Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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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!
Enterprise Value
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.
I am leaving a corporation that says it has 1.5M debt. The corporation makes about 300k / yr after servicing the debt on its 9M mortgage with little or no equity. They claim that I owe them 650k and that their payoff of this amount is capital gain for me, even though I received no distribution. Is this correct? My recourse liability for my 1/9 ownership has been 1.1M.
Thanks!
Hi HP,
It’s sounds to me, based on what you’ve described, you are involved with a corporation with a recourse loan from a lender and the lender has foreclosed on the real estate at a value less than what’s owed.
If this is the case, the deficiency which is the excess or amount over the borrower’s adjusted basis in the property would be treated as a capital gain.
Not sure this is exactly what you are dealing with…
I hope this helps…
Can a company buy another company and only assume its assets. What happens to the liabilities? For example, Company A makes speakers with a lifetime guarantee. Company B purchases Company A and only assumed its assets and not its liabilities. Does Company B have to honor Company A’s lifetime guarantee for the products it sold to the consumer.
Thanks!
Good morning GC,
Yes, a company (or individual) may by another company and only acquire its assets and not assume the liabilities recorded on the books or the liabilities which have not been recorded on the books.
In your case, it appears the seller transferred only the assets. Hence, the unrecorded liabilities such as a lifetime warranty would remain with the seller.
The asset purchase agreement should specify exactly which assets were transferred in the sale and also the liabilities which were not being assumed by the new owner. We have some additional information in this post about the differences between an Asset Sale vs. a Stock Sale when a business is acquired.
All the best…
Great website!
I’m trying to understand the tax impacts in the following situation:
12-year old sub-S corp
Enterprise Value: $5MM
Asset Sale (FMV of all tangible assets = $300K and tax book value = $100K; no intangible assets other than goodwill)
Company Debt: $1MM (to be paid off at Closing by buyer; buyer is not assuming debt)
Seller receiving $1MM cash at Closing
Seller receiving $3MM note from Buyer (5 years at 5%)
Single shareholder (stockholder equity on recent balance sheet = $400K)
Will the $4MM in debt get subtracted from the purchase price and result in lower tax? What would the tax impact be if the company had an enterprise value of $5MM and never had debt?
Thank you!
Hi John,
Congrats on the pending sale of your business!
I believe you meant to say “With the $1MM” and not $4MM in debt.
Essentially the buyer is paying $5MM for your business and instead of being paid $2MM in cash at closing, (and another $3MM over the next three years), you will receive $1MM and your lender will receive the other $1MM. The tax consequences will be the same whether your business has the $1MM debt or not.
According to your statements in your question, it appears you are considering the sale of the net assets of your S Corp with an installment note. There are ways to minimize the tax bite and you should find a CPA who specializes in such transaction planning to help you John. Without proper tax planning in advance of the drafting of your asset purchase agreement with the buyer, your tax consequence may not be favorable to you.
All the best…
I am selling my business that has been valued at 225,000 I have around 110,000 in debt, what is the best way to negotiate a sale like this and what are my IRS consequences, this is a LLC company.
Hi Donald,
The debt in the business will reduce your net cash after the sale of your business. Certain buyers may want to assume the debt (if possible) instead of paying off the debt. It really depends on what type of debt your business is carrying. If it is Accounts Payable, then in many cases the Buyers may chose to acquire the debt along with the assets. On the other hand, if your business debt is a bank loan or line of credit, the lender typically won’t allow the seller to transfer the liability to a new owner. Truly, there are many ways to negotiate the sale of a business with debt and the best way to do it… depends on many factors.
As for the questions about the tax consequences, the sale of the assets of an LLC may be taxed on a Schedule C if it’s a single member or as a C Corp, S Corp, or Partnership. All of these tax structures available to an LLC have very different tax consequences when you sell your business.
I am sorry I can’t be more specific Donald. There are just too many variables.
All the best…
I am selling my small business,do the past due accounts receivable stay with me after the sale?
Hi Steve,
Whether the past-due Accounts Receivable (or any other asset or liability on the balance sheet) will be retained by the Seller or assumed by the Buyer is determined based on how the business sale is structured.
If the sale is structured as a Stock Sale, then the buyer is purchasing the business entity’s stock from the individual business owner and everything on the business’ balance sheet remains as is. In other words, in a stock sale, the A/R would belong to the new owner.
If the sale is an Asset Sale, then the answer to your question is “it depends”. In an Asset Sale, the buyer and seller negotiate which assets and liabilities are transferred to the new owner and which will remain with the seller after the sale.
Stock Sales are more common with large businesses. And Asset Sales are very common with small businesses.
All the best…
I am a 50/50 owner of an LLC. My business partner and I have decided to go our separate ways. We currently are personal guarantors of $170,000 in bank debt. He would like to sell me his shares of the business for the assumption of his portion of our business debt. Is this a viable way to “buy out” a partner?
Good afternoon!
The quick answer to your question is ‘yes’… however, you should consider many matters, some of which may include:
If your 50% business co-owner wants to sell his share of the business to you in exchange for his or her release from personal guarantees provided to your lender, consider the following:
1. Is this a fair exchange for his 50% ownership of the business?
2. Will your lender permit it and if so how will the release of the guarantee be documented? (Many lenders will require you to refinance the debt with a new credit facility).
3. If your lender permits your co-shareholder to be released from the personal guarantee, will they require you or the business to put up more collateral or to find another personal guarantor?
4. Are there any tax liabilities (or tax credits) associated with the business for the current year that may be the co-shareholder’s responsibility when he or she files their personal tax returns–this may be the case if the LLC is taxed as a pass-through entity for tax purposes.
5. Are there any tax liabilities (or tax credits) associated with the business for the current year that the company may be responsible for? This may be the case if the LLC is being taxed as a C-Corporation.
Your CPA should have a good handle on your tax consequences should you and your co-owner agree to separate. You should consult with him or her before agreeing to anything!
All the best…
A high interest one year loan is made by a 3rd party to their friend’s LLC, without any collateral required. Repayment terms are not included in the agreement. The LLC is now trying to sell their business. What will happen to the loan if the business is sold ? Will it depend on whatever agreement is reached by buyer and seller, as your article suggests ? Also, is there any “conventional” repayment structure or schedule regarding what portions of the payments are interest and what portions are principle if/when the LLC begins repayments before it is sold ? Thank you.
Good morning,
I’ll tackle your questions one at a time…
The LLC has a loan on its Balance Sheet and if the LLC is sold under a Stock (or Equity) Sale, then the Loan will remain on the books of the company. All that would change in this scenario is the ownership of the LLC and the new owners will need to repay this loan. This is an unlikely scenario.
Most typically, a small business would be transferred to new owners under an Asset Purchase Agreement. Accordingly, the Loan from ‘Friends and Family’ will be a point of negotiation in the selling process.
If I were representing the Buyer in this case, I would have great concern about a loan on the books which does not spell out the terms of repayment. It’s a recipe for misunderstandings (and a legal dispute). If I were representing the Seller in this case, I would resolve this matter by defining the repayment terms before the LLC goes out to market.
As for conventional repayment structures or schedules, loan interest and principal payments are determined by three factors: 1. Loan Amount; 2. Interest Rate; and 3. Loan Term. With this information in hand, it’s simple enough to break down its parts by using a Loan Amortization Calculator.
I hope this helps you. All the best…
Majority partner (80%) wants to sell to minority partners (20%). Bank finances 14 million of AR and inventory while majority partner finances the other 7 million. The majority partner wants to sell the business at a multiple of earnings (i.e. 5 times earnings) and get repaid his 7 million dollar loan to company. Let’s say the sales price is 25 million which would value majority partner’s stock at 20 Million. My question is, how is the debt handled in such a sale? The company has some other small equipment loans but otherwise is debt free. Thanks.
Hi Mike,
Well, I may need a little more information to be able to answer your question.
Let’s start with my assumptions, based on your description…
I am assuming the majority partner’s loan to the business in the amount of $7M is documented with a Note Payable and bears the appropriate amount of interest. It’s likely subordinated to the $14M bank loan as well.
I am also assuming the majority partner did not want to include forgiveness of his or her $7M loan to the company as he or she sells their equity to the minority partners. The $20M purchase price was for the 80% equity stake only.
If my two assumptions defined above are correct, then the former 80% equity partner would still have a Note Receivable from the business after he or she sells their ownership to the other partners. In other words, the debt would remain on the books of the business.
One word of caution if you proceed to sell the majority partner’s equity interest in the business to the remaining partners… Given the fact the business has a substantial loan from a bank, you should check to confirm whether there is a bank covenant restricting equity transfers or a business sale. It is not unusual for a commercial bank to include in its bank loan covenants a provision that states the bank must approve the transfer or sale of the business or in some cases prohibits the sale or transfer altogether.
If I didn’t make the proper assumptions in your situation Mike, please just let me know and I will give it another try.
All the best…
Our employer owned 3 S-Corps with another partner (50-50). They closed all 3 and opened one LLC, moved all of the debt and assets of all 3 companies into the one company. So the new company received all of the debt, accounts receivable, and assets. No money was exchanged.
My thought is that the assets must continue to be depreciated in the same convention as when owned by S-Corp. Many of the assets have been fully depreciated. How do we value the assets on the new books? Do we do a group evaluation of the assets? Thanks.
Hi Laura,
From what you’ve described in your question and from a tax perspective, your employer has sold the assets and liabilities of his/her three S Corporations to a new entity (the LLC.). There will be three transactions that need to be reported to the IRS even though no money has been exchanged between the parties.
Having said that, I highly recommend your employer seek his CPA’s advice on the matters related to tax reporting and how to set up the assets, liabilities and equity in the new entity.
The assets sold to the new entity would be recorded on the books (for reporting and tax purposes) based on the fair market value as agreed between the transaction’s parties.
All the best…
Company has $5 MM of debt, personally guaranteed by the 60 % shareholder. A buyer offers to buy that 60 % for the assumption of all personally guaranteed debt ( $5 MM) plus 2.5 MM cash at closing. Does that mean the buyer has valued the company at $12,500,000.? (5 MM + 2.5 MM is 60 % of 12.5 MM.)
Thank you,
David Fields
Hi David,
This is a great question. Before I answer your questions, I’d like to clarify a couple of important points and offer you some background information.
When a business buyer offers a business owner his willingness to assume the seller’s personal liability for business debt, the buyer isn’t actually putting up the capital ($5MM in your case.) They are simply pledging their personal assets as a guarantee for the business debt. It’s not the same as writing a check to the seller for $5MM. And in fact, it may not even be possible. Most banks and other lenders won’t let others assume the personal liability or guarantee the debt without their approval. In practical terms, the bank or other lender will want to refinance and set forth all new bank loan documents.
Your question is really related to a concept called ‘Enterprise Value’. The enterprise value of a business considers the total capital required to operate a business to produce its profit. When computing the business’ enterprise value, both working capital and permanent capital (such as a term loan) is included.
Your business is large enough to be considered a lower-middle market business which uses enterprise value for valuation purposes.
With that background, I can answer your question.
You are correct to include the $2.5MM in your 60% computation: $2.5MM divided by .60 is equal to $4,167,000.
The $5MM should be added to the $4.167MM for a total company valuation of $9,167,000.
Before I sign off, I want to congratulate you! That’s a very impressive offer.
I hope this helps you David!
All the best…
On the other hand