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 currently own 50% of the business. I have 2 other partners (Husband and Wife) each have 25%. They want to sell their portion (50% combined)to me for $300k. We have a $150k loan that we all signed guarantees on that the business is repaying. Does the Guarantee fall 100% on me after the Buyout? How do we get the Personal Guarantee Debt away from them? Is this possible without a New Loan or a restructure of the current loan?
Jane:
As with many things in business, you get what you negotiate. There is no absolute rule on relief from personal guarantees. You will need to discuss with the lender the reasons for having the guarantee removed for former owners, and more importantly, be able to satisfy the lender’s need for security in case of default.
Best of luck!
What happens to shareholders loans when he sells his/ her business.
Mbuso:
You asked about shareholder loans when the business is sold. Unless the buyer and seller made a specific agreement to the debt, the Seller remains obliged to pay the debt back to the corporation. Debts don’t just disappear. If the corporation forgives the debt, then the Seller has income in the amount of the forgiven loan.
What is common practice when buying a business
that has preexisting gift cards as well as paid memberships for services not yet rendered. The seller wants me to take on the liability and pay only what it would cost me to pay the employee working that particular shift. Is there a common practice. And hiw would you handle it.
Hi Lucas,
This is typically a sticky point of sale negotiations.
The business owner benefited from the cash he/she received for the gift cards and prepaid memberships without incurring any costs. The cash received should have been recorded on the books as a Liability (not income). When the services are subsequently rendered, the Liability would be removed and Income would be recorded. If this were done, the seller would be able to tell you exactly how much has been prepaid. It would be showing up as an Asset and equal Liability on the Balance Sheet. Here’s how:
The cash received should have been deposited (or moved) into a separate checking account and not utilized by the business until the services are rendered. I am going to guess this has not happened.
If it did, there would be a checking account with the outstanding gift card/membership prepayments balance that represents the business’ Liability on its Balance Sheet.
That balance does not belong to the business owner (seller) until the services are rendered to the customers.
If this balance is not on the Balance Sheet, it’s what we call an off the books liability. And that liability is one that can get a buyer into trouble.
So, with all that said Lucas, here’s what I would do:
First, I would ask the buyer to identify how much is truly owed for outstanding gift cards and memberships. This amount is a liability that should be defined in the Asset Purchase or Stock Purchase Agreement and the seller should represent and warrant the amount is accurate.
Second, I would reduce the purchase price by this amount.
Why? Again, it’s the seller’s liability — not yours.
If instead the liability were a deferred loan from a bank, would you agree to pay it? Not likely.
If the seller says it’s not likely that all of the customers will redeem their gift cards or memberships, it’s an invalid argument because for many businesses (state dependent) an unclaimed gift card must be turned over to the state as unclaimed property.
I hope this helps a bit Lucas!
I am rooting for you…
If the private assets of the owner can be sold to defray the debts of the business then the owner has what?
Hi Ezi,
I am sorry, I don’t understand your question…
Happy to try to help if you’d rephrase your question 🙂
How does a partial owner of an LLC sell their shares of the business when the business is in debt?
Hi Caliope,
The same way any other business is sold between LLC members.
The existence of debt, if substantial, is typically considered and negotiated when the enterprise business valuation is calculated.
In the instance of an asset sale of a S-Corp in the State of Georgia do debt liabilities go with the business after the sale or do they stay with the original owner because of the S designation? We are trying to purchase a business that is going to go bankrupt at a discounted price and are willing to take on the debt (less than $100k) but the seller seems to think he will remain liable.
Alan: When you sell the assets out of an entity, anything that was not sold remains in the entity! Of course, that means if the entity has liabilities before the sale, those liabilities remain with the seller unless they are specifically sold to the buyer (which is uncommon).
The main reason a buyer wants only the assets is because the buyer doesn’t KNOW what the HIDDEN assets are–is there any unhappy former customer waiting to file suit? Are the debts that are undisclosed? Buyer doesn’t want that baggage!
Of course, you can assume any specific debts if the buyer or seller agree.
If you don’t assume all the liabilities, then the seller is stuck with them. And if the seller has filed bankruptcy, then any cash realized in the sale, the court will likely assign to pay some or all of the debts that remain on the seller’s books.
I own a business with EBITDARM circa £560k which also owns the trading property which has value of £4m. There is net debt of £2.2m. I am involved in a project whereby my business is to merge with other similar businesses into a larger group, so I will exchange my shares for shares in the group pro rata. At the same time private equity will buy 50% of the group shares on a multiple said to be 11x. I understand the new group is intended to run debt free. The intention is that the proceeds from PE investment will be used to pay the group shareholders so we get 50% cash and 50% shares. At this very early stage it has been stated that the new group will also purchase the property so my assumption is there are one of 3 scenarios.
1. We are paid for 100% of the property – £4m – which then allows for repayment of the bank debt, then the EBITDA is adjusted down for a market rent and the 11x multiplier applied to this adjusted EBITDA, and then receive 50% of this as cash plus 50% as shares in the new group.
2. The property is not considered separately and so the value is EBITDARM x11 less net debt, and the debt is refinanced by the new group. Again the deal is 50% cash and 50% shares.
3. Private equity buys 50% i.e. 560k x 11 = 6.16m – 2.2m net debt = 3.96m x 50% = 1.98m. This is not sufficient to pay off the debt in total and does not give me cash although the income from the shares will be the highest. Or am I wrong with the way I am viewing it?
The person organising this has always spoken in terms of the value of the business as a multiple of EBITDA and stated they would also buy the property. I am guessing he is used to an OpCo/PropCo split which happens to be an unusual scenario for our business where the property is integral to the business (think hotels for example).
I understand how to get a sense of the returns for me from scenarios 1&2 . Scenario 1 gives me more cash and a lower income from the residual shares, and option 2 gives me less cash but more income. However I can’t quite see how it works for scenario 3.
This deal is at a good premium to what I would expect from a usual trade sale on a standalone basis and has potential for growth from the group shares. The organiser has been very focused on selling the future prospects for the shares as he will of course be saying to the PE investor. Since I am close to retirement I am personally more focused on the initial cash consideration. As interested as I am in the potential future growth and the likely dividend income, as the saying goes ‘cash is king’, and the rest is speculation. If anyone can shed some light on scenario 3 for me it will be very helpful in deciding whether to continue with this if scenario 3 is how it turns out. This is not expected to go to due diligence for another 3 or 4 months. I suspect scenario 1 is the one which we will have and scenario 2 would also be satisfactory, but want to understand how they all potentially would work for me.
Any comment on the above will be appreciated. I will of course, once the shape of the deal is known in detail and I have a valuation, be taking formal advice with regard to the contract.
I bought a business and guaranteed the loan partially with my personal real estate assets. I put in 75% of the capital and my partner put in 25% but I put up my houses as collateral as well. We want to establish a fair process for selling shares from me to my partner and need to understand how to value the risk exposure I have as part of determining that value of a share of stock when I sell it to my partner.
Kevin – the value of your business does not include the personal risk that you took on in the process of acquiring the business. The price and value of your company is that which you are willing to sell to a third-party, whether it be your minority partner or someone outside of the business. The best place to start might be consulting with a professional on the valuation of your business on a 100% basis and then work backwards to figure out what discounts / premiums are associated with each shareholders stock.
Kevin: I understand the question is how to value the additional risk you accepted by using personal assets as collateral. However, in the interest of fairness of a partnership, loans should not be part of the valuation of the business. If you are selling 100% of your interest to your partner, then your partner needs to find a way to collateralize his loan without you. If you are selling only a portion of your shares and maintain an interest in the business, you should offset your capital interest reduction by a similar amount of offloading of the collateral.
If I am buying a C-corp for $5.5 M in cash at the close, and the company has $1.5 M of long term debt on the balance sheet, does it mean that that I am assuming that debt. The seller is getting paid $5.5 for the balance sheet. Right? I am not paying $5.5 M plus I have to assume the debt of $1.5M. Am I right on this?
I am paying $5.5 M and receiving all assets ( tangible and Intangible) and that $5.5 M includes $1.5 M of LTD .
Jacques:
Right off the bat, I am concerned for you! You are about to spend a lot of money and it sounds like you don’t *KNOW* exactly what you are buying! You COULD be buying that debt or MAYBE not! This is something that should be CRYSTAL CLEAR before you ink this deal.
If you are purchasing the STOCK of the corporation, then you are acquiring the corporation, in its entirety. That means you are responsible for the debts and contingent liabilities, too! Anything the corporation signed for or did becomes yours if you are buying 100% of the corporate stock.
If the agreement calls for you to buy ONLY the assets of the corporation, then you get exactly that—just the assets and none of the liabilities.
But either is a real possibility. Without seeing your written agreement between the parties, I cannot offer any advice other than–if you haven’t spoken to BOTH a knowledgeable business attorney AND a tax advisor to review this situation, then RUN AWAY from this deal until you have done that.
Best of luck and Happy Holidays to you!
Private equity wants to purchase a majority of my business with debt. Do I assume my portion of that debt when the company sells again in 5 years? Or is the loan repaid by PE proceeds?
Paul:
When you state that the Buyer wants to buy a portion of the business, I am *assuming* that you are the owner of the remaining portion. When you say they are purchasing “with debt”, again, I am making the assumption that the BUSINESS is the borrower and the Buyer is either arranging for this debt or guaranteeing its repayment.
Under these assumptions, you, as shareholder, own a portion of the entirety of the business–meaning assets AND liabilities. The purchase of the company is essentially being leveraged by the business’ assets.
If someone later comes along any purchases the 100% ownership of the company, then your interest is bought-out. But the value of the company will be diluted–in other words lessened–by the debt used and not paid back prior to the second sale.
Imagine your company is worth $5M today with no debt. The PE company comes in and gets a $3M loan to buy 60% of the company from you. In 5 years, the company is worth $10M, and $2M of debt is still on the books, so they sell the company for $8M. You own 40% of the company at the time of the 2nd sale, so you will get $8Mx40% = 3.2M for your share. Add this to the $3M you got earlier, and you have 6.2M for your company.
If you had held 100% for the next 5 years with NO debt, the company would have been worth $10M, and you’d have gotten 100% of that.
So, you have to figure what the ADDED VALUE of selling to the PE firm is. Will they compound the growth that you could not do? Will they add value in some other way? Or could you just wait 5 years and sell out for a bigger number? With the PE firm, you get some cash now (guaranteed) and some later–with no guarantee.
Good Luck!
Paul:
The business pays off all the debt, so your pro-rata share ownership should increase in value at the same rate as the private equity group as the business continues to pay down the debt. This is true if you’re both in the same security or equity. If they are in a preferred equity and you’re in a common, they may accrue a greater return than you. We typically like to see all shareholders in the same equity security.
With most private equity there are no personal guarantees on the debt, however, all the equity is subordinated to the debt holders meaning whatever you “rollover or retain” in the new company is subordinated to the lenders. If the business goes under, you could lose some or all of your roll-over dollars.
Key questions you should ask yourself in a private equity deal:
1. Am I in the same stock or security as the private equity group or are they in a “preferred” security that could provide them with a better, preferred return?
2. Is my future ownership calculated based on the value of my roll-over equity, as a part of the total equity used to finance the transaction, not the purchase price? Your roll-over equity should equate as a percentage of the total equity in the transaction, NOT the purchase price.
3. Am I comfortable with the level of debt service that will come on the company? You know better than anyone else how much debt service the company can support. Just because a lender will provide debt on a business, doesn’t mean it’s prudent for the business. We typically see clients wanting no more than 3 turns of EBITDA in the form of leverage. If you have $5M of EBITDA, then total indebtedness is $15M or less. Many private equity groups look to increase their returns by over leveraging the business. If everything goes perfect and the business continues to grow and doesn’t hit a speed bump, no problem. However, if you hit an obstacle or slow period, you can find yourself in a lot of pain and in default of loan covenants that could impact the value of your company and related roll-over equity.
Matt
Paul:
We do about $150M of transactions annually with private equity groups. Here’s how this works. The business takes on debt and there are no personal guarantees on the debt, however, the value of all equity is subordinated to the debt.
You’ll want to make sure that the equity you retain equates to a % of the equity going forward if debt is used, NOT the purchase price. Here’s an example: If your business is worth $10M, and you are rolling over $2M, and the business will take on $5M of debt, then the total equity in the business after the transaction is $5M (10M value minus $5M debt) Your $2M roll-over would equal a retained interest of 40% of the equity going forward ($2M your equity roll/$5M equity total equity). Often times we see private equity groups say that your $2M roll-over equals 20% of the business. They put in $3M of equity and borrow $5M. These numbers are a head fake. If the business was flat for three years and sold again for $10M, you want to make sure you are getting 40% of the proceeds after debt, not 20%.