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Buying Or Selling A Business: The Drive For The Goal Line

We are currently experiencing a significant increase in the number of business buy/sell transactions and it appears that the trend will continue at least through the end of the year. There are a number of reasons for this uptick, including:

  • The largest segment of the baby boomer generation is reaching transition age in reference to their businesses and personal wealth.
  • Interest rates remain relatively low.
  • Approximately $900 Billion of “dry powder” is sitting in private equity firms waiting to be deployed.
  • Projected changes in the tax laws will significantly increase capital gains rates.

Of all the reasons listed above, the largest factor driving deal flow is the significant increase in the tax rate on capital gains from 20% to 39.6% as part of the Biden tax plan, which is projected to take effect on January 1, 2022.  On a transaction with $10,000,000 in capital gain, this increase would represent an additional tax liability of $1,960,000.

If you are considering buying or selling a business, you may not be sure where to start.  The purchase or sale of a business is a process—not an event—and successful transactions require a great deal of patience and planning.  Although the actual process may vary depending on the individual circumstances, most transactions have certain aspects in common and typically flow through the following stages.

The Search (Dating Before Marriage). A transaction usually begins with informal, preliminary and high-level discussions with one or more potential buyers. Some companies may also engage an investment banker to provide introductions to potentially interested buyers and to guide these discussions. This stage is generally more focused on value exploration, fit and feasibility.  A potential buyer will want to inspect the business and its records before making the initial decision to move forward. Potential buyers should work closely with their advisors in the preparation of a “due diligence” checklist of critical information to be requested from the seller. Public records should be searched to determine if there are any tax liens, judgments, suits, bankruptcy proceedings or security interest filings against the target company or its assets.  Before engaging in any serious discussions with or providing any sensitive confidential information to potential buyers, it is critical that potential sellers require potential buyers to execute a non-disclosure agreement that includes a non-solicitation provision.  Sellers want to avoid disclosing their sensitive information to prospective buyers who then walk away from the deal and use the information for their own competitive benefit.

The Letter of Intent (The Initial Non-Binding Roadmap)At some point, the buyer will be ready to provide a proposal describing the deal structure and how much they will pay for the business.  This proposal is memorialized in a letter of intent (LOI) or term sheet outlining the basic terms of the proposed deal.  The terms  in the LOI should include critical terms such as structure (see asset vs. stock sale discussion), purchase price and adjustments, earn-out structure, indemnification and escrow, no-shop exclusivity provisions, and treatment of employees post-closing. The primary considerations relating to deal structure are: (i) transferability of liability, (ii) third party contractual consent requirements, (iii) owner approval, and (iv) tax consequences.  The LOI can confirm agreement on basic terms while identifying any major areas of disagreement before too much time, money and emotional capital is invested in negotiating a formal contract. On the other hand, the LOI should not be allowed to take on a life of its own. At some point, the parties will be better served by turning their attention to negotiating the contract of sale.

The LOI is usually intended to be non-binding, but if it is not carefully negotiated and written, it may actually constitute a binding contract. There has been significant litigation surrounding this very issue. To avoid legal disputes, include language stating that the LOI is non-binding and for discussion purposes only.  Once the LOI is executed by the parties, due diligence will begin and a significant amount of leverage will generally shift to the buyer.

Asset Sale vs. Stock Sale (A Pivotal Tipping Point).  Whether the transfer takes the form of a stock sale or asset sale is a key factor that should be vetted and negotiated at the LOI stage of the process. In a stock sale, the company is acquired intact; only the owners change. All liabilities remain with the company, including contracts, potential lawsuits, tax liabilities, employee benefits, etc. To avoid assuming unknown liabilities, the buyer will, in many instances, prefer an asset sale, or, in the alternative, will ask that company liabilities be fully disclosed in the sale contract.

Another element in deciding whether the transfer should be structured as a stock sale or an asset sale is the representations and warranties – assertions that a buyer and a seller make to each other in the sale contract. A representation is an assertion as to a particular fact that is given to induce the other party to enter into the contract. A warranty is a promise of indemnity, i.e. security against legal liability, if the assertion is false. The scope of the representations and warranties included in the contract are an important consideration for both the buyer and the seller.  Sellers are generally expected to make more encompassing representations and warranties in a stock sale.

In addition to the above considerations, the ultimate decision regarding the structure of the deal may depend in large part on a number of competing tax planning considerations. For tax-planning purposes, sellers tend to prefer stock sales, and buyers tend to prefer asset sales.

For example, if the selling entity is a “C” corporation or an “S” corporation with built-in capital gains, the seller may propose a stock sale to avoid double taxation. If a C corporation sells assets, the corporation is taxed on the sale price of the assets at ordinary income rates, and subsequently the stockholders will be taxed a second time when they receive distributions of sale proceeds from the corporation. By contrast, there is no double taxation in a stock sale since stock and not assets are being purchased and gain on the stock sale will generally be taxed at the shareholder level at more favorable capital gains rates. Consequently, 100% of the sale proceeds are paid directly to the stockholders rather than the selling entity.

In an asset sale, even if the seller is an S-corporation or an LLC, the seller may be subject to recapture tax on depreciated assets. Recapture tax is at ordinary income tax rates rather than the lower capital gains rates the seller may receive in a stock sale.  Additionally, in an asset sale, the buyer and seller will negotiate the allocation of the purchase price among the various classes of assets. The buyer may want to allocate more of the price to assets that can be depreciated over a relatively short life thereby allowing for higher annual tax deductions. Assets that fall into this category include “hard” assets such as equipment. Goodwill and other intangible assets tend to be amortizable over a longer period, which provides the buyer with less favorable tax treatment. In contrast, to the extent the price is allocated to these intangible assets, the seller will be taxed at the more favorable capital gains rates, rather than the higher recapture tax rates imposed on the sale of equipment.  This potential problem of double taxation in the sale of the business is sometimes the main reason for electing to be a pass-through when the entity is first formed, especially if the owners hope to sell the business at some point in the future.

An additional consideration in an asset sale is that a 6% bulk sales tax will be imposed by the State of Maryland on the amount of the purchase price allocated to equipment and other hard assets (other than inventory that was purchased for resale) and real estate transfer and recordation taxes would also be imposed on any real estate being conveyed. The seller can mitigate the effect of sales taxes by pushing to have less of the purchase price allocated to hard assets (which has the added benefit of reducing recapture taxes) inventory and receivables, or requiring the buyer to pay a greater share (or all) of the sales tax.

Focused tax planning is critical in any transaction to realize the most favorable tax results.  We highly recommend that you consult with your tax counsel in the very early stages of the process.

The Sale Contract (The Rubber Meets the Road). Once the major deal terms are nailed down, the buyer and seller can begin creating a formal contract of sale. This process can be a rigorous contest of allocating risks.  Some of the most hotly negotiated provisions are the representations and warranties made by the seller. The buyer will want as much recourse as possible against the seller if there are any post-closing hiccups. The seller, on the other hand, will want to minimize his or her personal liability in the transaction. In the best of all seller worlds, the sale contract would provide for an “AS IS” sale, shifting the risk to the buyer and compelling the buyer to make a thorough due diligence investigation. On the other hand the buyer, wanting to hedge their investment risk as much as possible, will tend to ask for strong warranties. At a minimum, the seller should expect to make certain basic warranties (e.g. that there are no liens on the assets, that tax returns and financial statements are accurate, and that the seller has disclosed any current litigation). That said, the contract of sale should not be viewed as an insurance policy, and the seller should not be expected to underwrite the buyer’s business risks.

As a compromise, the buyer may suggest holding back some of the purchase price, either in escrow or under a promissory note, in order to secure the seller’s liability for breach of warranties, while not imposing too much liability risk on the seller.  It is a good strategy to make it clear up front (i.e. in the LOI), the warranties that the buyer expects and the ones the seller is willing to give.

Consulting and Non-Competition Covenants (Another Conversion of Capital to Ordinary). The buyer may want the seller to continue with the company as a consultant, in which case a portion of the sale price may be in the form of consulting fees — a currently deductible expense to the buyer. These fees, however, would be taxed to the seller at ordinary income tax rates rather than as capital gains. The seller may also be asked to sign a covenant not to compete. Again, part of the purchase price may be treated as a fee for this covenant which is also taxed at ordinary income tax rates.

NOTE: At this point, you may notice a pattern in that a tax benefit for one party tends to be a tax detriment to the other. To some extent, the IRS will respect the agreement between the parties because the IRS tends to come out ahead either way, assuming the parties file consistent tax returns. The IRS ensures this consistency by requiring both parties in an asset sale to report the agreed upon purchase price allocation with the filing of their next income tax return.  In certain limited circumstances, and with careful planning, a structure may be available that will represent a tax win for both the buyer and the seller.

Payment Terms (Show Me the Money). Fortunate is the seller who can negotiate a cash deal. Even with airtight documentation, a seller takes a significant risk anytime they finance the deal. (Advice to live by: The best paper a seller can receive in a transaction is paper bearing the pictures of Presidents.)

Often the seller is forced to finance at least a portion of the purchase price.  One advantage of a seller-financed deal is the potential to defer taxes until payments are actually received (an “installment sale”). Rarely, however, does this tax benefit outweigh the risks of taking back paper.  The well advised seller will also ask for personal guaranties from the buyer’s principals and will want the buyer to pledge the sale assets as collateral for the seller-financed portion of the price. This is accomplished by having the buyer grant a security interest in the sale assets and recording that security interest in the public records to put future lenders on notice that the sale assets are encumbered.

Distributing the Proceeds (Finally).  When all the closing conditions are satisfied, the deal is ready to close and the funds are exchanged.  This is the time that the transaction actually occurs.  The structure of the transaction will determine the methodology for the distribution of the sale proceeds.  The seller should always consult with their tax advisors as to the optimal method for distributing sale proceeds to owners before the contract of sale is signed. That tax advice may prove pivotal in determining whether the seller is willing to accept a stock sale or an asset sale.

Successful acquisitions require a great deal of patience and planning. A deal may seem simple at the LOI stage, and that’s an important first step. But buyers and sellers alike should be prepared to confront difficult decisions as the formal contract is negotiated. If you are well prepared in advance of the transaction, the rewards can be well worth the effort.

For questions about this article, or any other business-related matter, please contact an attorney in our Business and Transactions practice group.