Structuring The Business Buy
Business valuation experts can independently appraise a business'
value. Bear in mind, however, that they rely on the representations
of the seller. They render a conditional opinion based on the
assumption that the financial statements are accurate and complete.
They will attempt to independently verify only certain information.
Accountants are best used to perform an audit (if one
is needed), help interpret financial statements, or provide advice
in structuring the transaction to minimize tax consequences for
the buyer and seller.
Probably the most often consulted advisor in the purchase
or sale of a business is an attorney. Attorneys are asked to
do everything from assessing the viability of a business and
appraising its value to negotiating the purchase process and
preparing the necessary documents.
Attorneys, however, cannot assess the viability
of a business undertaking. That is something only the buyer and
seller can do. Attorneys also generally cannot value a business,
but they can occasionally help negotiate a price between buyer
and seller. The involvement of an attorney (or any individual
other than the principals) can, however, strain the lines of
communication between buyer and seller, so they should be invited
into the negotiation process only after careful consideration.
The primary function of an attorney is to prepare the purchase
and sale documents as negotiated by the parties. It should include
reasonable and balanced protections for both parties. Experience
and reputation are important criteria when selecting an attorney.
The attorney chosen should have experience handling similar transactions.
It may make sense to choose one attorney to represent both buyer
and seller. This avoids the adversarial relationship that opposing
attorneys often adopt and improves the odds of successfully completing
the transaction. It also eliminates some of the emotion in the
negotiation process, improves the lines of communication between
the parties, expedites completion of the deal and is less expensive.
Structuring the Transaction
Tax and other consequences of the structure of a transaction
have an important effect on the overall value of the transaction
to the principals. Each type of structure carries with it different
tax consequences for the buyer and seller. The type of corporation
owned by the seller (regular corporation or S corporation), the
size and date of the transaction, and the type of consideration
paid may all have a bearing on the tax consequences. Since tax
law is constantly changing, it is important to seek legal and
tax advice in determining the best way to structure the purchase
Asset Versus Stock Transactions
The purchase and sale of a business can be structured in either
of two basic formats: (1) the purchase of the stock of the sellers
corporation, or (2) the purchase of the assets of the sellers
In an asset transaction, the assets to be acquired are specified
in the contract. Practices vary from industry to industry but,
in general, all the assets of the business except cash and accounts
receivable and none of the liabilities of the business convey
to the buyer. The seller uses the proceeds from the sale to liquidate
all short term and long term liabilities. This means that the
buyer purchases all of the business' equipment, furniture, fixtures,
inventory, trademarks, trade names, goodwill and other intangible
An asset transaction generally favors the buyer. The buyer
acquires a new cost basis in the assets which may allow a larger
depreciation deduction to be taken. The seller must pay taxes
on the difference between his basis in the assets and the price
paid by the buyer for the business.
The buyer may also prefer an asset transaction for liability
reasons. By purchasing assets, the buyer may avoid the possibility
of becoming liable for any of the sellers corporations
undisclosed or unknown liabilities. The most common liabilities
of this type are federal and state income taxes, payroll withholding
taxes and legal actions.
Stock transactions generally call for all of the assets and
liabilities of the sellers corporation and the stock of
the corporation to be transferred to the buyer. In some cases,
the buyer and seller may choose to exclude certain assets or
liabilities from being conveyed. The seller must pay taxes on
the difference between the sellers basis in the stock and
the price paid by the buyer for the stock.
Sometimes stock deals are more expedient for both parties.
Stock transactions provide for continuity in relationships with
suppliers. They also preclude the necessity of obtaining a lease
assignment when the lease is held only in the name of the corporation
and when there is no provision in the lease calling for an assignment
in the event of a change in the controlling interest of the corporation.
The risk of inheriting undisclosed debts of the seller in a stock
transaction can be minimized by providing for the right of offset
to future payments due the seller.
In choosing to structure a deal as a stock transaction, the
seller should be aware that the U.S. Supreme Court has ruled
that the sale of the stock of a closely held corporation fall
under the umbrella of federal securities laws. This places a
greater burden on the seller in a stock transaction to fully
disclose all material information about the business. Failure
to do so opens the seller up to the risk of securities fraud
It is rare for a privately-held business to change hands for
an all-cash price. Almost all transactions are structured as
installment contracts which provide for the seller to receive
some cash, but for the bulk of the purchase price to be owner
financed. For smaller privately held businesses, the down payment
often ranges from 10% to 40% of the selling price and the buyer
executes a promissory note (secured by the assets of the business
only) for the balance. Such notes are typically for a period
of 3-15 years at an interest rate that varies with the prime
rate but is most often a market oriented rate. The payments required
to retire the debt service should generally not exceed 25-50%
of the discretionary cash flow as calculated in the section on
"Pricing the Business."
Just as in an installment sale, a leveraged buyout uses the
assets of the business to collateralize a loan to buy the business.
The difference is that the buyer in a leveraged buyout typically
invests little or no money, and the loan is obtained from a lending
This type of purchase is best suited to asset rich businesses.
A business that lacks the assets needed for a completely leveraged
buyout may be able to put together a partially leveraged buyout.
In this structure, the seller finances part of the transaction
and is secured by a second lien security interest in the assets.
Because leveraged buyouts place a greater debt burden on the
company than do other types of financing, buyer and seller must
take a close look at the business's ability to service the debt.
An Earn-out is a method of paying for a business that helps
bridge the gap between the positions of the buyer and seller
with respect to price. An earn-out can be calculated as a percentage
of sales, gross profit, net profit or other figure. It is not
uncommon to establish a floor or ceiling for the earn-out.
Earn-outs do not preclude the payment of a portion of the
purchase price in cash or installment notes. Rather, they are
normally paid in addition to other forms of payment. Because
the payment of money to the seller under the provisions of the
earn-out is predicated on the performance of the business, it
is important that the seller continue to operate the business
through the period of the earn-out.
In some instances a business owner may want to accept the
stock of a purchasing corporation in payment for the business.
Typically, the stock he receives (if it is the stock of a publicly-held
company) may not be resold for two years. If the stock may not
be freely traded, it is not as valuable as freely traded stock,
and its value should be discounted to allow for this lack of
There is an advantage to the seller in this kind of transaction.
Taxes incurred by the seller on the gain from the sale of the
business are deferred until the acquired stock is eventually
sold. This kind of transaction is termed a tax-free exchange
by the IRS. There are several tests that must be met to qualify
for this tax treatment. Check with a competent accountant or
tax attorney or request a ruling from the IRS Reorganization
Branch in Washington, D. C.
reprinted from the SBA Management Aids, number