| p>Selling a privately held business is often | | | | successfully than when it comes to the details of |
| romanticized as face-to-face negotiations over | | | | the financing. Many sellers actively prefer to do |
| business valuations and purchase price. Whether | | | | the financing themselves as they can negotiate |
| small or large, business transactions can be | | | | the highest transaction value when offering |
| extremely complex and require a great deal of | | | | flexible owner-finance terms. In addition, the |
| work behind the scenes. As the size and/or | | | | interest earned on the promissory note will add |
| complexity of a transaction increases, the need | | | | significantly to the actual selling price. Interest |
| for innovative structuring options also increases. | | | | rates are currently hovering at their lowest level |
| Deal structure, financing, and tax management | | | | in years and sellers recognize that they can get a |
| must be a proactive process that is addressed at | | | | much higher rate from a buyer than they can get |
| an early stage. In many cases the Seller and | | | | from any financial institution. |
| Buyer often place all of the focus on the | | | | Tax Benefits |
| transaction price at the expense of the 'net | | | | Seller financing could be a way for the owner to |
| results' of a business transaction. By carefully | | | | defer tax on the sale of the business. If the sale |
| negotiating the terms and structure of the | | | | complies with the IRS installment method of |
| transaction, a business seller could walk away with | | | | reporting for tax purposes, capital gain taxes |
| a deal that provides a significantly larger economic | | | | could be recognized when payments on the seller |
| benefit than a transaction that provides 100% of | | | | financed note are received versus 100% of the |
| the proceeds at closing. For asset sale | | | | gain recognized upon closing the sale. It will be |
| transactions, the 'allocation of purchase price' can | | | | important to consult a tax professional as not all |
| become another area of negotiation after the | | | | assets would qualify for deferred capital gains |
| price, terms and conditions of the sale have been | | | | treatment. Typically, the assets that have |
| agreed to by the buyer and seller. Each type of | | | | depreciated beyond their original purchase price, |
| structure carries with it different tax | | | | such as real estate, are eligible for installment |
| consequences for the buyer and seller, having a | | | | sales, as are intangibles (such as goodwill) that are |
| material impact on the overall value of the | | | | established during the course of the business. |
| transaction. The type of business entity owned | | | | Completing the Transaction |
| by the seller (C-corporation, S-Corporation, LLC, | | | | Seller financing can be a useful tool to complete |
| Partnership, or Sole Proprietorship) in addition to | | | | business sale transactions that need extra |
| whether the transaction becomes an asset sale | | | | financing as part of their structure. The pool of |
| or stock sale will have a major bearing on the | | | | qualified buyers increases exponentially when a |
| decisions made in structuring the transaction to | | | | portion of the transaction is financed by the seller. |
| afford maximum economic benefits. The purpose | | | | For some businesses, carrying back a note for |
| of this communication is to advance a few of the | | | | some or all of the purchase price may be the |
| techniques available in structuring small business | | | | only way to sell the company. The credit market, |
| sale transactions and to emphasize the value an | | | | as a result of the sub-prime financial crisis, is still |
| experienced team brings in structuring the | | | | very tight. The plentiful, easily obtainable, flexible |
| transaction. Asset sales of pass-through entities | | | | and inexpensive credit that flooded the market |
| (LLC, S-Corp, & Partnerships) are handled very | | | | several years ago has changed dramatically. Many |
| differently than stock-sales of C-Corps and it | | | | buyers will leverage bank financing to acquire a |
| would be impossible to cover all of the structuring | | | | business and the majority of these lenders will |
| alternatives within this short document. Proper | | | | require a component of seller financing to |
| legal and tax counsel should be retained and the | | | | underwrite the loan. Seller financing, in the lender's |
| cost of these professionals is usually offset by | | | | eyes, mitigates risk as they will have the additional |
| the benefits they bring through their involvement | | | | confidence knowing that the seller has a vested |
| in the transaction. | | | | interest in the business succeeding. The seller, in |
| The following factors will be relevant in structuring | | | | this instance, will be providing secondary financing |
| the transaction: | | | | to the bank's acquisition loan (i.e. subordinated |
| 1. Legal Business Entity | | | | debt) for the remainder of the price. |
| - LLC | | | | In the event of a default by the buyer on the |
| - S-Corp | | | | seller financing note, the seller would have a |
| - C-Corp | | | | number of options for recourse and the specifics |
| - Partnership | | | | will vary per transaction based upon the |
| - Sole Proprietorship | | | | involvement of a primary (1st position) lender, the |
| 2. Type of Sale | | | | extent of collateralized assets, in addition to |
| - Asset Sale | | | | personal guarantee's made by the buyer. The |
| - Stock Sale | | | | specific rights will be detailed in the security |
| 3. What is being sold | | | | agreement that is associated with the promissory |
| - Entire business | | | | note and can involve a number of stipulations |
| - Partial Interest / Investment | | | | including restricting the new owner's sale of |
| - Inclusion of Real Estate | | | | assets, acquisitions, and expansions until the note |
| 4. Installment Sale or component of Seller | | | | is paid off in addition to specifying the receipt of |
| Financing | | | | quarterly financial statements to enable the seller |
| 5. Who is the buyer | | | | to keep tabs on the business. Having an |
| - Financial Buyer (Entrepreneur) | | | | experienced transaction attorney involved in the |
| - Strategic Buyera. Corporationb. Private Equity | | | | drafting of the promissory note will be essential. |
| Group (PEG)c. Family Member (Succession) | | | | 5. Earn-Outs |
| 6. Plans after the sale (Short term/Intermediate | | | | An earn-out provision is an excellent structuring |
| Long Term) | | | | vehicle to bridge the gap on a valuation difference |
| - Consulting Contract | | | | between what the seller expects to receive from |
| - Employee Contract | | | | a sale and what the buyer thinks a business is |
| - Covenant not to Compete | | | | worth. Earn-outs are contractual contingent |
| 7. Personal Tax Situation | | | | payments in which the purchase price is stated in |
| STRUCTURING THE TRANSACTION | | | | terms of a minimum, but the seller will be entitled |
| 1. Asset Sale / Stock Sale | | | | to additional compensation if the business reaches |
| Determining what is being sold, the individual | | | | certain financial benchmarks in the future. Although |
| assets of a business or the stock in a corporation, | | | | the benchmarks can be calculated as a |
| will be critical in determining the optimal structure | | | | percentage of sales, gross profit, net profit or |
| of a transaction. The majority of small businesses | | | | other figure, an earn-out is most often based on |
| that are sold each year are structured as an | | | | sales (not profits) and is typically tied to increasing |
| asset sale. An asset sale is when a buyer | | | | revenue over historical levels. An earn-out is a |
| purchases all or a portion of the assets of a | | | | good way to maximize the total selling price of |
| business (e.g., facilities, equipment, vehicles, real | | | | the business, especially if the seller is confident of |
| estate, etc) whereas a stock purchase is the | | | | future sales and the new owner's management |
| purchase of the ownership shares/rights of the | | | | ability. It is not uncommon to establish a floor or |
| corporation - all assets and all liabilities of the | | | | ceiling for the earn-out, and in a down economy, a |
| entity are retained by the corporation and only a | | | | seller can use an earn-out provision to obtain a |
| change in corporate ownership has occurred. The | | | | value closer to what the business is worth in a |
| following highlights three notable differences | | | | healthy economic climate. Earn-outs are favorable |
| between each method; there are many additional | | | | to both the buyer and seller. The seller recognizes |
| considerations so it is critical to consult | | | | earn-outs as payment of money predicated on |
| professional advice to determine the most | | | | the future performance of the business and is |
| appropriate method. | | | | therefore in a position to potentially obtain a |
| Change in Legal/Tax Entity: | | | | higher value for their business than what would be |
| With an asset sale, the legal entity and tax | | | | afforded in a traditional sale in the current market. |
| identity do not transfer to the purchaser. The | | | | Buyers, on the other hand, are attracted to |
| Buyer receives a stepped-up tax basis in the | | | | earn-outs as they pay less money at the time of |
| assets acquired equal to the FMV purchase price, | | | | sale but compensate the seller based upon the |
| the point from which new depreciation is started. | | | | future success of the business. Buyers are |
| Under a stock sale, the tax basis of the assets | | | | protected against overpaying for a business that |
| remains unchanged, and all of the tax attributes, | | | | doesn't meet the projections or growth that the |
| including depreciation methods, tax year, | | | | original owners expected. Furthermore, Buyer's |
| corporate tax election, are preserved. | | | | recognize the vested interest the earn-out |
| Liability: | | | | creates with the seller and the shared goal in the |
| With an asset sale, the Buyer's liability is limited. | | | | continued success of the enterprise. Most |
| The Buyer is purchasing some or all of the assets | | | | successful earn-outs are achieved when they are |
| and has the option to identify any liabilities they | | | | limited to one or two variables based upon a solid |
| are interested in assuming. Under a stock sale, the | | | | 3-5 year sales forecast. Earn-out provisions |
| Buyer purchases the stock of the company and | | | | require a greater degree of involvement by the |
| assumes all liabilities (known, unknown, contingent | | | | seller, and are most often implemented in |
| or otherwise). | | | | conjunction with a seller employment or consulting |
| Assignment of Contracts: | | | | agreement where the seller is positioned to |
| Most businesses have contracts in one form or | | | | ensure that all of the steps are being taken to |
| another. The most common are commercial real | | | | reach the goals. Furthermore, it is also important |
| estate leases, contracts involving business | | | | to specify in the contract the person or firm that |
| relationships, and contracts with employees. An | | | | will be responsible for managing or reviewing the |
| asset sale transaction involving the assignment of | | | | books and verifying the business's performance. |
| these contracts requires considerably more work | | | | ASSET ALLOCATION |
| and has a potentially a different outcome than a | | | | In a small business sale, the owner is selling a |
| stock sale. Contracts need to be evaluated to | | | | collection of assets, some tangible (such as |
| determine if they permit an assignment without | | | | inventory, vehicles, buildings, and FF&E) and some |
| consent. Should they not permit assignment | | | | intangible (such as software, customer lists, trade |
| without consent, third party consent will need to | | | | names, trained & assembled workforce, patents, |
| be obtained. In stock sale transactions, the legal | | | | non-compete agreements, and goodwill). Unless |
| entity that is the party to the contract continues, | | | | the entity is a C-Corp and stock is being sold, the |
| and the general rule is that the contract remains | | | | total transaction price is allocated sequentially |
| in force between the original parties. (No consent | | | | based on the fair market value of the acquired |
| to assignment is needed as assignment typically | | | | assets. The Tax Code shows that assets fall into |
| does not occur). There are exceptions, as some | | | | 7 different categories (asset classes) based on |
| contracts stipulate that a change in ownership of | | | | IRC section 1060 (Form 8594), and requires that |
| the business will be considered an assignment of | | | | the buyer and seller adopt and maintain a |
| the contract. If such a 'change of control' clause | | | | consistent purchase price allocation method for |
| exists in the contract, the same issues will arise | | | | tax future calculations that will determine both the |
| as with an asset transaction. Performing due | | | | buyer's basis in the assets and the seller's gain or |
| diligence and having legal counsel thoroughly | | | | loss. In most cases, the tax impact on the |
| review all of the company's contracts will be | | | | individual assets sold are measurably different for |
| critical to determine the available options. | | | | the buyer and seller and therefore the negotiation |
| 2. Covenant Not to Compete (CNTC) | | | | of the dollar amounts allocated to each of the 7 |
| A covenant not to compete (CNTC) is a | | | | categories becomes an important element of the |
| contractual condition by which the seller promises | | | | business transaction. |
| to refrain from conducting business or | | | | Class I - Cash |
| professional activities of a nature similar to those | | | | Class II - Marketable Securities |
| of the business being sold. In a contract for the | | | | Class III - Market to Market Assets & Accounts |
| sale of a business, a reasonable value can be | | | | Receivable |
| allocated to a 'covenant not to compete' which is | | | | Class IV - Inventory |
| generally enforceable provided it is reasonable and | | | | Class V - Assets Not Otherwise Classified |
| limited as to time and territory. The buyer may | | | | Class VI - Section 197 Intangibles other than |
| amortize this amount over 15 years even though | | | | Goodwill and Going Concern |
| the actual term of the CNTC is usually much | | | | Class VII - Goodwill and Going Concern Value |
| shorter. For this reason, buyers often prefer a | | | | (Residual) |
| larger amount be allocated to tangible assets or a | | | | Minimizing taxes plays a major role in structuring |
| consulting agreement with a shorter useful life. In | | | | and negotiating a business transaction. Many |
| order to be legally binding, it is recommended that | | | | promising deals have fallen through because the |
| some consideration is allocated to a CNTC. | | | | buyer and seller couldn't agree on how to |
| 3. Consulting Agreement | | | | structure the deal to minimize taxes. Typically, the |
| Depending upon the goals of the seller/buyer and | | | | seller seeks to have as much money as possible |
| the complexity of the business being sold, the | | | | allocated to assets that would be taxed as capital |
| seller could be retained as an independent | | | | gains versus assets that would be treated as |
| consultant. The consulting agreement should | | | | ordinary income. The buyer on the other hand |
| specify the schedule of time (days or hours | | | | strives to have a larger weight allocated to assets |
| involved), type of training or services provided, | | | | that are currently deductible or where stepped-up |
| the length of the agreement, and compensation. | | | | assets could be depreciated quickly under IRS |
| This is a popular structuring method which can | | | | regulations. Particular attention should be paid to |
| benefit both the buyer and seller. For example, | | | | the identification and valuation of the "intangible" |
| the sales price could be lowered in exchange for a | | | | assets as they can be significant in negotiating |
| lucrative consulting contract. The buyer benefits | | | | terms. While Buyers are often indifferent to an |
| as they pay less money up front and have the | | | | allocation between goodwill and a CNTC, because |
| ability to deduct the payments in the year made | | | | Sec. 197 allows a buyer to amortize goodwill or a |
| as a business expense. The seller could benefit by | | | | CNTC over the same 15-year period, they will |
| receiving the compensation over a period of | | | | often prefer a larger allocation to a consulting |
| several years, possibly reducing the tax impact. | | | | agreement which is able to be expensed in the |
| There are additional tax related issues to the | | | | year paid. Sellers, however, prefer goodwill & |
| seller, pertaining to the deductibility of business | | | | going concern allocations (capital gain treatment) |
| expenses incurred as a consultant and potential | | | | over a CNTC or a Consulting Agreement |
| self employment taxes, and it is therefore | | | | (ordinary income treatment). |
| recommended that proper tax counsel is obtained. | | | | ENLIGN strongly advises its clients to seek |
| 4. Seller Financing / Installment Sale | | | | independent tax & legal advice from professionals |
| It is rare for a privately-held business to change | | | | who possess an expertise in business transactions. |
| hands for an all-cash price. More common in small | | | | We often find that many buyers have already |
| business sales would be to have a component of | | | | completed several transactions and have a team |
| seller financing as part of the deal structure. Seller | | | | of experienced merger and acquisition |
| financing is a mechanism where the business | | | | professionals in place. Conversely, we find most |
| owner would fund the sale of their business and | | | | business sellers approaching the sale for the very |
| or business assets with a promissory note helping | | | | first time. The resources in place for the seller |
| the buyer finance all or a portion of the acquisition | | | | traditionally are comprised of general business |
| of the business and/or business assets, which is | | | | practitioners lacking the strong business |
| then paid back from the business' cash flow. This | | | | transaction experience necessary to address the |
| type of deal can be very flexible - the seller can | | | | multitude of issues associated with complex |
| adjust the payment schedule, interest rate, loan | | | | business transactions. ENLIGN does not provide |
| period, or any other terms to reflect the seller's | | | | legal, tax, or accounting advice and, for this |
| needs, business cash flow, and the buyer's | | | | reason, we have developed the ENLIGN |
| financial situation. | | | | Professional Partner Program (EPPP) to enable our |
| There are several benefits to the business owner | | | | clients to access the expertise of experienced |
| in providing seller financing: | | | | transaction professionals in both accounting and |
| Maximization of Transaction Value | | | | law practices. |
| Few areas offer more opportunity to negotiate | | | | |