*Always Consult your Account and Attorney regarding your specific situation*
First, some basics: When one sells a going business, they are selling the FF&E
(Furniture, Fixtures & Equipment), goodwill, inventory and other business-related
assets . In most small business transactions, these assets are sold because the
owner/seller owns them and has decided, for whatever reason, to sell. The crux of
this whole issue is when the seller, again, for whatever reason, decides to
incorporate. He or she may be doing this for tax reasons or liability purposes or on
the advice of their attorney or accountant. The owner of the business now does not
legally own it - the corporation does. The former owner now owns only the stock of
the corporation, which, in turn, owns the business. Now, try and tell the owner that
he or she doesn't own the business.

When the seller now decides to sell his or her business, it would seem a simple
transfer of the assets of the business is the easiest way to go. Unfortunately, the
seller can't do this because he or she really doesn't own the business, the
corporation does. So, now, the corporation must sell its assets - the business. The
seller, as the sole stockholder, receives the proceeds by dissolving the corporation,
or by declaring a very big dividend, or by any other method available.

However, the seller may discover that tax issues dictate how the business is sold.
For example, when the corporation sells the assets of the business, the corporation
must pay taxes on the profits of the sale, and the seller then has to pay taxes when he
or she pulls the money out of the corporation. This means there is double taxation,
which doesn't make the seller very happy. However, if the corporation just transfers
the stock from the seller to the buyer, this creates only one taxable event, since the
seller is merely selling stock. Of course, the buyer, by buying the stock of the
corporation, inherits any liability issues such as pending litigation or any future
litigation, product liability; and any other unresolved issue.

Hopefully, the above comments provide a brief overview of this very complex issue.
Taxable Asset Sale
Buyer - Advantages
  • Choose which assets to purchase
  • "Step-up" in asset's tax basis
  • Free of contingent liabilities
  • Union contracts can be terminated
  • Can change state of incorporation
Seller - Advantages
  • Can maintain corporate existence
  • Still own non transferable rights
(e.g. Licenses, franchises, patents)
  • Can keep the corporate name
(unless the name is sold)
Buyer - Disadvantages
  • Unable to carryover seller's tax attributes
(e.g. NOL & Capital loss)
  • Bargain purchase tax cost
  • Non transferable rights are lost
  • Loss of W/C and other ratings
Seller - Disadvantages
  • Double taxation - C Corporations
  • Higher taxed ordinary gains likely
  • For both buyer and seller
Selling individual assets is more complex
Often requires a lender's approval
Taxable Stock Sale
Seller - Advantages
  • Avoid double tax - C Corporations
  • Single capital gain - no allocations
  • All liabilities transferred to buyer
  • For both buyer and seller
Less complex; may avoid lender releases
Buyer - Advantages
  • Seller's tax attributes survive
  • Obtain non transferable rights
  • Retain W/C and other ratings
  • Retain right to use corporate name
  • Retain favorable debt structure
Buyer - Disadvantages
  • No "Step-up" in asset's tax basis
  • Inherit contingent liabilities
  • Union and benefit plan continue
  • State of incorporation unchanged
  • Minority shareholder "rights"
Seller - Disadvantages
  • Seller cannot pick assets to retain
  • Non transferable rights are lost
  • Requires obtaining S/H approval
  • Reduced price
because of no buyer basis step up
*Always Consult your Account and Attorney regarding your specific situation*
Q. Is a stock sale or asset sale more advantageous?
A. One should always consult with their accountant on these matters. However, from
a lender’s standpoint, both forms of sale are acceptable. As a buyer, you should be
aware that in a stock sale, you may be responsible for prior sins of the corporation
you are buying. Your attorney can assist with language, rights of offset against seller
notes and other defenses against some of these risks.

Also, under the stock sale, assets are valued based on their book value, which is
often less than the replacement or market value. A separate appraisal may be
required to address this discrepancy in value as a means to provide the maximum
financing. In an asset sale, many lenders will use the asset values as agreed to
between buyer and seller, regardless of their book value, which negates the
requirement of a costly appraisal.

Q.
Should I resist a stock sale?
A. All things being equal, the asset sale is recommended over stock. Always check
with your accountant and attorney before negotiating the structure of the sale. There
are situations in which a stock acquisition is better or necessary .

There may be licensing that runs to the corporation that requires the stock sale
Forcing an asset sale may result in the seller raising the price of the company to
compensate for the additional capital gains taxes
The company may have a favorable long-term lease that runs to the corporation

Q.
When is a Stock purchase recommended over an Asset purchase?
A. Typically, C-Corporations will sell as stock transactions because the seller
avoids the double taxation penalty that would result under an asset sale. All other
entities will typically sell the assets, plus the trade name under which the business
operates. A non-compete clause from the seller will typically be included in the sale
as well.

The buyer’s and seller's tax issues are directly opposed. Buyers may be wary of a
stock purchase since they inherit both the good and bad things the corporation may
have done in the past, like failing to pay certain taxes. By recommending an asset
sale, the buyer avoids this risk. The seller will then usually modify the price to
include the extra taxes owed if the business is sold as "assets" only. This means the
buyer will be asked to pay a premium for the business to cover the seller’s increased
tax liability.

Be sure to include your accountant in this scenario to determine your tax implications.
Your attorney should also be consulted so the proper language may be included in the
sales agreement.

Q.
Are the motivations of sellers and buyers typically different in a business sale?
A. Besides the obvious fact that the seller is looking for the highest price, while the
buyer is seeking the lowest, be aware that price is only part of the issue a lender must
consider. Lenders look at how the price is to be allocated amongst assets being
purchased, which affects both loan amount and the calculation of loan term. This
accordingly affects monthly payment, down payment and seller financing.

As a buyer, you should want the maximum market value applied to real estate and
equipment in that order. As an example, the seller may wish to have the real estate
valued at $100,000 less than market to assist with his or her capital gains. The lender
uses the lesser of cost or market and as such if the appraised value of the real estate
is $100,000 more than the allocated price, they will use the allocated price and you
lose $100,000 of loan availability. The situation is the same with the equipment
allocation. Allocation of price is often as important as the price itself.

Q.
What is the value of a business?
A. The value of any business is subjective. This is because each business has a
different value to each buyer. For example, if a buyer presently earns $40,000 a year
as a salaried employee and can potentially earn $80,000 if he buys a $200,000
business, the purchase is probably viewed as a reasonable decision. What if another
buyer, who earns $125,000 a year, looks at the same business that will pay him
$80,000? Is this business worth $200,000 to the second buyer?

Sometimes the real value of a business is hidden. This means that a good business
that is presently mismanaged may be a gold mine to an experienced person who sees
all the mistakes being made and knows how to fix them. In this situation, the asking
price may be paid. The value of the business is in its potential not in its current state.
Some businesses are doing as well as they ever will but are safe and will provide a
steady income with little growth potential. Buyers of these businesses are often
referred to as "buying a job". These businesses have value to some buyers, but not to
others.

Q.
What is Goodwill?
A. Goodwill represents the difference between the reasonable value of the assets
involved in the purchase and the actual price paid. If you were looking at a pizza
shop that had chairs, tables, ovens and equipment that had a reasonable replacement
cost of $50,000, and the owner was asking $150,000, the Goodwill value of this
business is the difference, or $100,000.

What does this mean and how is this value determined? In the simplest of
explanations, Goodwill is the value of the cash flow generated by the business.
Appraisers use a variety of techniques to analyze this aspect. Below is a quick tool to
test this element.

Assets versus Goodwill
When you look at any business, first determine what is actually for sale. Often,
sellers of businesses are selling assets, but not all the assets. For example, asset sales
usually exclude Cash and Accounts Receivable. Included are leasehold
improvements, furniture and fixtures, machinery and equipment, certain vehicles, and
other tangible or real assets. These assets, depending on age, condition, mileage, etc.,
can be valued on a replacement basis. Suppose you determine the replacement value
to be $120,000 and the purchase price of the business is $250,000. The difference is
$130,000, which is the Goodwill price being asked.

If we ask the broker to show us the cash flow calculation on this business and he
responds with a number of $50,000, we would take this number and divide it into the
total price of $250,000, which gives us a multiple of 5 ($250,000 / $50,000 = 5).
Ordinarily, a value that exceeds 3.5 to 4 times in the small business arena is
considered excessive. (It can happen but it usually means the business is showing
tremendous growth trends year after year.)

If we use 3.5 and multiply this number times the cash flow of $50,000, we arrive at
$175,000. We then deduct the tangible asset value ($120,000) and the more realistic
Goodwill value ($175,000 - 120,000) is $55,000. This 3.5 multiple may still be high
but this process is a good rule of thumb for testing asking prices against cash flow
and tangible asset value versus Goodwill.

Business Broker does all these calculations for you and more. However, when you
are in the field, remember to ask for the cash flow and divide it into the asking price.
If the resulting number exceeds 4, you may have an overpriced business. See if the
broker can explain why this business is priced at the resulting multiple determined
when the majority (but not all) small businesses sell at multiples in the 2.2 to 2.8
times cash flow range. Whether or not the broker can answer your question, he/she
will respect you as a knowledgeable buyer.

Q.
What items should be requested from the seller?
A. Please note, different industries may require specialized items. Below is a general
checklist.

Ask for three years of back tax returns on the business including the most recent
returns. Many sellers have their business for sale and are on extension with the IRS.
Demand that the tax returns be filed and provided to you before the due diligence
clock starts.

Ask for a current Interim Balance Sheet and Profit and Loss Statement showing the
last 45 days.

Ask for an aging of Accounts Receivable and Accounts Payable as of the interim
date. Make sure the totals reconcile with the Balance Sheet. Check the repayment
history of key customers. Sixty-day payment histories may require outside working
capital financing to support these accounts. Any receivables over 90 days should be
deducted from sales as well as cash flow calculations. Check the repayment terms to
which this company has subjected their suppliers. If it shows lots of 60 to 90 day
payments, you may find yourself on C.O.D. terms after the sale.

Examine the inventory. This is especially important when you have a retail business.
There are often odd sizes and other dead inventory items that should be discounted.
There are professional firms who will do this for you and the money may be well
spent.

Check the customer sales totals and look for customer concentrations. If a company is
doing more than 10% of its sales with one account, this can represent significant risk.
If margins are outside industry standards, ask for copies of invoices and determine if
the cost-to-price ratio is accurate or whether some sales are not being rung up. This
is quite common, and in many cases, expected by the lender in some industries.

Ask for copies of all contracts, loan agreements, and leases. Consider if the location
of the business is critical to its success. As in retail, a short-term lease with the
landlord will affect value. For example, if the business has five years left on the
lease and the landlord refuses to renew or sells the building, the value represented by
this location is gone. Also, the lender will tie their loan term to the lease term or ten
years, whichever is less. A short-term lease means a lower loan amount and / or
higher monthly payments. Either way, the lease becomes an important feature in the
sale.

Who are the key employees and will they stay? Do you want them to stay? At what
point will you have access to these individuals to verify their intent to stay?
Sometimes, buyers will pose as consultants and be introduced to the staff. In this
way, you gain access to daily operations without concerning the employees.
Will the seller stay on for an extended time for training and transition – especially
with key customer introductions, suppliers, etc.?

Why is this business for sale? Never accept reasons like, "I'm tired and want to do
something else." If the seller states a medical reason, ask for evidence. A letter from
his/her physician, past medical records, etc. Uncovering the real reason for sale is
critical. Never trust the broker's answer. Verify it for yourself.

Sometimes, when there are doubts, you can test the waters by asking about the seller's
willingness to assist with some financing. If you are not comfortable with the seller’s
reason for sale and he/she refuses to assist with any financing for you, be concerned.
Thoroughly review each and every asset category involved in the sale. Check the
mileage of vehicles, maintenance records, etc.

Check with the town and state relative to permits, licensing and anticipated changes
in governmental requirements for this industry.
Check the insurance policies and verify that renewal rates will be comparable. Check
for unusual claims submitted by the business.

If the business is susceptible to national competition, you can check with the town or
municipality to determine what building permits or plans have been submitted for
hearings in coming months to see if new competitors are coming to town.
If you are dealing with a service company, determine the importance of the owner
and his/her influence with customers. Often times, customers have a personal
relationship with an owner that ends with the sale of a service business. This is not
the rule, but you should investigate the possibility.

How much of the sales volume is directly influenced by the owner?
Does the owner have direct customer contact?
What is the relationship of other employees to the customers?
Does the owner object to signing a non-compete contract?
Will the owner stay on to assist with introductions?
Will the owner agree to seller financing? If so, will they agree to a “right of offset”
against any key customer fall-out after the sale?
Can a 12 to 18 month consulting agreement be negotiated to keep the owner around
for a period that enables you to develop a relationship with the customers and
employees?
Get things started by calling 626-673-5344
Fairmate, Inc.