Chapter Six

Will it be an “ASSET” sale or a “STOCK” sale? The first (and most fundamental) question when structuring either an internal or external transition of any business, is whether it will be structured as an “asset” sale or a “stock” sale. Since most companies are either corporations, or LLCs taxed as a corporation, this discussion will refer to corporations. If your business is a sole proprietorship or partnership, your situation will be similar to an “S” corporation.

Most sales are structured as an “asset” sale. In some cases a “stock” sale is more appropriate, although the parties to the sale may not realize this. There are major legal and tax issues involved, and they impact the buyer and the seller differently. The difference can be profound, with major operational, legal and tax ramifications.

This fundamental decision can become a highly contentious difference between what the buyer and the seller want in the sale!

Buyers: Although it will not always be the case, buyers will usually prefer an “asset” sale structure.

An “asset” sale exposes the buyer to less potential carry-over legal liability than a stock sale, so the starting point recommendation from most attorneys representing the buyer will be an asset sale. The tax effects in an “asset” sale also tend to favor the buyer compared to a stock sale, so most CPA’s for the buyer will also favor an asset sale. Accounting rules for publicly traded corporations favor “asset” sales, so big national buyers favor asset sales.

Although the starting point for most attorneys will be to favor an “asset” sale, the legal issues are complex and varied. There is much more involved than just potential carry-over liability, and other issues can sometimes favor a stock sale instead of an asset sale. For instance, favorable contracts of all kinds with third parties are often much easier to preserve in a stock sale. Legal issues are covered in more detail in other chapters.

Sellers: The decision is not as clear-cut on the seller’s side of the table. In some cases, taxes on the seller will be essentially the same regardless of whether a sale is structured as an “asset” sale or a “stock” sale. In these cases, the seller is usually neutral between an “asset” and a “stock” sale.

In some cases, the seller will be taxed much more heavily in an “asset” sale. In these cases sellers will strongly prefer a “stock” sale. The extra tax can be so high that it will actually kill the deal unless either the sale is structured as a “stock” sale, or some other way can be found to reduce the tax.

There are various ways to mitigate the tax damage; all of which add complexity, and none of which completely eliminate the problem. The simplest solution is to mutually agree to a “stock” sale. The disadvantages to the buyer can be offset by a reduced price.

An overview of the tax issues is provided at the end of this chapter. Ways to potentially mitigate the damage are covered in other chapters.

Basic Steps in an Asset Sale:
In an “asset” sale, the assets of the corporation are sold directly by the corporation – not by its shareholders personally. Let’s assume for purposes of illustration that the primary asset sold is the company’s customer accounts or book of business (an “intangible” asset) in a heavily intellectual property based business. The stock of the corporation is not sold – that would be a “stock” sale.

The basic steps in a typical “asset” sale by an incorporated business are as follows:
(1) The buyer is often an existing company that is already incorporated. That corporation is the “buyer”; not the shareholder(s) of that corporation. If seller financing is involved, the shareholder(s) of the buying corporation will generally be required to guarantee payment of the purchase.
(1.a.) NOTE: If the buyer is an individual who intends to operate the business as a corporation, that buyer should form the buying corporation PRIOR to the acquisition.

(2) The buying corporation pays the selling corporation for those assets. The money and/or seller-financed promissory Note goes to the corporation, not directly to the selling corporation’s shareholders.
(2.a.) The buying corporation may need to renegotiate various legal agreements, such as leases, contracts with key vendors or customers, etc. These negotiations are often started prior to closing of the sale, particularly if a favorable lease or critical vendor or customer contracts are involved.
(2.b.) The buying corporation becomes the NEW employer of the selling corporation’s employees. New employment contracts should have been presented to the employees prior to closing, with enough time for their attorneys to review the drafts prior to signing. In order to make non-piracy covenants in those new contracts enforceable, the employee should not do any work for their new employer until they have signed their new terms of employment.

(3) Next, the selling corporation pays whatever liabilities it owed at the time of the sale, plus any taxes owed on the sale of its assets. The corporate taxes are owed in the year of sale.
(3.a.) An often overlooked seller obligation is accrued employee vacation, even if the seller keeps its books on a cash basis.
(3.b.) An “S” corporation might not owe much tax; although this is not always the case. Always check with your CPA on this.
(3.c.) If the seller is a “C” corporation, the federal tax at the corporate level is likely to be 34% or more, plus whatever tax your state imposes. Much, but not all, of this draconian extra tax can be mitigated by pre-planning or a more sophisticated structure for the sale.

(4) After taxes and whatever other liabilities the selling corporation may owe are satisfied, that corporation then “liquidates” itself and distributes the remaining after-tax cash and/or promissory Note that it received from the buyer to the selling corporation’s shareholders.
(4.a.) Any remaining assets owned by that corporation that were not included in the sale are also distributed to its shareholders at this time. For instance, the seller’s company car is often in this category.

(5) The shareholders then pay personal capital gains tax on what they received. If significant taxes were owed at the corporate level first (such as with “C” corporations), then this is essentially a second tax on the same sale!
(5.a.) Counting state and federal taxes at both the corporate and personal levels, the combined tax on the seller can easily be over 60% of the total sale price. 

Taxes this high can obviously be disastrous to a seller. Worse, the impending tax hit may not be known by the parties until the seller's C.P.A. is brought in just before closing. All parties (particularly the seller) are dismayed by the taxes about to be owed, but it can be difficult to restructure a sale at that late date. But if the tax problem cannot be solved, it can rightfully become a “deal killer”.

Disasters like this can be avoided by advance planning by the seller prior to the sale, and by a more sophisticated sale structure at the time of sale. For instance, if the selling “C” corporation had switched to “S” status 10 years earlier, then most of the problem would have gone away. Likewise, it is often possible to greatly reduce the double tax problem with a more sophisticated sale structure at the time of sale. This is discussed in a later chapter.

When is an Asset Sale “OK” from a Tax Standpoint?
From a tax standpoint, an asset sale is most appropriate when the draconian tax at the corporate level can be avoided. This is most likely when the selling company is either not incorporated at all, or is an “S” corporation that was never a “C” corporation in the first place. In each of these cases, the corporate level income tax on the sale of the book of business can be avoided. There may still be other taxes, but this avoids what is usually the worst tax hit at the
corporate level.

If the selling company is an “S” corporation that used to be a “C” corporation, then the date of the conversion is crucial. A “C” corporation that converts to an “S” corporation must wait 10 years before most of the tax at the corporate level goes away. However, if 10 years have not gone by since the switch, an “S” corporation may have just as big a problem as it would have had if it were still a “C” corporation. For “S” corporations in this situation, the corporate level income tax will be on what the IRS refers to as “built-in gains”.

All shareholders are taxed in an asset sale, even if they are not selling their own shares. Hence, if one shareholder is selling but the business as a whole is not being sold, then an “asset” sale is rarely appropriate. Shareholders not involved in the sale would not appreciate having to pay taxes just because someone else sold. This situation is almost always a “stock” sale of that shareholder’s shares.

Basic Asset Sale Tax Effects on the Buyer
Assume the primary “asset” being sold by a company is its customer accounts. The price paid for this asset will be amortized (i.e., deducted for tax purposes) by the buyer over a 15-year period regardless of the length of time over which payments for it will be made. Obviously, a tax deduction spread out over 15 years is not worth as much as a deduction that the buyer gets to take right away; but it is still worth having.

If the buyer subsequently re-sells that book of business, the amortization that was taken each year will have to be “recaptured”. In most cases, this means the deductions taken each year must be reversed and treated as income in the year of sale. This “phantom income” in the year of the subsequent sale generates tax at the corporate level that must all be paid in the year of that sale! This is a major future tax that the buyer should consider and plan for at the time those customer accounts are originally purchased.

Amortization of intangibles (such as a company’s book of business) is covered by Section 197 of the tax code. In 2005, the rules were changed on how this amortization is “recaptured”. The intent was to collect more money (naturally). Under the new rules, it is very difficult to avoid “recapture” of the entire amount previously amortized when a purchased book of business is resold. Obviously, this has the potential to be a major unexpected tax hit in an
“asset” sale even for an “S” corporation.

There appear to be ways to avoid full amortization recapture. They are more likely to work if they are planned for at the time the accounts are purchased rather than after the fact when they are re-sold. These methods appear to be entirely consistent with tax law, but are a “facts and circumstances” issue that cannot be guaranteed. To your authors’ knowledge, they have not been tested in court.

Basic Asset Sale Tax Effects on the Seller
If the selling corporation is NOT a “C” corporation or an “S” corporation subject to the draconian corporate tax described above, then in most states the corporation itself will not owe income tax on the sale of its assets.

The selling corporation's shareholders will still owe capital gains tax at the personal level. Capital gains tax will be about 20% at the federal level, plus whatever state and local taxes your state imposes. For many sales, an additional Obamacare Net Investment Income Tax of 3.8% will also be included.

If the seller is a "C" corporation, then sellers will be taxed first at the corporate level, and then what’s left will be taxed at the personal level.

The selling corporation will owe corporate income tax on almost the entire amount received. State tax rates vary by state, but the federal tax will be about 34% depending upon the size of the sale. Next, the individual stockholders will then owe capital gains tax on what’s left at the personal level. The state tax will vary, but the federal tax will be about 20% plus a potential Obamacare Net Investment Tax of an additional 3.8%. The combined federal tax will be about 50%. When state and local taxes are added in, the total tax on the seller can easily exceed 60% of the total sale proceeds.

Many sellers would rather not sell at all than pay taxes this high. If the seller has this tax predicament, several basic tools are available to at least partially remedy the situation. They will be explained further in subsequent chapters.

CHAPTER 3

GETTING READY 
FROM THE BUYER'S PERSPECTIVE

In the previous chapters, we talked about sellers who are in the process of considering a sale.  The focus in this third chapter starts instead with the BUYER, and then moves on to look at the big picture aspects of the PRICE.

A critical question worth repeating as we move on to rules for buyers is:  Do you really have a willing seller?  Or, is the seller so emotionally tied to the business that no buyer will ever actually be good enough to pass muster?  Is the seller reluctantly willing to sell -- but only if the price/terms are unrealistically high?

Potential sellers should think these things through very carefully before spending a lot of everyone’s time and money on a seemingly desirable deal that is unlikely to actually take place. 

Once it becomes apparent to you as a potential buyer that the seller is not really ready to sell, then it's time to politely walk away.  Don’t burn your bridges though; the seller may very well be more ready at some point in the future and you can resurrect the deal at that point.  Just don't waste time and money before the overall timing is right.

Buyers
The following rules are presented from the buyer’s standpoint, but sellers should be acutely aware of these things too: 

First:  
The first rule for buyers is:  Know what YOU are looking for.  Buying a business is risky, expensive, and a LOT of work for the buyer.  Do your homework first.

*Not every business is worth the same to you as it is to other potential buyers.

• What business would fit the best with what you already own?
  
•  What can YOU bring to the table to enhance its value after the purchase?
  

In other words, what business can you buy that will result in a 1+1 = 3 scenario? (or even 4?)

• This is so important, that if the resulting effect of 1+1 is not more than 2, then perhaps you should not buy it at all.
  

Second:  
Another rule for buyers is:  YOU are for all practical purposes "selling" yourself personally and/or your existing company to the seller at this point as well.  That’s because if you really want to buy that target business, someone else probably does also.  It’s about a lot more than just price and terms. 

So, why should this seller sell to YOU?

*Be ready to sell yourself and/or your company as the most appropriate buyer for that particular business. 

• The seller is almost always looking for a buyer he or she feels comfortable with personally and believes will take proper care of the business, its employees and its customers post-sale.
  
• If you fail this unspoken test, you can lose the opportunity before you ever get to issues such as price and terms.  
  

Third:  
The third rule for buyers:  Be ready.

Be ready financially -- a strong balance sheet, good banking relationships, and enough uncommitted cash flow with which to do the transaction are essential. Be ready with your own time -- if your time is already fully committed, how are you going to handle the additional management burdens?

Fourth:  
Another rule for buyers:  Consider the basic steps in a business sale.

• Is there a business broker involved, and if so, on which side does their allegiance lie?  Which party pays the commission?  If I as the seller sign a listing agreement, can I get out of it, and how long does it last?  What if I bring the buyer to the table myself, do I still owe a commission to my broker under an “exclusive right to sell” agreement?
  
• Can or should both sides use the same attorney or C.P.A. in order to save professional fees?
  
• Should you sign a confidentiality agreement up-front?  At what point?
  
• Will this deal be seller-financed in whole or in part, or do I need to get a banker on-board early and see if financing is available beyond what cash I have for the down payment?
  
•  Am I willing to personally guarantee all or part of my company's promissory Note to the seller for the balance of the purchase price, or to pledge additional collateral?
  
• How much cash will I need for working capital until the cash flow situation in the new business settles down following closing?
  
• Do I need a business valuation, and if so should it be a full-blown appraisal or just an opinion letter?  Will my banker require an appraisal in order to loan me the down payment or all of the purchase price as the case may be?
  
• What role does a letter of intent (an "LOI" or "terms sheet") play?  What kind of LOI should you create?  Should it be binding on both parties or non-binding, or should only portions of it be binding?
  
• Will the seller request a good-faith cash deposit up-front, perhaps paid into escrow?  Refundable or non-refundable?
  
• What due diligence is needed, and when, and should the other party pay part of the cost if they back out prematurely for no good reason?
  
• What contracts are likely to be needed, and which side should have the subtle advantage of drafting first and controlling the documents (customarily the buyer, since it has the most risk in how the transaction is structured and written up)?
  
• What should you expect at closing?
  
• Will an independent third-party professional escrow be necessary for the eventual closing?
  

Fifth:  
The fifth rule for buyers:  Know the legal basics.

• What are the crucial legal distinctions between an "asset sale" and a "stock sale" that will determine the overall structure of the entire deal?
  
• What additional risks do I effectively assume if I buy the stock of the seller's corporation, as opposed to buying the assets out of that corporation and thereby shedding most of those risks?
  
• What to do with the employees? 
  
• What about a non-compete agreement with the seller entity as well as the individual owner(s) thereof, or with key employees of the target business who might leave following closing and go right into competition with the very business you just paid a lot of money for; or
  
• Does the target company already have those crucial non-competes in place with key employees, and if so are they enforceable and transferable?
  
• You need to know the basics, but you will definitely need professional help to get this right.
  

Sixth:  
Another critical rule:  Know the tax basics!

• If I personally buy the company's stock from the seller, I'll have no tax deductibility on the purchase price.  Does that matter to me, or would I rather have that higher tax basis and thereby pay less tax when I re-sell the company sometime in the future?
  
• Or, should I have my own company buy that same stock instead?  Can my corporation or LLC buy stock in another without causing serious tax consequences?
  
•  Am I comfortable with the hidden or unknown risks in this industry or this particular company that come along with a stock purchase format, including the risk of prior taxes unpaid or under-paid by the target corporation; or do I want to insist on an asset purchase format instead and thereby try to “shed” most of those potential liabilities?  Can I mitigate that risk by having the selling stockholder indemnify me for all or part of those taxes, interest and penalties, or even other unknown and/or unexpected exposures?
  

Never forget, there are three parties to every business sale -- the seller, the buyer and the IRS.  A sale can be a lose/lose/win (guess who the losers are…); or, the same sale can be re-structured to constitute a win/win/lose.  If there is a “loser” in this deal, you want it to be the IRS.

• The taxes on sale of a business can exceed 50% of the total sale proceeds if the sale is structured wrong!
  
• The seller can even end up owing more to the IRS at the front end than he receives as the down payment from the buyer . . . a particularly unfortunate (and generally avoidable) result of poor tax planning.
  
• You don’t need to be a tax expert; but you do need to know there are ways to mitigate this kind of tax disaster and also be able to point the seller in the right direction for professional help.
  
• You need to be willing to work with the seller to resolve what may be critical issues to the success of the sale. 
  
• You need to know the basics, but you will need professional help to get this right.

Seventh:  
The seventh rule for buyers:  Know how to use your own professional advisors, and when to bring them into the picture (earlier is better, even up to a year or more under some circumstances).

• CONTROL your professionals in order to keep expenses down and prevent them from killing your deal.  It’s YOUR transaction, not theirs.  Get advice from them, but do not let them renegotiate the sale.
  
• Keep relationships cordial.  You will almost certainly need help of some kind from the seller after the sale closes, so don’t let your professional advisors poison that well.
  

MOST IMPORTANTLY:  The most important rule for buyers (and for sellers too for that matter):   The sale must be perceived as a “win” on both sides.  In most cases, neither side is compelled to do the transaction.  If either side concludes that the sale is a “lose” for them, then the deal is likely off at that point.

Special Situations
Some special situations will be covered in more detail in later chapters but deserve a brief mention now:

Internal Sales  
Many business owners would love to sell their company to their key employees, but they don’t think it’s possible.  The most frequently cited reason is “but they don’t have any money.”

You work with these key employees every day.  You probably already know they have the basic talent to run the business, or you would not even consider selling to them.  They may already have been running it for many years already from a practical standpoint.  Only money seemingly stands in the way.

The fact is, the money issue can almost always be handled to everyone's satisfaction.  The REAL key issue is instead, “Do they have the fire in the belly, and the risk tolerance, to be an entrepreneur?” 

The heart of an entrepreneur is an intangible that can’t really be measured or pinned down; but if your key employees have what it takes to be one, then you can probably arrange win/win terms that work financially for them and give you a better long-term after-tax price than you could receive from an outside third-party sale.

As always, YOUR expectations need to be reasonable.  Just as with a third-party sale, the price and terms must “pencil-out” for the buyers in any internal succession.  The down payment is likely to be less, and the seller financing will probably run for more years.  Terms are likely to include a way to split the fruits of future success.

We’ll discuss this more in subsequent chapters, but suffice it to say that if your key employees have what it takes to succeed after you are out of there, then internal succession can be your best exit strategy financially.  It can also be an excellent way to attract and retain top-notch employees with an expectation of participating in the buying group and a way to ensure a satisfactory sale of your business when the time is just right in the future.

Family Sales 
Family sales are a particularly difficult kind of internal sale.  All the usual considerations of internal succession apply, plus uniquely complex tax considerations.

The IRS is deathly afraid parents will do something nice for their children.  So an entire chapter of the tax code is devoted to making sure the IRS gets its “fair” share (they consider about half the total value of the business to be “fair”).  Needless to say, this adds to complexity.

Intra-family dynamics can be even more complex.  Just because a child has the talent, does not mean that he or she has the experience to run the business.  And talent + experience still do not mean the child has the intangible heart of an entrepreneur.  Even establishing the price can be more difficult than in an arms-length sale since a child can find negotiating with a parent over price and terms to be essentially impossible.

Price
What about “Price”?

Ultimately, the “Price” must be justified by (i) the future cash flow the buyer can reasonably expect from the acquired business, and (ii) the risk the buyer must take in order to receive that cash flow.

 But “Price” is much more than just money to a seller.  It can even be seen by him or her as a reflection of their individual worth as a person.  A buyer overlooks this only at their great peril.

Starting the conversation with comments designed to push down the price can be fatal to an emotional negotiation like this.  You are not haggling over the price of a car here.  “It will have to pencil-out, of course, but it’s probably worth quite a bit…” is often a good starting point comment for you as a buyer. 

Emphasize creating a “win/win” transaction overall.  Remember, the seller most likely does not HAVE to sell, and likewise you do not HAVE to buy.  As soon as either party perceives the transaction to be a "lose" for them, the sale will die.

An emphasis on AFTER-TAX cash to the seller is also extremely helpful.  Thanks to our overly-complex tax laws, it is often possible to restructure a sale with a lower stated “price”, but more actual after-tax cash for both the seller and the buyer.

An “all-cash” deal is low risk for the seller, but much riskier for the buyer.  Therefore, the price is almost always significantly lower in an all-cash transaction in order to compensate for this mismatch in the risk area.

What about payment terms? 
Terms are not as emotional, but in a practical sense can be even more important than price.  In fact, your authors are fond of saying "The price is not the price . . . terms are everything!"  Terms determine how the sale will “pencil-out” for the buyer.  For example, seller financing over a period of 10 years is much easier for the buyer to pay for out of ongoing cash flow from the business, and thus justifies a higher price. 

Terms can also dramatically affect taxes for both sides.  Since it only counts if you get to keep it, this consideration alone can be more important than price.

Terms affect the risk for both sides.  Terms so stiff that the sale cannot possibly pencil-out will obviously raise the risk for the buyer.  Less obvious, the seller may incur more risk from draconian terms like this as well.  An upside down buyer is much more likely to look for an excuse to rescind a sale or some way to sue the seller for misrepresentation or a breach of the seller's representations and warranties in the purchase and sale agreement. 

Terms can be massaged to share the risk, thus lowering the effective risk for the buyer.  Lower risk translates to a higher price.  It is fairly common for part of the price to be dependent on future results and retention of business (called a partial "earn-out"), which is a great way to share risk and reward.

Other factors will affect the price as well.  For example, do key employees have, or can you create at closing, enforceable non-competes (see our later chapter entitled NON-COMPETES)?  What about major customer accounts?  Will key vendors terminate their contracts when the "founder" of the business is no longer around? 

What about the building occupied by the company?  Does the target company’s owner also own that building?  Is the Lease transferable, and/or how much longer will it run?  Are there any options to extend or to buy the building and not have to incur major expenses in moving the entire business later on?  Is the business owner a personal guarantor on that existing Lease, and will the landlord release him or her from that guarantee at closing or simply execute a brand new Lease with the new owner?  Is rent likely to be raised post sale?

Finally, it’s not all about “Price” anyway.  Price certainly matters; but is rarely the key to a sale. 

A seller is likely to have other “hot buttons” that can make or break the deal.  Some are obvious, such as how key employees will be treated post-sale in all respects.  The seller may want to see to it that a couple of his "pet" long-term employees are retained for a number of years at the buyer's expense. 

Other hot buttons can be quite unusual.  Your authors well remember a sale that hinged on providing a parking space on company property for the retiring seller’s yet to be purchased RV.  The buyer initially balked, which would have killed the sale.  It has been many years now since the closing, and the seller never did quite get around to parking his RV in that spot that seemed so crucial to him at the time.