Possible Pitfalls in Stock Sales
The biggest surprise many business sellers receive concerns what parts of the business are actually being sold. What should presumably be a simple concept is regrettably often quite complex and not intuitive. Here is a primer on what you might encounter during the sale of your business.
The first matter is whether you are selling certain assets or the stock of your business. All things equal, a seller prefers a stock sale as it generally minimizes taxes on the transaction while allowing the seller to “walk away clean” after closing. Buyers generally do not embrace a stock sale because of the potential of inheriting unknown liabilities and reduced future tax benefits due to getting assets at often heavily depreciated values which leaves minimal depreciation expense available for the buyer. But let’s say you have some valuable, off the books assets (like contracts with customers) which will transfer to new owners in a stock sale, but “go away” in an asset sale. The buyer of your business is thus willing to enter into a stock transaction in order to keep your valuable customer contracts. Great, you say. What could be easier? Please read on…
First of all, most stock sales are “cash free, debt free.” The good news is that you get to keep the cash in the business at close. The bad news is you have to retire all debt at close. Debt obviously includes banks loans (both term and line of credit), and it often includes less obvious forms like leases, credit cards, and money owed for the shareholder loan you gave the company during the tough 2009-2010 years. Many capital intensive businesses have far more debt than cash so before you know it, a big chuck of the proceeds from your stock sale are used to retire bank debt and pay back the shareholder loan you haven’t thought about in years. And if you elect not to pay it back (it’s just to me…I’ll just forgive it) guess what? A forgiven loan, even to yourself, is considered taxable income to the business.
If you are OK with the cash free, debt free nature of the transaction, what else should you watch for? I’ll bet you have never heard of a 338h(10) IRS election. If the buyer plans to make this election (you will have to agree), your assets are written up from the low, depreciated value to market values. That’s wonderful for the buyer because he now has the advantage of a higher asset value base which means more tax avoiding depreciation. Unfortunately, you as seller will have to pay ordinary income on the amount written up under the 338h(10) election. And if you decline to cooperate on this write-up, you could jeopardize the entire sale.
We will discuss one more pitfall, and this one is generally the most contentious – the amount of working capital left in the business. But wait I can hear you saying. You wonder why you should have to leave a dime of working capital in the business. On stock deals greater than $2.0 million, it is the expectation of buyers that an “adequate” amount of working capital (A/R + inventory – A/P; remember you have already pulled out the cash) be left in the business at close for the buyer. Who determines how much working capital remains in the business? The buyer of course. And if you cannot negotiate a working capital formula which is acceptable to you, again you could lose your buyer. Working capital nuances are often too complex to address in a blog; suffice it to say that if you feel working capital discussions (or other aspects of stock sales) are out of your comfort zone, please consult with professionals experienced with such matters.
Contributed by Michael Greengard, Praxis Business Brokers.