Positioning Your Business For Sale

(Reprinted with the permission of the Orange County Business Journal from article published November 13, 2000.)

For owners of businesses, the most likely means to realize the appreciation in the value of the business will be through a sale. To achieve a successful sale, owners must plan for such sale well in advance. Three key goals are maximizing value, minimizing taxes, and, once the main sale terms are agreed to with the buyer, having the sale proceed quickly to closing.

Pricing.

Businesses are frequently valued based upon a multiple of historical pre-tax earnings, earnings before interest, taxes, depreciation and amortization (“EBITDA”) or comparable formulas. However, owners often operate their business to minimize income for tax purposes. Accordingly, in advance of a sale, owners should trim costs and identify potential “add back” items. “Add back” items are those expense items that a buyer would not have to incur, such as owner salaries, interest on shareholder loans, above-market real estate leases, and non-recurring expenditures. Sellers should carefully evaluate their own income statement for “add back” opportunities to significantly increase the purchase price. For instance, if a business sells at six times EBITDA, $500,000 of add backs for officer salaries and other non-essential expenses would equate to a $3 million purchase price increase. In all events, for at least three years prior to a potential sale, the company should keep its financial statements in sufficient shape for a buyer to be able to correctly analyze income and expense items.

Understanding the Sales Process.

In most sale transactions, the buyer and seller will usually enter into a non-binding letter of intent (“LOI”) or term sheet prior to the negotiation and execution of a formal purchase agreement. As a general rule, the seller will have the most leverage in its negotiations of the LOI or term sheet since at that time the seller is not committed to the transaction and can still explore alternatives. However, as time passes, sellers for a variety of reasons are typically less able to break off negotiations and pursue other alternatives. It is therefore in the seller’s best interest to ensure that all significant deal points are addressed in the LOI.

Doing Your Own Due Diligence.

As part of any business sale, the buyer will review and investigate the company’s financial records, key contracts, capital structure, environmental and land use matters, employee relations and other items. This process is commonly called the buyer’s due diligence. A last minute surprise raised by the buyer’s due diligence before an anticipated closing can easily unravel a deal or result in a buyer demanding a purchase price reduction. Accordingly, sellers should conduct their own due diligence well in advance so any potential negatives can be addressed and dealt with earlier in the process when it is less likely to have a disruptive impact on the sale. If the seller has not done so, it should update all of its corporate records, simplify, if possible, any complicated capital structures, and locate key agreements and documents well before a sale. Any existing arrangements between the business and the existing owners, such as shareholder loans or real estate leases, should be properly documented.

Income Tax Efficiency.

The income tax implications from a business sale will depend, in part, on whether the deal is an asset sale or stock sale. Asset sales for corporations which are taxed as C corporations are especially problematic since income tax may be imposed at both the corporate and individual owner level, resulting in an effective tax rate of approximately 70%. While owners of C corporations can seek to structure the transaction as a stock sale, the buyer may require a downward adjustment on the purchase price for several reasons, including the inability to depreciate for tax purposes the amount of the purchase price in excess of the book value and the increased risk to a buyer in a stock sale transaction.

Accordingly, for new closely-held businesses, the most desirable organizational structure is a limited liability company or S corporation which, for the most part, is taxed at the shareholder level and not at the entity level. For businesses which are already C corporations, the company can elect to convert to S corporation status, but if the business is sold within ten years following the election, the company will still be subject to a corporate level tax based on the value of the business at the time of conversion. For this reason, resolving the best corporate structure far ahead of the sale is essential to minimizing the income tax liability.

Estate Taxes.

The federal estate tax will only at best be phased out over the next decade and most likely be with us for many years in the future. Estate tax rates quickly escalate to 55% and can have a devastating impact on owners’ families. To minimize this exposure, effective estate tax planning should be done well in advance of the sale and not subsequent to the sale. One effective tool for mitigating the effect of the estate tax is to transfer a portion of the business to the children through the utilization of an “intentionally defective grantor trust” (“DGT”). By transferring a portion of the ownership of the family business to the DGT whose beneficiaries are the children, the parents can remove the future appreciation in the value of the business from their own estates to their children while retaining control of the business. Further, upon transfer of the business into the DGT, the owner’s estate can be reduced by 20% to 40% through the use of minority and marketability discounts. The DGT is called “intentionally defective” since it intentionally treats the parents and the DGT as being the same person for income tax purposes only. This is just one of many techniques to reduce estate tax in advance of a business sale. There are several other estate planning issues which should be reviewed prior to a sale of a business.

Summary.

The time and expense of advance planning for a sale will result in significant returns to the owners of businesses. Knowledgeable and trusted advisers to the company, such as attorneys and accountants, should be consulted early on and not at the final stages of a transaction.