Compass Newsletter - Articles

How to Sell a Business

by Deborah Lush
Fall 2004

Preparing to Sell. Before selling, a business owner should prepare the business for sale. A seller may wish to memorialize business procedures, update employment handbooks, cut overhead, and update all financial statements, stock certificates, and the corporate minute book. A seller may also re-negotiate critical leases or contracts to obtain terms that would attract buyers ( e.g. , an option to renew) and to avoid terms that could limit interested buyers ( e.g. , high interest rates).

Structure of the Sale. Parties may structure a business sale in one of three ways:

1. Sale of assets. In an asset sale, a seller sells some or all of the assets of a business and is not necessarily relieved of its liabilities. The parties negotiate which assets are sold. Buyers receive a "step-up" in basis. Asset sales are taxable to the seller, require title changes, and may disrupt business operations.

2. Sale of stock. In a stock sale, a buyer purchases the stock of the business and steps directly into the shoes of the selling shareholder. The buyer assumes all liabilities-known and unknown-of the business, including payroll, taxes, and lawsuits. Absent a personal guarantee or warranties required by the buyer, the seller is no longer liable. Stock sales prevent double taxation on the sale of a C corporation.

3. Merger. A merger occurs when two businesses combine and continue business together. Parties may avoid immediate tax consequences by structuring the sale as a merger.

Price. The final price reflects which assets and liabilities the buyer acquires, how anxious each party is to close, and may fluctuate based on the actual inventory and accounts receivable on the closing date. The difference between the price and total value of the assets is "goodwill," which is an intangible asset that represents the value of the location, customer base, and reputation of an ongoing business.

Asset Allocation. In an asset sale, the parties allocate each asset into one of three categories: cash-like assets ( e.g. , bank accounts); tangible property ( e.g. , inventory); and intangibles ( e.g. , goodwill). Buyers typically prefer to allocate more of the price to inventory or equipment, which is depreciable over 3-10 years, rather than to intangibles, which are amortized over 15 years. Conversely, sellers typically prefer to allocate more to intangibles, which results in capital gain, rather than to inventory or equipment, which may result in ordinary income from depreciation recapture. Because of these economic consequences, the parties may debate this issue heatedly.

Letter of Intent. Parties who are serious will sign a non-binding letter of intent in which each agrees to negotiate fairly and in good faith to close the sale. The agreement may or may not be binding, depending on whether the parties want to be bound before closing.

Confidentiality Agreement. The parties may also sign an agreement that requires confidentiality whether or not the sale closes. This agreement prevents premature disclosure of the sale and protects each parties' business and financial information.

Full Disclosure and Due Diligence. After the letter of intent and confidentiality agreement, the seller makes full disclosure and the buyer performs due diligence. The seller should make full disclosure of, and the buyer should examine corporate records, financial statements, payroll records, leases, contracts, depreciation records, insurance policies, etc. Buyers should carefully assess the risk of overstated earnings, undisclosed debts, poor employee relations, defective inventories, and uncollectible receivables.

Noncompete Agreement. A seller will frequently sign an agreement to not compete with the buyer for a specified period of time and geographic scope. Some of the overall purchase price may be assigned to this agreement, depending on the parties' desired tax treatment.

Summary. Business owners must recognize that selling a business requires considerable time and energy. The more prepared they are, the more they may save time and money, as well as avoid pressure to relent on important terms. They should also understand and evaluate the tax consequences ahead of time.