Selling a Company: The “Nuts and Bolts” of Selling - Part Two

The Tax Man Is Watching

Most negotiations for the purchase and sale of an operating company start with a letter of intent from the potential buyer which will contain the most important terms of a sale including price, timing, and what the buyer actually wants to buy.  Does the buyer want to purchase the ownership interests in the company or just the company's assets?  If the latter, what assets does the buyer want to purchase and how are these assets going to be valued?  The answers to these questions have important tax consequences.

The tax consequences of the sale of a company can be complex and should be analyzed thoroughly by both the buyer and the seller.  If the seller is selling stock in a corporation or a membership interest in a limited liability company, the seller generally will have a capital gain or loss upon the sale.  Whether the gain or loss is long-term or short-term will depend on the length of time the seller held the stock or membership interest.

If the sale is structured as an asset sale, the seller will have gain or loss equal to the difference between the amount received for each asset and the seller's basis in such asset.  If the seller is a C corporation, the corporation will recognize the gain or loss on the sale of the assets and the corporation's shareholders also will recognize gain or loss if any sales proceeds or other property are distributed to them by the selling corporation.  If the seller is a pass-through entity such as an S corporation or limited liability company, the entity's shareholders or members will recognize the gain or loss on the sale of the entity's assets. 

The seller and buyer in an asset sale are required to allocate the purchase price among the acquired assets.  The allocation determines the buyer's basis in the assets and the seller's gain or loss.  There are seven classes of assets to which the purchase price must be allocated, in order:  (1) cash; (2) securities; (3) accounts receivable; (4) inventory; (5) furniture, fixtures, and equipment; (6) Section 197 intangibles other than goodwill and going concern value; and, (7) goodwill and going concern value.  The seller and buyer will be bound by any written purchase price allocation, and the IRS generally will respect an allocation if it is consistent between the parties. 

A common area of negotiation between a seller and buyer is how much of the purchase price to allocate to the company's goodwill and going concern value.  Goodwill often is a capital asset the sale of which may generate capital gains.  An individual or pass-through entity may desire to allocate a greater portion of the overall purchase price to goodwill and going concern value in order to obtain long-term capital gains, rather than ordinary income, on the sale.  The buyer, on the other hand, often wants to allocate a greater portion of the purchase price to the tangible depreciable assets because the buyer can depreciate them over a shorter time period than the buyer can amortize an intangible asset such as goodwill.  C corporations do not benefit from long-term capital gains rates and will have less incentive to allocate any part of the purchase price to goodwill.  

The Rubber Meets the Road – The "Real" Due Diligence Investigation and Contract Negotiations

Once the buyer and the seller have agreed upon the broad terms of a purchase and sale and have signed the letter of intent, the buyer will expect the right to conduct a thorough and complete due diligence review of the company with the seller's full cooperation.  This usually will include meetings with the seller, the company's senior management, and outside advisors such as accountants, and a review and analysis of all material agreements, contracts, financial statements, and other documents relevant to the company.  If the company is large, this due diligence process can take significant time and a number of people to accomplish.   Nevertheless, no deal has been made at this time, so the seller's need for confidentiality and secrecy remains undiminished.

During this stage of the purchase and sale process, each party will retain an attorney to begin negotiating and preparing draft documents that will memorialize the terms of the deal.  Such documents normally will include a purchase and sale agreement and associated addenda, schedules, disclosures, warranties, representations, and other matters constituting the necessary details of the transaction.   The buyer often presents the first set of documents to the seller, and they should include the relevant points presented or negotiated in the letter of intent, as well as any additional items agreed upon by the seller and the buyer during the due diligence period. 

The primary document that controls a purchase and sale transaction will be either a stock (or, if the company is an LLC, a membership interest) purchase agreement or an asset purchase agreement as discussed above.  The purchase agreement will:

• Set forth how the purchase price will be paid (and, if it is an asset purchase, how the various assets are valued);
• Contain a number of representations and warranties that the buyer will require the seller to make with respect to the operation and condition of the company and/or its assets;
• Contain a number of representations and warranties the seller will require the buyer to make regarding the buyer's authorization to purchase; the payment of the purchase price; the post-closing obligations of the buyer to the seller such as employee relations, consulting agreements with the seller, and how payment for the services will be made;
• Contain all other terms and conditions that have been negotiated during the transaction; and,
• Generally provide that the written purchase agreement supersedes all prior negotiations and agreements. 

Thus, anything and everything that had been discussed and is important to the seller (or, for that matter, to the buyer), should be addressed in writing in the purchase agreement.

Further, disclosure schedules often are provided by the seller with, or during the process of negotiating, the purchase agreement.  Much like they sound, disclosure schedules are documents in which the seller will disclose to the buyer all material issues or items with respect to the company.  In many cases, the disclosure schedules are used by the seller to insulate the seller from future liability to the buyer for those items disclosed.  The defense of "I told you about that" is a powerful one.  

Keeping Expectations on Both Sides in Check Will Make for a More Pleasant Process

The sale process usually takes longer than anticipated.  Depending upon the company's size and the complexity of its business, the due diligence process, the negotiation of a purchase agreement, and the closing of a final deal can take enormous amounts of time and expense.  A seller should expect this, prepare for it mentally, and budget for it financially.  It takes time, energy, and money for the buyer to learn about the company being bought, and new information often requires another trip to the negotiating table.  So a seller must keep expectations about a quick sale process in check.  The seller also can expect several separate requests for information from the buyer.  Some requested information may seem to be and, in fact, may be, irrelevant, but the seller needs to understand that a sophisticated buyer cannot, and will not, just take the seller's word that the information is irrelevant because it may be very relevant to aspects of the buyer's situation and plans that are unknown to the seller.

On the other hand, the buyer should expect that things will change between the day the letter of intent or purchase agreement is signed and the day the deal is closed.  Businesses are fluid by nature and things happen within them (and in the marketplace) each day that will change the outlook of the company, at least in the near-term.  Any expectations by the buyer that the business it is buying will not change are simply unrealistic.  However, it is fair for a buyer to expect that no material changes will occur that may severely impact the purchase price or the value of the company to the buyer.  If such a change does arise, the negotiation of a different purchase price or terms may be in order. 

The buyer also should be patient with the seller and have reasonable expectations.  The reality is that even the best managed companies don't save every piece of paper or get every agreement signed in a way that a buyer would like.  Accordingly, the buyer should be realistic about taking small risks necessary to get the deal done, and that means understanding the practical nuances of an operating company.

Conclusion

Selling a business can be lucrative for sellers.  Realizing a dream of a profitable business and then selling it off to another is the American way.  However, that dream does not become a reality overnight.  Knowing what to expect in a deal before making it will save a lot of time, frustration, heartache, and expense on the back end. 

For further information regarding the issues described above, please contact Deana A. Labriola.

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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.