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.
If I sell my business with just equipment debt of 1-2 years old (debt is less than the actual value of the asset/truck) and the buyer made his offer based on a multiple of EBITDA. Why would I pay off this specific debt at close when the asset/truck is going to produce future revenue for the new owner? This does not seem reasonable IMO.
Paul, a multiple of EBITDA helps get to an enterprise value, based on a cash-free/debt free transaction. IF you have extra cash in the business, you most likely retain it, subject to a few terms and if you have debt, you would pay it off. Think of it in terms of the value of your house. It is worth what it is worth, but the equity you have in your house ties back to the level of mortgages or home equity lines you might also have in place. Same with your business. The enterprise value of your business is the multiple of EBITDA based on a cash-free, debt-free basis, however, the equity value in your business is enterprise value, minus debt, plus the cash you receive.
If you have no debt, the enterprise value is the multiple times your EBITDA. The equity value is the multiple, times your EBITDA, plus your excess cash.
Matt
Matt,
In making this type of “asset” purchase, where you are basing the price on a multiple, say 3times EBITDA, how are the A/R and A/P accounted for. Does the Seller have to pay the A/P from the purchase price and the buyer gets the A/R?
Hi Mark,
In an Asset Purchase business sale, the buyer and seller agree to the inclusion/exclusion of A/R and A/P. There’s no standard way that it’s handled.
This negotiation should occur when the seller receives the LOI or the inclusion/exclusion may become a purchase price reduction as the parties creep closer to the closing table.
Good luck!
If you sold you business at Mar 19 and the SPA says that the buyer can make relevant claims for estimates 18 months of the sale, can they claim for bad debts and credit notes that were understated 18 months after sale ? As the position of debt will be bad and uncollectable 18 months later ? Realistically we cover for those debts at the time of sale and that we can control as it is covered under our bad debt provisions made at Mar 19?
Hi Timmy,
I am not exactly certain what you are asking.
I’ll give this a whirl though…
Generally speaking if your Stock Purchase Agreement (SPA) states that the buyer of your business may make claims against the seller for a period of 18 months, the buyer has this window of time post-closing to identify any differences or inconsistencies with the reps and warranties made by the seller which may be present. There are typically other terms that may apply when making a claim against a representation or warranty.
If you identified an amount of bad debts in your SPA or on the P&L at the time of closing, this would have been part of your representations (in the form of a financial statement). So, it’s a matter of identifying what the seller represented (or warranted) at the time of the closing vs. what was actually the case. If there is a difference and it’s within the 19 month timeframe, there may be a valid claim from the buyer.
Please consult with your M&A attorney!
If I do a strict asset sale of my business, inventory, shelfs, equipment only, do I have to close my line of credit for that business?
Hi Mathilda,
What you’d have to do should be spelled out in your line of credit agreement.
Typically, lenders require they be paid in full when the majority of the business’ assets are sold.
Hope this helps…
I loaned the company I worked for money. The owner sold the business without paying me. Are the new owners responsible for the debt that I loaned to the company?
Ruth:
Did you put this loan in writing? A classic mistake is to loan money and not have written evidence of the loan.
The answer to your question is based upon WHOM you made the loan to. Did you make a personal loan to the old owner? Did you make a loan to the business entity?
If you made a loan to the owner, the new owner does not assume that debt. If you made a loan to the business entity, it depends whether the prior owner sold the ENTITY in its entirety to the new owner, or just sold the assets of the business. If the owner sold just the assets, then the old owner remains liable. If made a loan to the business entity and the entire entity was sold, you’ll need to collect from the new owner. If the seller didn’t inform the buyer of the debt, you may have to prove your debt!
Sold a business for 10 million, buyer also paid off business debt of 2 million (accrual basis) … is the 2 million also considered income?
Karen: Yes!
By the way you ask the question, I’m concerned that this wasn’t discussed with your financial advisors prior to the transaction closing!
I purchased a franchise 10 years ago using my retirement funds, (ROBS transaction) for $200,000. I am selling my business for $450,000. The prospective buyer wants to use part of their retirement fund (ROBS transaction) and part SBA loan to purchase my business. Is this possible to do and how to we allocate the purchase price between the two?
Yes, I am a SBA lender – this sort of transaction happens all the time. How to allocate it? Typically the SBA loan is 80% or 90% of the total project cost (Which is purchase price plus closing costs and SBA fees). Then the borrower/buyer must inject 10-20%, sometimes more. Therefore I often see that the ROBS can be used for the equity injection/down payment-so it can be 10-20%, for instance. Once in a while I’ve seen some put down more to lower the SBA debt. Also, the equity injection/down payment can be a mix of cash, savings and ROBS rollover funds.
Hi,
We are looking to purchase a Business which comes with a building. This will be a complete asset sale as the company which owns this business owns several other businesses. Due to current LTV ratios, can we ask the owner to secure a mortgage against the building as they will get a better rate, and we can take up on that commitment ?
The money raised from the mortgage can pay-out the owner the price of the asset and we can secure a cashflow loan for the goodwill.
The main thing I want to know is that if the mortgage can be transferred to us at the time of purchase and if the funds raised can be used to pay out the owner?
Thanks,
Anas:
In answer to your direct question, when the ownership of a property changes, MOST loans require any outstanding debt linked to the property to be paid off in full. It is rare (but not unheard of) for a lender to allow a change in ownership of the property because the new borrower might not be qualified to take on the loan obligation. The seller may also be required to put a personally guarantee on the loan which cannot be transferred at the borrower’s option to another person.
The bigger thing that I see is that you may not be asking the right questions here. Have you spoken to both an attorney and tax advisor as to the best way or ways to structure your purchase deal? If not, you could be setting yourself up for some future headaches that you don’t even know are there.
Feel free to ask for help regarding tax issues from us our your tax advisors.
Hello. I am considering selling my small shareholding in a privately owned business. It has Bank Debt, Debt to the other shareholders and Debt to me. The debt to me is due from a previous share sale. Which of these debts should be considered when valuing my shares?
Sean
It appears that the entity has bank debt and shareholder debt. The shareholder’s debt is generally considered junior debt in a company’s debt portfolio versus bank debt, which is regarded as senior debt.
To determine the entity’s stock value, you would need to establish a company’s value. This can be accomplished by:
Market Capitalization = (Shares Outstanding x Current Share Price) + Current Long-term Debt.
Enterprise Value = Equity Value + Debt + Preferred Stock + Noncontrolling Interests – Cash
In either of these equations, debt is factored in when determining the value of the company.
Sincerely,
Chris
Disclaimer
The information provided is not designed or intended as legal or financial advice. It is for the educational or sharing of informational purposes only. It is not a substitute for consulting with your legal or financial advisors to obtain their professional consultation.
We are evaluating taking over a wholesale distributor LLC of dry food products who has been in operation for 20 years. Annual sales averages about $1.8M but has potential to grow with the right systems in place. The owner wants outright purchase of the remaining inventory and fixed assets like furniture and fixtures and a small cargo truck. Office and warehouse space is being rented with a contract renewal of 2021. My concern is the small 25k revolving working capital loan, ITR transparency, and seemingly high inventory and asset valuation. We plan to hire an auditor to look at the books and get a realistic value to assets. Anything else we need to do?
Dear Alvin
Congratulations on your desire to grow through acquisition. The process does have a lot of moving pieces and will most likely be an asset sale.
Here are some of the items you should consider:
Financial concerns
Current business financials
Cash flow issues
Acquisition financing
New business working capital requirements
Operating budgets and proformas for both current and new business
Recasting of financials
Acquisition requirements
Cultural fits /goal alignment
Process alignment: payroll, HR, benefits, inventory, management, suppliers, manufactory methods
Facility concerns: EPA, Licensing, zoning
Ownership structure: Partnership, joint venture, merger, etc.
Employee retention
Asset / Equipment age / Value
Buy-side due diligence
Financial
Customer make up
Production processes
Government filings /documents (FDA)
Product / service lines
Equipment
Purchase agreement
Employment contracts
Deal structure
Business Valuation
Advisors: Legal, CPA, Business Broker
Sincerely,
Chris
The information provided is not designed or intended as legal or financial advice. It is for the educational or sharing of informational purposes only. It is not a substitute for consulting with your legal or financial advisors to obtain their professional consultation.
Alvin:
A wholesale operation doing $1.8MM seems like, small potatoes (excuse the pun). I don’t know how many times they are turning the inventory, but as a wholesale operation, I would think that it would turn would be 10-20X a year at the minimum. Therefore the value isn’t really in the assets/inventory here. The value is in the ongoing relationships with customers and vendors. If you takeover this business and you lose a handful of key customers, then your business is in trouble–fast. Wholesalers have thinner margins and rely on volume. Valuing the assets should be a numerical thing–how fast do they turn their inventory historically and how much inventory is supposedly there right now. If the numbers are far apart it indicates that there is a lot of “dead” inventory you probably don’t want. Sitting there and taking a physical inventory may be expensive relative to your need for that data.
Considering the pandemic, this is when the troublesome customers are going to show up—the ones that can’t pay or sell your products.
In summary, my advice is to investigate the sales chain as more important than the nominal cost of the assets. Never take the tax returns as anything but “worst-case scenario”–owners hide income; rarely do they hide expenses to pay more to Uncle Sam.
I sold a business for $300k, from which $100k was used to pay off corporate tax debt and I received $200k. My basis is $150k. Would my gain be $300k-$150k=$150k or $200k-$150k=$50k.
please advise
Karee:
Based on the information provided in your question, it cannot be determined what your gain is. Because you mentioned that this was a corporation that was sold, we don’t know if you sold the assets of the corporation, if you sold the stock, or how you arranged this transaction. Furthermore, you state your basis is $150K, but again, we don’t know if there is an adjustments needed to that basis or if that figure represents adjusted basis.
If you are asking just in an informational way, DEBT does not affect basis of a sale. If you sell for $300K and your basis after any adjustments is $150K, then you have a $150K gain (300-150=150).
If you would like to discuss your situation, please feel free to call or make an appointment with me or your local tax advisor. We can be reached at 832-572-5400.