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Entrepreneurs may often be under the wrong impression that their business debt will disappear when the business is sold. In some cases, the debt is absorbed or is assumed by the buyer. But usually this is not the case.
Knowing what happens to business debt when selling a business is a critical part of the exit planning process and in determining which buyer is making the best offer.
The pandemic introduced PPP Loans, which may not be forgiven by the SBA, further complicate things. The SBA issued a Procedural Notice to address how to handle an outstanding PPP Loan when selling a business.
Furthermore, understanding how the debt on the company’s books ultimately affects the purchase price paid by a buyer or investors is important. And regardless of how the business is transferred, it’s important to understand how debt on the company’s books influences the price paid by the buyer or group of investors.
Stock vs. Asset Sale
While larger businesses and those sold in the public markets are typically sold under a Stock Purchase Agreement, such transactions can occur in the lower-middle and middle market. Stock sales are consummated with the transfer of the common and/or preferred shares of stock to a new owner. When this occurs, the buyer or investor is responsible for all debt and liabilities recorded on the books, as well as any undisclosed liabilities which may be present. Because of this, many small businesses are not sold under a ‘stock sale’ arrangement.
Asset sale arrangements between a business owner and a buyer involve the transfer of title to certain assets and in some cases certain liabilities. The combination of assets and liabilities transferred in an ‘asset sale’ is varied and subject to negotiation.
For example, in an asset sale a buyer may purchase the Inventory and one half of the Accounts Receivable while assuming all of the Trade Accounts Payable. The seller may retain one half of the Accounts Receivable and the Line of Credit. Any combination of Assets and Liabilities may be transferred to a buyer and/or retained by the seller in an asset sale transaction. A better term for an asset sale may be a non-stock sale.
As you can imagine, every buyer wants to acquire different assets and may be agreeable to assume certain forms of debt or liabilities, so comparing multiple offers in an apples-to-apples fashion can be challenging.
To further complicate the comparison process, each asset being transferred holds a different tax basis which affects the net amount of cash the seller receives after filing his federal and state tax returns. Don’t try this at home!
When public companies are compared in acquisitions, sophisticated Investors use a financial measurement called Enterprise Value to compare companies with different capital or debt structures.
Enterprise Value is a measurement of how much it takes to buy the entire company, not just the stock or equity. A company may sell its shares of common and preferred stock to investors for a sum of ‘X”, and at the same time assume the debt or liabilities equal to ‘Y’ and enjoy the cash on its balance sheet equal to ‘Z’.
Enterprise Value considers all three factors: Stock Price (X); plus the debt or liabilities on the books (Y); less the cash on the books (Z). EV = X + Y – Z.
Enterprise Value is a more accurate measurement of a company’s value because it includes the debt that the business must pay to its creditors and also accounts for the offsetting cash on its books.
Debt Counts No Matter What the Size or Kind of Business Sale
Business buyers, who understand capital structure and how a company’s debt negatively impacts its value, incorporate debt into the amount they offer to the seller. This is true whether the transaction is a stock or an asset sale.
If it is a stock sale, the buyer has added the amount of debt owed and subtracted the cash on the books to compute the company’s value.
If it is an asset sale, the debt is accounted for.
However, it is not a straightforward computation and the debt’s impact on the cash they ultimately receive from the sale is not always obvious to the seller.
When selling a business, the entrepreneur will be well-served if he seeks advisors who are able to provide apple-to-apple comparisons while accounting for debt and other liabilities. Although the computations needed to do so are not as simple as calculating the Enterprise Value of a public company, the principle is the same.
Am I responsible for the debt of my newly acquired business?
Oh, my, James! If you are asking this question AFTER the purchase, then you didn’t do your homework! You definitely needed to know the answer BEFORE you signed the paperwork.
Unfortunately, I don’t have the answer, because “It Depends”. It depends on what you bought! Did you buy the ASSETS of a business, or did you buy the STOCK or MEMBERSHIP interests of the business. If you bought just assets, then the answer is typically that you are not liable for any debts of the prior owner, UNLESS the assets themselves are encumbered. If you bought the entire business, then you probably ARE liable for all the debts and claims of the prior owner.
I recently got power of attorney to help my ill Father sell his business. After 40 years he has a negative owner’s equity over 300k and retained earnings of positive 100k. He average annually, 500k in sales and an ok profit margin of about 20%. I am unclear how to explain this negative owner’s equity to people inquiring about buying the business. They see the balance sheet and think the company has no value.
Are they right? What kind of transaction can remove this? I guess if deposits 300k; but what else can erase previous years of taking too much from the company?
Good morning Ryan,
Without reviewing the P&L and Balance Sheet statements and based on what you’ve described, I would agree with your assessment that the distributions or dividends paid to the business owners were too high. This is why the Owner’s Equity is negative. It does not mean your father’s business has no or negative value.
For most small businesses, buyers acquire the assets, possibly certain liabilities and not the entire business entity under what’s called an Asset Purchase Agreement. In such case, the value of the business has really nothing to do with the Balance Sheet or the Equity it may or may not have. Instead, the value is based on how much cashflow the business produces each year and most importantly in the last twelve months.
There are other factors that appear on the Balance Sheet that do matter. One of those types of assets may be Inventory.
You should consider having a business valuation (or calculation) prepared so you are able to understand the business’ fair market value and be able to defend your asking price.
If you simply want to resolve the negative Equity, your father would have to contribute $300,000 to the business which would increase the Equity on the Balance Sheet by the same amount.
I don’t recommend doing so because sophisticated buyers understand they are buying the business’ assets and not the business entity. The negative equity due to taking too much money out of the business has nothing to do with its underlying value.
Hope this helps!
All the best…
I just sold my company for 52 million. I had bank debt of approx 10 million so my net cash proceeds was approx 42 million. My question is how will the 10 million in bank debt be treated tax wise? I know I can’t write 100% of it off. Can I only write off my ordinary income tax bracket percentage off of the 10 million bank debt? Sorry if the way I asked the question is confusing. I have a competent person helping with my return but I am trying to understand this before hand. Thanks!
Congratulations on your exit! That’s always exciting, even if the number is a fraction of your gain.
As for how debt is treated for tax purposes is usually simple — it’s ignored. The reason is that when you took out the loan, the cash you received (or spent) was not considered income. Therefore, the payback of the principal is not an expense. The interest you paid on the loan, assuming it was for business, was deducted each year that you paid or accrued it.
Consider how that transaction would look if there was no debt involved–you would not have any extra income nor extra expenses. Think of the debt as a “side transaction” that has no effect on profit or loss.
Randall Klein, EA