Volume 7 Issue 2 -- March/April 1995
In the last issue we looked at the buyer's perspective on buying a business. This month we'll look at the same transaction from the seller's standpoint.
Let's suppose that you, Howard, are the owner of Howard & Sons, Inc., a medium size garage, and that you want to sell the business to a prospective buyer, Susan.
Your reasons for selling should dictate what you sell, when, and how, but often much effort goes into price negotiation without adequately considering the other needs of the buyer or seller.
Business sales are nothing but contractual agreements and can be as broad or narrow as the parties desire. Howard can agree to sell all or part of the business using a variety of methods, which vary in risk and should affect the price.
If you sell all of the stock of Howard & Sons, Inc., it is certain that the buyer will get control over all of the assets, including intangibles such as the corporate name, along with customer lists, hidden debts and claims -- the entire bundle of things and rights associated with the business.
But if Susan wants to buy assets, rather than stock, you have to decide which assets you want to sell. If Susan is already in the business she may not need all of the assets, such as tools. Perhaps she wants only the land and building. The most important point is that both the buyer's and the seller's desires and needs must be considered.
If you are eager to retire, you probably want to sell all of the assets for a lump sum price and forget about the business. If so, the easiest type of sale is everything "on the barrelhead" for cash.
Such a sale has the virtue of simplicity but often results in the lowest price for the seller, because the buyer is taking most of the risk that the business will continue to be profitable.
What if, as often happens, Susan, says "Well Howard, I can only pay part of the price now. Can you give me some payment terms?"
What Susan is asking you to do is finance the deal. This is often called "seller financing" and is O.K. but is subject to risks, including the risk of never getting paid.
There may be a compensating benefit. Nearly all sellers who provide financing retain a security interest in the assets sold. Upon a default, you may get the assets back. For this reason, it is a good idea to have inspection rights over the assets to make sure the buyer is not frittering them away.
Suppose Howard is not ready for retirement and wants to continue working, but without the full responsibility for the business. Susan could pay Howard for the assets (or stock) and keep Howard on as an employee-manager.
Because salary is deductible for tax purposes, some buyers want to keep the former owner on a guaranteed salary thus getting, in theory, a lower purchase price.
For tax purposes, however, it is extremely important that the asset (or stock) sale and Howard's employment agreement be segregated. Both subjects should never be addressed in the same agreement.
If the IRS determines that Howard's employment agreement is really part of the purchase price for the business, then Susan will not be able to deduct Howard's compensation in computing the business's income tax.
Despite the tax benefits, Susan should be very cautious about keeping Howard on as an employee-manager. Often, former business owners do not make good employees because they are accustomed to being independent and are not good at taking orders.
What if Susan wants Howard to promise that there are no existing tax audits, employee claims for unpaid over-time, and the like? Such promises are generally called "warranties," which are contractual promises that a thing works as promised or that a fact is as represented. Susan may want Howard to promise, for example, that the business's receipts are really what are shown on the financial statements.
It is common for sellers to be asked to provide warranties if the condition or representation is vital to the success of the business being purchased.
Howard may also ask Susan for warranties, such as about her financial resources. If Susan is a savvy business person, she may ask Howard to agree to a cash escrow regarding the warranties or other representations. For example, if a warranty or representation turns out not to be true, the cash escrow may be forfeited to Susan.
"Covenant not to compete" is a fancy term for a promise not to engage in or start a competing business. Whether Howard sells his stock or assets it is very likely that Susan will ask Howard to sign such a covenant. Howard should not be surprised.
Without a covenant not to compete, Howard would be free to set up another garage business directly across the street. Obviously such competition would undermine what Susan believed she had purchased.
If Howard agrees to stay on in some capacity, it is likely that the employment or management agreement with Susan will prohibit Howard from competing whenever he leaves the business, for whatever reason.
By Tax and Business Professionals, Inc.
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Manassas, VA 20110
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