor liability theories but, generally speaking, asset deals pose little risk of successor liability.


© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Casey W. Riggs About Casey W. Riggs

Casey Riggs is a corporate and business attorney who represents companies of all sizes, from startups to large corporations, and in all stages of the business life cycle, from entity formation through an exit event. Casey also represents many of his clients in estate planning and administration.

You can read more about Casey here.

Leave a Reply