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What Happens to Debt When selling a Business
When it comes time to sell a business, many business owners incorrectly assume the debt that the business has will disappear when the business is sold. This comes from the belief that a new buyer will simply take over the debt. In some cases, the debt is absorbed in the transaction as part of the sale. However, it is wrong to automatically presume you, the current business owner, will be free from all debt just because you sell your business. Rather, it is important to understand where debt goes when you sell your business, and that largely depends on how the transaction is structured. There are two ways a transaction can be structured: as a stock sale or as an asset sale. Both will be discussed in turn, followed by some important exceptions to the rule.
A stock sale occurs when the buyer purchases the stock of the entity and assumes everything that the entity (Corporation, LLC, etc.) owns, including its assets and liabilities. Generally, when you structure a transaction as a stock sale, you are buying everything that entity owns – including any unknown liabilities. This is the reason most stock sales are done by larger companies. In fact, less than 5% of businesses that sell for under $10 million dollars are structured as stock sales.
A business owner will typically decide to do a stock sale if he wants to inherit something that corporation or entity owns that cannot be transferred. For example, some contracts are specific to a corporation, LLC, or entity and structuring the transaction as a stock sale would ensure these pass along to the new owner (assuming the contract does not state that a change in control requires consent of assignment of the contract). When you are structuring a stock sale, you want to determine two things, what assets are being purchased and what liabilities are being assumed. Then, all you have to do is sign over the stock certificates and all the other assets are transferred automatically, unless they are owned by an individual rather than the entity.
In an asset sale, there is only a transfer of specific assets and liabilities from the buyer to the seller. You can basically pick and choose which assets and liabilities are included in that transfer.
The asset sale involves the transfer of title to certain assets and sometimes certain liabilities. The combination is varied. It's subject to negotiation. For example sometimes all of the inventory is included and sometimes none of the accounts receivable is in included. Again, there are multiple combinations. Sometimes they pick and choose some assets and leave other assets and don't keep the cash, they don't keep the working capital, but they take the inventory and the hard assets. Again, any combination is possible.
Most of the small businesses that are sold are structured as an asset sale because of the contingent, or unknown liabilities. A contingent liability means you don't know what's out there and so you don't know what you're inheriting. If you're buying the stock of the company, there could be any liabilities out there and you're hoping the seller discloses those.
To affect the sale, the buyer forms a corporation and that corporation purchases the assets of the selling corporation.
The purchase agreement is more complex in an asset sale than a stock sale because you're picking and choosing the assets and liabilities. Whereas in a stock sale all you have to do is sign over the stock certificates and all the other assets should be transferred automatically, unless they're owned by the seller or the individual.
There are a couple of exceptions.
Exception #1 - Leased Equipment
If equipment is leased by an individual, that lease or asset would have to be transferred over, regardless if it's an asset sale or a stock sale.
Exception #2- Successor Liability.
There is some successor reliability in the sale of a business, which means that the buyer could potentially be liable for certain things, even though that wasn't agreed to contractually. Examples could be unpaid utilities, sales tax, property tax, payroll taxes, income and social security taxes and so forth. Successor liability occurs by operation of law, not by contract.
Additionally, in certain states, you could be subject to claims of creditors in states in which the bulk sale law is still in effect. As a result, regardless of the type of the transaction the buyer should perform, extensive due diligence should be performed to avoid the possibility of successor liability. Additionally, the buyer should use an escrow company and basic representations and warranties should be included in the purchase agreement.
Another creative thing to do would be to not pay the seller all cash at closing, but to pay a portion of it, and to structure a portion of the price as a promissory note. The buyer may then have a write of offset against the note for certain claims. So if you pay the seller $10 million for his company, maybe you pay 5 million now, and then a million a year for 5 years for a total price of 10 million. And if a big claim pops up for sales tax or payroll tax, and the state or government is coming after the buyer, then the buyer could deduct those amounts from the promissory note. This would still likely result in litigation, however, the buyer is in a much more powerful position because he has the money.
How to Handle Debt at the Closing
There are a couple of options in how to handle debt at the closing.
#1 - It could be paid at closing.
#2 - It could be assumed by the buyer.
#3 - You could negotiate with the lender before the closing to see if they can reduce the amount.
#4 - The simplest way would be to deduct the debt from the proceeds of the sale. If you're selling a company for 10 million and you have 2 million in debt, then escrow deducts 2 million from the proceeds at closing. And then the remaining 8 million would be paid to the seller.
Jacob Orosz Bio
Jacob Orosz ,President
Jacob is the president and founder of Morgan & Westfield. A certified business broker and licensed business/real estate broker, Jacob has over 15 years of experience facilitating mergers, acquisitions, sales and other business transfers with transaction values ranging from $30,000 to $75 million. Jacob has successfully participated in or managed the sale of over 300 privately held companies...