Jeff: There are two main types of sales in most M&A deals, stock sales and asset sales. What's the difference between the two, the advantages of each, and how to know if one might be better than the other for you? If you're a business owner looking for answers you've come to the right place.
From our studio in Southern California, with guest experts from across the country and around the world this is Deal Talk, brought to you by Morgan & Westfield, nationwide leader in business sales and appraisals. Now, here's your host, Jeff Allen.
Jeff: Welcome to the web's number one content source for small business owners committed to building a business for eventual sale. It's our mission to provide information and guidance from our growing list of trusted experts that you and all small business owners can use to help you build your bottom line and improve your company's value. Let's learn more now about asset and stock sales from someone who has a lot of experience with each from his seat as a numbers guy and a business owner himself, Mr. Andrew Gantman, CPA and owner of Gantman & Associates in West Hills, California. Andrew Gantman welcome to Deal Talk, good to have you sir.
Andrew: Thank you very much for having me.
Jeff: Give us kind of a taste of your background, where you've been and where you're at?
Andrew: I spent a couple of years in manufacturing and private industry, and a bit over 25 years in public accounting dealing with companies anywhere from startups through multi-billion dollar companies, working from small CPA firms to a couple of the Big Four.
Jeff: Andrew, let me start by asking you, we talk about stock sales and asset sales, and very distinct differences indeed. Why is it important to know the difference between those two for business owners?
Andrew: The real importance is how the person's going to be taxed on it. When you're looking at a stock sale and there are a lot of legal issues also, I'm aware, but when you're dealing with a stock sale you're selling the equity of the company all in one shot. It could be just your share, but you're not looking down at the underlying assets. When you're doing an asset sale you're actually selling the particular assets that the buyer wants to have, and the buyer can pick and choose amongst them but the tax implications are very, very different.
When you're doing an asset sale you're actually selling the particular assets that the buyer wants to have, and the buyer can pick and choose amongst them but the tax implications are very, very different.
Jeff: Is there such a thing as a hybrid where you combine the two, asset and stock sale, or is there no such thing?
Andrew: Well, it really depends on the facts and circumstances. In many cases an individual might have several different companies and they might want to sell the assets from one and the stock from another. Also, there could be certain circumstances where they have personal assets that are not within the company that they also want to sell. It really depends on the facts and circumstances.
Jeff: Andy, let me ask you then, as a business owner I may not be ready to sell my business at all, maybe I'm looking at 10 years, I want to do something like that, so I've got plenty of time here to make certain considerations. But how am I able to really determine what is the best course of action for me as a business owner? Does that depend on my exit strategy and what it is that I want to do? Does it depend on my financial situation at the time of the sale, whether I decide to go buy asset or a stock sale? How does that all work and how do I decide what is best for me?
Andrew: I think that the points that you just made are perfect. You really have to think about what's right for you. And what's right for you is going to change over time, but it really starts at the beginning with the business planning. What you want to do is any time you're starting with a business, that business has a life cycle and it's going to start as a startup perhaps, and then grow, and eventually you want to get out of the business. Or maybe you have a family, you want to pass it on to your heirs, or maybe you want to bring in a new partner. There could be a variety of different things and those things change over time. But the key point is talking to people like Morgan & Westfield, or your lawyer, or your accountant and letting them know what your thoughts are, and your life changes, and what your ultimate goals are so that you can do the things that are right for you. Because anytime you're having these discussions upfront it allows you a much broader variety of options when ultimately it comes time to make that decision.
Jeff: Are there any real critical issues that stock or asset sale could face? Or maybe when you're making a determination as to which one that you need to do what kinds of issues, what kinds of questions need to be answered that come up time and time again that you've seen from a CPA's perspective?
Andrew: What I've seen in my experience is that in many cases a seller's going to want to sell their equity or their stock and a buyer's going to want to buy the assets, and of course the natural question is why. In most cases when a seller sells their equity or their stock in most cases they get capital gains treatment which is subject to a lower tax rate, at least at the federal level. The buyer wants to buy assets because if they're buying the assets then they can take what they call depreciation or amortization tax deductions for those increased prices of those assets, so the cost of the assets, and write those down over time. Whereas most of the time if they're buying a stock of a company they won't be able to do that.
In most cases when a seller sells their equity or their stock in most cases they get capital gains treatment which is subject to a lower tax rate, at least at the federal level.
Jeff: You've got a stock sale on the one hand that would benefit the selling business owner, the sell side, and then you've got the asset sale which would benefit again from a tax consideration standpoint the buyer. How do you kind of bridge that gap or come up with a way that will work for both sides, or is that even possible?
Andrew: It's very often very possible and ultimately comes down to negotiations between the parties. The buyer may not have a great need for those depreciation deductions. Oftentimes they do, but oftentimes that can be worked out in either particular details when it comes to the negotiations or the purchase price. For example, you want to sell me your business for $10 million but I really want those depreciation write-offs so maybe I'm saying, "Hey, it's worth seven to me." And then we go back and forth and decide what fits both of our needs.
Jeff: What role, Andy, do you play in a negotiation, if any, certainly in representing one side or the other in working with the business owner to determine the proper course of action and what they need to do. If I'm a business owner and maybe I'm not working consistently with a CPA, or I bring one on, or I'm kind of in transition, how important is having a guy like you on my team to help me decide what's right and the types of pitfalls I need to avoid?
Andrew: It's very important for a couple of reasons, and the role that I play is very technical sometimes in telling people the ins and outs of the various rules and how it's going to affect them in modeling the different amounts of money that they're going to get and over what time they're going to get it. But also I sometimes joke that I'm a bit of a psychologist and a massage therapist. In that way it's a matter about bringing the parties together because over time I found that being able to communicate between the various parties, not necessarily needing to be the smart guy in the room, but to find a way for everybody to find out what their common goals are and then drive that deal to the end. Because if they want something they have to determine a price. But a lot of times underneath it all is the psychological aspect. Do they feel like they're getting a good deal? Do they feel like the other person is treating with respect and that they're looking out for their interests as well as just their own? Sometimes leaving a few nickels on the table for the other person makes a deal actually in your better financial interest than if you push for every penny. Again, this is psychological but it's also telling about the tax code. And so the things that might not popup obviously to them might be the sales tax impact of having an asset sale. What can you do to possibly to mitigate those issues. And seeing what those pitfalls are and the opportunities that maybe they haven't thought of. Things like personal goodwill, and we'll get into what goodwill is in a minute, but getting somebody capital gain treatment that they might otherwise consider getting a non-compete on and have to pay ordinary income, or tax as if ordinary income.
Things like personal goodwill, and we'll get into what goodwill is in a minute, but getting somebody capital gain treatment that they might otherwise consider getting a non-compete on and have to pay ordinary income, or tax as if ordinary income.
Jeff: What you're saying in essence is that the way that a deal is structured can sometimes be just as important as doing the deal in and of itself because you like the company, the company's got a strong evaluation, both market above valuation, and revenue growth, and is profiting nicely, it's the structure of the deal that can sometimes make the difference.
Andrew: It very much can. It can potentially mean millions of dollars. If you look at something as simple as an asset sale that might subject to sales tax depending on what jurisdiction or what state you're in you sell even a million dollars of assets that could be in California, easily $90,000 of sales taxes that if you had planned for it ahead of time you might be able to avoid by doing certain things that are totally legal, totally legitimate. But nobody wants at the end of the day everybody starts pointing their fingers at one another saying, "I'm not subject to that 90,000. I shouldn't have to pay it." And the numbers can add up or sometimes it means how you structure certain holdbacks so that somebody is not taxed earlier than they might otherwise be. And this is real money in real people's pockets, and the numbers can be astronomical sometimes. Somebody who's got their business that they've been working on for many, many years, and even something like an extra $90,000 can mean a real big difference to them.
Jeff: Andrew, you opened up a door there that I'm going to walk through a little bit. We're talking about nomenclature, the various vocabulary that's used in M&A transactions. And for some business owners who may either just be getting started or they're just busy folks and they've had no time to really consider, or interest in considering selling their business right away. Later on they'll want to holdbacks, earnouts. Give us kind of an idea of the meanings of those terms. What do you mean by holdbacks?
Andrew: Okay. A holdback is basically money that you're entitled to, but the buyer is either putting it in an escrow account or giving you a note for it and they're going to pay you for it later rather than all cash up front. For example, let's say I'm buying your business and I've looked through it, it looks okay. The price is $10 million. Let's say I'm buying your stock and say, "There might be some liabilities that I don’t know about in there, or maybe you've promised that a certain part of the business is going to sell real well, a certain widget that you had produced.” And I say, "You know what, based on your projections $10 million is fair. However, what happens if that new widget has some problems, or it doesn't hit the market like we think it should? I'm going to hold back a million dollars in it for you. I'll put it in an escrow account. And once it meets certain thresholds then you can have it."
Earnout would be similar. Let's say we're thinking that a particular element of the business is going to turn a profit or have a certain cash flow. I say, "I'm going to give you $10 million for example, and then I can give you up to another million dollars for example if this part of the business has a 25 percent profitability over a two year period." The only way to measure that two year period is to wait for the two years to pass. And then based on that I come back and say, "It did meet it. Here's your other million dollars." Or maybe there's no cap to it and let's say that it hit its 40 percent then I'll give you an extra million dollars on top of that. They're fairly similar although there are some differences. Earnout's more based on activity, holdback's based more on a liability type of thing or just a cash flow type of thing, meaning you're just going to have to wait for the money.
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Jeff: That man right there is Andrew Gantman. He's a CPA and owner of Gantman & Associates in West Hills, California. My name is Jeff Allen. We're talking about stock versus asset sales and we're getting into some other stuff as well here as part of the conversation. We're glad that you've tuned in. This is Deal Talk. We're going to be back to continue our conversation with Andrew Gantman here when we resume in just a moment.
If you'd like to share your knowledge and expertise on any subject related to selling businesses or helping business owners improve the value of their companies, we'd like to talk with you about joining us as a guest on the future edition of Deal Talk. Interested? Contact our host Jeff Allen directly. Just send a brief email with "I'd like to be a guest" in the subject line. In a brief message include your name, title, area of specialty, and contact information, and send it to firstname.lastname@example.org, that's email@example.com.
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Jeff: Welcome back to Deal Talk.
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Jeff: I'm Jeff Allen with my guest Andrew Gantman, CPA and owner of Gantman & Associates. Andrew, once again, it's been a pleasure. Thank you so much for agreeing to join us again today. I'm really enjoying our chat here and our conversation about stock versus asset sales and we've kind of been covering a lot of ground in a way that I think is easy to digest for most of our listeners out there. We could probably talk two, three, four hours on this subject but we want to try to obviously, and I think you're doing a great job, boil this all down in a summary format that makes it kind of easier to understand. I know that there are, we touched on this a little bit ago, there are a number of issues involved in stock sales versus asset sales. We've covered some of those already on the program. There are a number of details that we can go into on this. Just a question, if you decide as a business owner to do an asset sale, or if you're a business owner for that matter and you are in conversations with a business owner about buying their business, what are some of the assets that might generate capital gains versus those that might generate ordinary income, and why is it important to know the difference?
Andrew: Bottom line is money and the tax that you're going to pay on it. Capital gains rates at a federal level right now are at 20 percent, and ordinary income rates can go up to 39.6 percent. If you're selling an capital asset and you have a gain, you're going to be paying roughly half of the tax on that gain than if you were selling an ordinary income asset. And those are gross generalizations but it could mean a 50 percent difference. A couple of examples capital assets might be land, certain kinds of intellectual property. It could be a variety of assets like that. Basically the way it's defined is that a capital asset is not an ordinary income asset and then the code gives a list of different kinds of ordinary income assets. Another one that a lot of people don't realize is what's called depreciation recapture. Depreciation recapture occurs when you sell an asset. Let's say you have a piece of machinery and equipment. You bought it for $100,000, you depreciated it down to $25,000, which means you took $75,000 worth of depreciation deductions, and let's say you sell that for $75,000. You might think ordinarily, "Hey, I bought it for 100, I'm selling it for 75, I have a loss." Well, you really don't. You actually have to take care of those depreciation deductions, it reduces your cost basis down to 25 so that when you sell it for 75 you really have a $50,000 gain. Not only that but because you took ordinary deductions in the form of depreciation before, you recapture that as they say by re-characterizing that $50,000 gain from capital gain to ordinary income. And there are some more complexities with that that's really beyond the scope of this podcast, but that's something a lot of people don't think about when they look at the books on their assets.
Another one is goodwill. And that's something that a lot of people don't really think about because many times it's not on the books. And to define goodwill what it really means is whatever you're paying in excess of the net assets you're buying. Let's say that you're selling me one kind of asset but it has a liability associated with. You're selling me land. It has a million-dollar cost, but let's say that there's a loan on it. Let's say a $750,000 loan. The net asset released $250,000. But let's say I'm willing to pay you $400,000 for it. What is it really? At this point I should probably mention what goodwill really means. Goodwill is basically the residual value after you buy the net asset. Let's say I'm buying your entire business. It's got a variety of assets, it's got workforce in place, a whole bunch of things that constitute the entire business, not all of which are on the books. Let's say that when you add up all the assets and liabilities it's worth let's say $25 million, but I'm willing to give you $32 million for it. Well, what is that extra $5 million? The extra $5 million is what we call goodwill. Let's say you had in this case $100 million worth of assets and $75 million worth of liabilities, the net of that is $25 million. But because it's a good business and I think it's going to continue on, there are elements of it like workforce in place, certain contracts, certain lease agreements, things like that. But even in excess of that there's that intangible, that really unidentifiable value that constitutes goodwill. That is a capital asset. When you sell me all of your assets that constitute your business and I pay that extra $5 million for it, that's a capital gain to you. And it's going to be the same to me as the buyer whether it's a non-compete or something else because I still have to write that off over 15 years as the buyer, but it's definitely good to identify that for the seller.
And goodwill can be not only in the business but goodwill can also be that owned by the owner. Let's say you've got a sole proprietor who has a trucking business or an ice cream business, and because of all the relationships they're selling their C corporation. And I'm willing to pay say $10 million for that and I'm paying $7 million for the stock of the business, or if I'm paying $7 million for the assets of the business less the liabilities, but then there's that extra several million dollars that goes to you, that can also help you avoid taxation at the entity level, almost a matter of whether it's an S corp, C corp, other things. There are some complexities also involved with that but that's the basic idea of goodwill.
Jeff: Goodwill really can benefit both sides when you think about it as long as you’ve got your CPA involved in that, that's something that you could take advantage of. What I'm wondering though is how common is goodwill in terms of those types of transactions where you'll see a gain like that?
Andrew: Very common, whether it's an asset sale or a stock sale that's something that unfortunately a lot of times gets overlooked and can really make a big difference. For example, let's say you have a non-compete on buying you out and I have a non-compete. Arguably, and you'd have to have a valuation person determine it. And oftentimes it's good to have a valuation person separates from the individual biases because somebody might look at it as somebody having a conflict of interest. But having somebody value, are we really paying for personal goodwill? And if you're paying for personal goodwill that means that the seller will be able to get the benefit of capital gains treatment potentially whether or not it's an asset sale or a stock sale as opposed to a non-compete agreement which would in all likelihood be ordinary income and tax it potentially at that 39.6 percent rate instead of the 20 percent rate. It can be a very, very important and it's a very, very common issue.
Very common, whether it's an asset sale or a stock sale that's something that unfortunately a lot of times gets overlooked and can really make a big difference.
Jeff: Andrew Gantman, CPA, owner of Gantman & Associates West Hills, California joining us today on Deal Talk talking about stock versus asset sales. Tell me, the really key individuals that a business owner needs to have on-hand, or should assemble in order to make sure that they're doing the right thing in any case in addition to having a good hands-on CPA with their best interests at heart. Who else should they have on-board to help them with their pre-transaction requirements?
Andrew: It's funny you should mention that because one of the first things that I mention to my clients if they're even considering about selling their business is talking to somebody like Morgan & Westfield because you need a firm that's really going to get in there and be able to explain the realities of life to them, explain to them what they need to do ahead of time to maximize their value, and make the deal go smoothly. The last thing you want is somebody to show how smart they are in the middle of a deal negotiations and just upset everybody and grind the whole process to a halt. You want somebody who knows what it's like to do due diligence, who can recommend ways to do self-due diligence, in other words identify the issues that you have before perhaps you even quite realize it. And certainly before the buyer realizes it. It's always better to know what your issues are before you even think of going to the deal table, and having the experienced M&A provider is immeasurable.
Jeff: I'm not going to have you reveal anything that would be completely untoward. Again, in your experience as a CPA you've had your chance to look in the books of many a company and talk to business owners, talk to their bookkeepers, talk to their attorneys in some cases. What have you seen, Andrew, that often stands out to you as a common problem that many business owners have with regard to their accounting that leaves you somewhat concerned, particularly if this is a company that is looking to sell their business sometime in the relatively near future, let's say two to five years from now?
Andrew: That's easy. But one thing that I've seen most of all, and it's pretty funny thing. When a family business or small business is running personal items through their books and they think, "I can argue that this was tax deductible." That's beside the point. The real issue is if somebody doesn't immediately identify as they're coming to the deal table the things that relate to their personal expenses, or arguably personal expenses that go through the business, they end up having a lower net income or EBITDA. And anytime you're talking about selling a business for a multiple of that EBITDA, by taking those expenses and treating them as business expenses, and lowering the EBITDA you're lowering by that multiple the amount of proceeds that you're going to get from the sale of that business. And I've actually had this relatively recently where I had to really impress upon them the fact that it's so important to identify to the buyer how much of those types of things are on the books. And they say, "But we took deductions for them." Okay, I understand that that's something that you have potentially to be concerned about, but if you don't bring it up to the buyer, the buyer's going to say, "I'm not going to pay a whole lot more money for a company that's less profitable." Let's say you're running $100,000 through those expenses. And let's say that you've got a multiple, just for argument's sake a five. By not bringing it up to the buyer you're losing out on half a million dollars. And to at least identify that and make sure that the other side knows it is real money in your pocket.
The real issue is if somebody doesn't immediately identify as they're coming to the deal table the things that relate to their personal expenses, or arguably personal expenses that go through the business, they end up having a lower net income or EBITDA.
Jeff: Andrew, this has been a great discussion. We're actually out of time here and we already kind of have an idea that we're going to have you back on this program to talk about a number of other things including really the difference that a type of entity can make with respect to how an M&A transaction can or should be handled on either side, or should be addressed. We're going to talk about also too goodwill I think in another program with you as well. So we can kind of make this a multi-part discussion because I've really enjoyed myself and I think that our listeners are going to really take some value out of our chat today. But what I'd like to do right now is leave you with some time to provide your contact information and detail so that if anyone in our listening audience would like to contact you, whether it be for a transaction or some other ongoing needs that they have in their business, how can they reach out to you?
Andrew: Thank you very much. I've really enjoyed this as well. I really appreciate the opportunity. My contact information is email: email@example.com. And my direct telephone number is 818-322-4707.
Jeff: Again Andy, a real pleasure. Thank you so much for taking time out of your schedule to join us here on Deal Talk and we'll talk to you again soon.
Andrew: Thank you.
Jeff: Andrew Gantman, CPA, Gantman & Associates has been our guest. Let us know for a fact what you thought of this program if you don't mind taking a little time out of your day, right now, just do it immediately. Interested in knowing your thoughts about this show and about Deal Talk in general, what you like, what you would like us to do to make the show even better for you. We wouldn't be here if it weren't for you. So take a quick two minutes or so, send us an email to firstname.lastname@example.org. Deal Talk is presented by Morgan & Westfield, a nationwide leader in business sales and appraisals. Learn more at morganandwestfield.com. My name is Jeff Allen, thanks again to my guest Andy Gantman, and thank you for listening. We'll talk to you again soon.
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