What Happens to Debt

It’s essential to understand what happens to debt when you sell your business. In some instances, the debt is absorbed in the transaction as part of the sale. But this isn’t the case most of the time.

The fate of any debt in the sale of a business is largely determined by how the transaction is structured. There are two ways to structure a deal – either as a stock sale or as an asset sale. 

The overwhelming majority of businesses that sell for less than $10 million are structured as asset sales. This type of sale is when specific assets and liabilities are individually transferred from the buyer to the seller at closing through a bill of sale. In contrast, in a stock sale, the buyer purchases your shares or membership interests and assumes everything that the business owns or owes.

In the following section, I will further explain the differences between a stock sale and an asset sale, and discuss the various ways debt can be handled at closing.

It’s essential to understand what happens to debt when you sell your business, and the two ways to structure a deal – a stock sale or an asset sale.

Stock Sale

A stock sale occurs when the buyer purchases the stock (or membership interests for an LLC), of your entity, such as a corporation or LLC, and assumes everything your entity owns or owes, including its assets and liabilities. Only a minority of businesses that sell for under $10 million are structured as stock sales. 

A buyer may decide to purchase the entity if they want to inherit something your entity owns that can’t be transferred if the sale is structured as an asset sale, such as a lease, or other valuable contract.

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 the consent of assignment of the contract. 

When structuring a transaction as a stock sale, you must determine what assets are being purchased and what liabilities are being assumed. At closing, you sign over the stock certificates to the buyer, and the buyer becomes the owner of your entity, making them an indirect owner of all the assets and liabilities that your entity owns.

Three exceptions to when liabilities and debt will continue to be your obligation after the closing in a stock sale include when:

  1. The liabilities are personally “owned” by you, as an individual, unless those liabilities are separately transferred.
  2. The buyer requires that you pay all debt at closing.
  3. You agree to be responsible for the debt post-closing, even though the entity may be legally responsible, such as a lawsuit.

Asset Sale

In an asset sale, specific assets and liabilities are individually transferred to the buyer at closing via a bill of sale. The parties pick and choose which assets and liabilities they would like to include in the sale. Most asset sales include all assets required to operate the business and exclude all of the liabilities associated with the business.

To affect the sale, the buyer usually forms an entity, then that entity purchases the assets of your entity. 

The following assets are sometimes included in the purchase price:

  • Inventory: The buyer usually purchases all of the salable inventory, but it’s typically calculated separately from the purchase price and added to the price in asset-intensive businesses.
  • Working Capital: Most larger transactions include the working capital and accounts receivable, even if the sale is structured as an asset sale.

Most small-business transactions are structured as asset sales because of the possibility of contingent, or unknown, liabilities. The amount of a contingent liability is unknown – thus “contingent” – therefore, the buyer can’t calculate the amount of the liability. Examples include litigation or product liabilities. 

Asset sales are more complicated than stock sales because the individual assets and liabilities must be purchased and sold, but this concept usually only applies to larger transactions. 

In a stock sale, by contrast, all you have to do is sign over the stock certificates. All other assets should be transferred automatically unless they’re owned by the seller or the individual. 

Exceptions to Paying Debt at Closing

There are a couple of exceptions to when debt may be paid at closing. 

Exception 1: Leased Equipment

If equipment is leased by an individual, that lease or asset would have to be transferred separately, regardless of whether the transaction is structured as an asset sale or a stock sale. 

Exception 2: Successor Liability

There is potential for successor liability in the purchase of a business, which means the buyer could assume the risk for certain liabilities, even if they didn’t agree to assume those liabilities directly. Successor liability occurs as the result of state law and may allow a creditor to seek recovery from the buyer for liabilities, even if the sale is structured as an asset sale and even if the buyer didn’t specifically agree to assume those liabilities. 

Successor liability is most common in the areas of product liability, environmental law, employment law, and for payment of certain types of taxes, such as sales tax. Successor liability is a function of state law, and the laws may vary significantly from state to state.

Handling Debt at the Closing

There are three options for how to handle debt at closing:

  1. You could pay off the debt with cash prior to the closing.
  2. The buyer could assume the debt.
  3. The debt could be paid at closing, through escrow, out of your seller’s proceeds before they are released to you.
    • For example, if you’re selling a company for $10 million and you have $2 million in debt, escrow will deduct $2 million from the proceeds at closing and the remaining $8 million will be paid to you at closing.