Buying or Selling a Business
Answers to your questions.
This is a quick brief on buying or selling a business. Get help before you go proceed.
A client says, ‘I’ve bought a business’.
We ask ‘Did you buy shares or assets?’
You can buy the assets of the business or you can buy the company that owns those assets. Buy the assets and you usually get the inventories, equipment and goodwill that are key to the business. You do not get the shares of the company. They stay with the seller. Buy the shares and you get the company that owns the assets and business.
‘Does it matter, we bought the business – What’s the problem?’
No problem, they are just completely different deals.
You buy shares, you take over a company that carries on that business. That company is not you; it has its own rights and responsibilities. It may have been around a while, so it may have misbehaved. You are now responsible for its past misdeeds.
Buying assets is usually less risky because you buy things — some trucks, some inventory, some goodwill, so you do not take responsibility for the seller’s past sins. POINT — Shares and assets are different deals – different taxes, prices, and risks.
‘You accountants always complicate things. I bought the shares. That’s the business, right?’
No, the company owns the business; you own the company that owns the business.
Your advisers will do due diligence. You might need environmental certificates – to satisfy your bank. We’ll all spend a lot of time – and make sure you can’t sue us if anything bad shows up later. No matter how good we are, we may miss those past sins. It’s costly and you won’t get 100% certainty.
‘I said keep it simple—we bought shares. That’s simple.’
Wrong. It looks simple.
Buy assets and you check titles and count inventory. You can often buy the assets on a bill of sale.
You do the same things and more if you buy shares, because you also have to consider past misdeeds and the company’s creditors. You may have to take on their liabilities—like trade payables.
These things affect the price you pay.
‘The seller insists on selling shares.
Maybe he got advice before he made the deal. Sellers commonly want to sell shares to reduce their taxes by using the Capital Gains Exemption. Also, they may want you to take over responsibility for their past sins.
You, the buyer, usually (there are exceptions) want to buy assets.
The two of you are both talking about ‘the business’ but you are thinking different deals so you get confused. We see few share deals. Most buyers want assets.
‘Let me worry about the past sins — the seller will indemnify me.’
Of course you will get indemnities as part of the deal. What are they worth?
The problems may show up years down the road. You’ll have to prove your loss and liability, and try to collect compensation. Indemnities are fine short term (if funds are escrowed)
‘No problem. I trust the seller. I’ve known him for years.’
Do you trust his kids or executor? Let’s look at how your share purchase might work.
Most often you buy the shares of a company that has only the assets you want— inventories, supplies, fixed assets, and goodwill. The seller takes out the cash, receivables, cars, cottages etc, and (hopefully) pays off all the creditors before the sale. You may take over some liabilities.
You buy a clean company with just the assets you want and some liabilities you agree to.
But, let’s look at your opening balance sheet. Let’s say you paid a million, but the assets you bought are on the books for $150,000 — $50,000 inventories, $100,000 equipment and goodwill $0. What happened to your other $850,000?
The inventories may really be worth $100,000 and the equipment $600,000, so the other $300,000 must be goodwill.
Here’s the bad news. It doesn’t matter what those assets are really worth — for tax purposes you take over his tax values.
If your company sells the $100,000 of equipment for $600,000 it will pay tax on $500,000 of depreciation recapture or capital gain. In effect, you picked up the seller’s tax bill.
Also, you can only claim tax depreciation on the $100,000 depreciated cost. Worse still, you’ll get no goodwill write-off against company earnings.
‘What about the inventories?’
Many businesses ‘understate’ their inventories to reduce tax. You may pay taxes on that ‘understatement’ too.
‘Why is there no write-off on goodwill? I just bought it.’
Goodwill is the difference between the price you paid and the values of all of the tangible assets (things you can touch or measure). If you had bought assets then your opening balance sheet would look different. Inventory and equipment would be at fair market value. Goodwill would show as an asset. When you buy shares the goodwill is not treated as an asset.
Goodwill is buried in your share cost with no tax benefit to you unless you sell the shares again. You have no goodwill to write off.
So, there are often substantial tax disadvantages to buying shares,
‘A share sale usually works well for the seller and not so well for me.’
Yes. The seller may pay no tax on the sale and you’ll pick up most of the taxes some time. Nice situation for the seller. Not so good for you.
‘We don’t need those problems. We’ll buy assets.’
You’re probably wise — however there are exceptions. Buying shares sometimes makes sense — it depends on the deal. Compare what happens if you buy shares or assets and then bargain based on knowledge. The price and conditions may change. Sometimes both sides win.
Occasionally you have to buy shares or have to walk away from the deal. We’ve also seen cases where the book value of the assets is much the same as the fair value and there is not a lot of goodwill in the price. A share sale may work.
Also, it is often easier to sell shares to a public company. Public companies sometimes buy small companies by exchanging shares.
Usually you’ll want to buy assets, and sell shares
You can see the problem. The seller wants to sell you shares, you want to buy the company’s assets. You need to come to an agreement.
‘What about the price?’
Let’s start with the ‘million dollar business’ problem.
Most sellers overvalue their businesses. They’ll sell if they get their price—a nice round figure snatched out of space. Be it coffee shop or agency – it’s the starting point—a nice million dollars.
How do you bridge the gap between the million dollar expectation and your value of one hundred thousand? What can you offer?
Let’s stop here for a minute — we have two problems already: shares or assets and the million dollar business. We’ve not dealt with what it’s really worth.
You will usually buy assets, you might buy shares. In either case you must know exactly what you’re buying before you decide the price is right. More on price and value in a minute.
‘OK, have we finished this share and asset business?’
Almost. Buying assets is simple in theory, but you always need to be careful.
You usually set up a new company to buy the assets, It has to fit somewhere in your organization. You might also use one of your existing companies. The choice depends on where that business fits in your organization. You have to decide.
Your company gets inventories, supplies, small tools, fixed assets, leases, patents, customer lists, and goodwill. It may borrow money to buy.
Goodwill is what’s left after you’ve assigned values to all the tangible or measurable assets. For example, if you buy a business for $1 million and the inventories are $300,000, the supplies and small tools $50,000, and the fixed assets $250,000, the client list $100,000, the purchased goodwill will be $300,000.
‘How do you decide on those values?’
Often after many discussions between you and the seller.
You’ll agree on the total price, and then come to an agreement over the values for inventories, fixed assets, goodwill etc. You’ll want high values on inventories and supplies (100% tax deductible), high values on fast depreciating equipment like trucks and computers, and low values on land (0% depreciable) and goodwill (depreciable at a smaller pace).
The seller prefers the reverse — a high value to goodwill (only 50% taxable), and to items that will result in a capital gain such as land.
‘What else should I know about buying assets?’
Asset deals are usually easier to put together and to finance. Your buyer (you) is a clean company with no history. You do less due diligence, pay less in legal and accounting.
The assets have serial numbers and histories, or you can assign them a value — like goodwill. The tax authorities are no worry. You’re not going to pay the seller’s old liabilities — unless you don’t check for liens. Checking for liens and encumbrances is routine.
You can elect out of GST issues as normally no GST is paid on a sale of all the assets of a business.
All these things make it simpler to paper an asset deal. You’ll also find you can borrow money more easily, because your bankers can take direct security on the assets. Bankers understand asset purchases. Share deals are more difficult to put together.
‘Let me understand this. It’s easier to borrow to buy assets?’
Most times—yes. But, it’s always hard to borrow for goodwill.
Goodwill has no serial number. It can evaporate quickly and it’s very difficult to sell. Expect financing problems on high goodwill deals.
You’ll need plenty of your own money in the deal or a lot of security. Bankers know goodwill generates income, but unlike inventory or physical assets, it’s difficult to to convert unto cash
‘What are the problems with buying assets?’
It may be more difficult to protect goodwill.
How do you make sure it stays with you. You need to control the name, location, process, people, or whatever it is that protects your goodwill. You can get ownership of the name. You can make sure you have a good lease if it’s location. You can secure individuals with contracts and non-compete agreements.
You pin down anything which might have goodwill, and you’ll always get the seller’s company to change its name.
You have to make sure you get good title to the assets you buy.
All provinces have laws to protect creditors when assets are sold. You should know if these exist. In some provinces the seller has to comply with a Bulk Sales Act for you to get good title to the assets. You must get a clearance certificate. Fail to do so and you could be handing over those new assets to the seller’s creditors.
Not a problem in Alberta now. But a factor other places. Worth repeating. The seller can not sell assets without considering debts – so creditors have to be paid out or agree to the sale.
If not they may have a claim against your new assets.
‘Goodwill aside, how much is a business worth?’
Let’s finish with asset purchases first.
You’ll need a good lawyer for protection against misrepresentation, and competition from the seller, through indemnities and non-compete agreements. You may also want to hold back part of the price for a safety period.
Now we can go back to value.
‘Well, what should I pay for assets?’
Difficult to say. What’s the business worth to you? Price and value are not the same. Price is what you pay after you’ve finished negotiating. Value is its value to you.
Valuators are useful. However, we stay away from them when doing deals. They can’t know all the factors that affect price — what one will sell for and the other pay. That is the job of negotiators.
So, don’t let valuators tell you what to pay — be a smart buyer.
Trust your instincts. Do your arithmetic. There are standard formulas related to tangible asset values, multiples of earnings and cashflow, and percentages of sales. They are all dangerous in the wrong hands. Listen to your advisors. Price is negotiable. One side is always stronger, smarter, more knowledgeable, richer, etc.
The price you pay will be affected by taxes, timing, the structure — and a number of other factors. Price is often less important than how the deal is put together. Look more at cash flow. See if the seller will carry part of the price. Make part of it contingent on business performance.
Good deals fall apart on price — but structure is often more important. Example — you buy the million dollar business with 10% down, payable out of profits over ten years without interest. No guarantees. The price is one million, the value is what?
‘What about the million dollar syndrome?’
Most accountants are very realistic about what things sell for. Urge the seller to get expert advice early on. You may still find the business is worth more to the seller than it is to you. He has a nice business he knows he can run.
You may have to borrow. Can you run it and pay back the debt? So, negotiate hard, take your time and don’t be panicked by ‘other buyers’.
Above all, know how much it’s worth to you on what terms.
ENDING WORDS BASED ON EXPERIENCE OVER THE YEARS
Buying and selling businesses is an art not a science. The price you see is not the price you normally pay. Study what the seller or buyer wants. Show respect and understanding.
And, here are a few last cautions — beware of overconfidence. It’s possible the present owner knows more than you, may be smarter than you. You may not be able to run that new business better.
Beware of personal goodwill. Goodwill is the sum of all those intangibles that make up a business that you can’t see or measure but generate a reward or profit beyond what you’d expect from the tangible assets. It may be a name, a location, a way of doing business, a product line, a process, a reputation, client list. Most of those and others are business goodwill. They may stay. Personal goodwill vanishes when a person leaves. Clients or customers may not stay if the owner or key staff leave. Spend time finding out why the business works. Goodwill is important.
Structure the deal to work for you — make part of the price contingent on results, make part of the price as tax deductible consulting fees. Look at assuming existing debt. Hold back an amount protection. Focus on cashflow – the business may pay for itself.
If you are selling be cautious on the other side. If you are selling through a broker watch for the ‘so much down’ deals that generate enough cash to pay the broker’s commission but leave you holding a vendor take back that you’ll never collect on.
Get the best advice you can from people who’ve been there many times before.
And, finally, be flexible. Whether you are buying or selling, look at all the alternatives — think shares or assets, royalty arrangements under licensing agreements, retaining a percentage ownership. Do not get locked into position too early — it’s the total you pay or receive and your certainty that are the important factors.