Before you can understand the importance of negotiating a final small/medium business sale agreement, it pays to brush up on facts about how sales are financed and how proceeds are taxed. Why? Because every decision regarding the payment structure affects when and how money transfers from the buyer to the seller and how the payments are taxed.
In the last article I described how to “minimize taxes when you sell.” You need to be mindful of the resulting Capital Gains or Ordinary income after the sale. In this article, I will focus on some of the cautions when the sale of the business is being financed. Knowing some basic information will help you understand the advice you’re receiving from those who are trained and up-to-date on the legal, financial, and tax implications of small/medium business sales.
Each payment approach provides either you or the buyer – but rarely both of you – an advantage, which means every decision translates to a financial benefit to one or the other, and therefore a point of negotiation.
Following is an overview of the approaches for funding and paying off small/medium business purchases. Your broker or your accountant will be able to provide more in-depth information and descriptions for how the approaches affect your particular sale.
Cash Payoff at Closing. Though rare, all-cash at closing eliminates concern about the buyer’s ability to make after-closing payments. CAUTION: An all-cash payoff has the potential to move you into a higher tax bracket, since you receive all proceeds as revenue during a single tax year. It also limits the buyer pool to those with cash resources or the ability to obtain cash through third-party loans. Research shows that cash-at-closing sales generally result in lower selling prices.
Third-Party Financing. Third-party loans allow the buyer to obtain the required down payment or to pay for the business at closing. CAUTION: Bank loans are increasingly hard to come by and time-consuming to obtain. If during prescreening a buyer indicates need for a third-party loan, request a prequalification letter from a lender prepared to provide the funding. Also, in advance of the sale, contact your bank or SBA office to learn whether and how the purchase of your business sale might qualify for an SBA loan.
Home Equity Loan. Homeowners can self-finance purchases by tapping the equity in their residences through a second mortgage. CAUTION: If the buyer requires a home equity loan to provide the source of the closing-day down payment, and if you provide a seller-financed loan for all or some of the outstanding balance, don’t accept the buyer’s home as loan security since you’ll have a subordinated position should you need to call on the asset.
Seller-Financed Loan. By offering to accept deferred payments through a seller-financed loan you attract more prospective buyers, ease and speed up the purchase transaction, convey faith in the future of your business, and, as a result, tend to obtain a higher purchase price. You also spread sale proceeds over multiple years, which may spare you from taxation at higher rates. A seller-financed loan is detailed in a promissory note that explains the repayment promise and loan terms. CAUTION: By signing a secured promissory note the buyer gives you legal right to valuable assets – collateral – you can seize as recourse if loan repayment terms aren’t met. Beware of collateral in which you take a subordinated or secondary position. Also beware of accepting business assets as collateral, as they can become devalued before you seize them. It is worth noting that the business itself is often collateral for the seller loan, which means the seller gets the business back if the buyer defaults? By requesting a personal guarantee as loan security (and buyer’s spouse’s personal guarantee as well, if they live in a community property state) you obtain a personal repayment promise that allows you to pursue personal assets as recourse if necessary.
Earnout Payments. By agreeing to accept part of the purchase price based on how well the business does in the future you enhance business attractiveness by demonstrating faith in its future. You also reduce closing day cash requirements and provide yourself with a negotiating chip that often protects sale pricing. Further, you spread sale income over multiple years, which may provide a tax advantage. CAUTION: The earnout must be defined in the purchase and sale agreement, including when payments are to be made, how they’re to be calculated, and whether earnout payments are subject to minimum and maximum amounts. Most agreements stipulate that “calculations must be made by an independent certified public accountant mutually agreeable to the parties.” Yet, this approach is risky, as your loan payments are subject to default, if the new owner fails at sustaining the business.
Stock Exchange. If your business sells to a corporation, the buyer may want to execute the purchase using stock rather than cash. CAUTION: Be aware that there are typically process and time restrictions that limit when you can sell the stock you receive, and that unless the stock is widely and heavily traded a sale at a high price may be difficult.
Identify and consult with your Success Team Leader early in the process, to ensure you are well informed about the options which might be best for your business. Email me now at DanYoung@b2bcfo.com to learn who should be the key players on the Success team when you are considering a business sale. A little planning goes a long way.
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