When Buying and Selling a Business, Deal Structure Counts
In fact, the $2.3 trillion value of U.S. deals was the highest since 1980, when Thomson Reuters began publishing its annual Mergers and Acquisitions Review. Deal volume was up 64% from 2014. M&A activity was led by health care, with value up 71%, technology, where value doubled, and energy and power, up 1%.
The momentum gained in 2015 is expected to continue this year. As a result, many business owners are asking if it’s time for them to jump on the bandwagon. Even if you have no plans to sell anytime soon, you never know when you might receive an offer that’s too good to pass up. Or a struggling competitor might offer its equipment and business backlog at fire sale prices. So, it’s important to understand your options today to make better-informed decisions tomorrow.
Sellers want to receive the highest possible price, and buyers want to pay as little as possible. But successful M&As are gauged by more than price alone. Often businesses don’t sell for 100% cash up front; instead, they create deal structures to alter the amount of cash that changes hands and help bridge the gap between the asking and offer prices.
M&A transactions are often structured as:
1. Installment sales. Instead of receiving the selling price in cash up front, parties sometimes agree to a higher amount payable over several years. For tax purposes, the amount paid must be allocated among the return of the seller’s adjusted basis, capital gains on the sale and interest income to the seller.
Taxes can be spread over the installment term or you can report all of the gain as income in the year of the sale. This might be preferable if you expect tax rates to increase or you have loss carryforwards or other carryforward deductions.
Installment sales may be attractive to sellers, because they often lead to higher prices overall and lower taxes. They also may appeal to buyers with limited cash on hand and limited access to financing.
2. Earnouts. With an earnout, part of the purchase price is contingent on the company’s achievement of certain financial or operational benchmarks after the deal closes. Payments related to earnout provisions are usually taxable, but they also may allow sellers to spread the tax burden over several tax years, similar to an installment sale.
Consulting or employment agreements. Buyers may ask a seller’s primary shareholder or key employees to stay with the business for a specified time. Key people may need to agree to temporary employment or consulting arrangements — or their continued involvement in the business may be a condition for making earnout payments.
Compensation related to providing these services is generally taxable to the recipient as ordinary income and is subject to employment taxes (for which both the recipient and buyer are liable).
3. Noncompetes. A buyer may be willing to up the ante if the seller agrees not to compete with the merged entity. Usually noncompete agreements are for a limited time and geographic area. The value assignment to the noncompete is usually considered ordinary income by the IRS.
Alternatively, a seller may be asked to “roll over” part of existing equity into an investment in the new entity. A seller, for example, might receive 60% cash and the remaining 40% of the asking price as stock in the buyer’s business. Especially popular in mergers with supply chain partners or competitors, these transactions require a valuator to appraise the expected value of the combined entity.
Asset vs. Stock Sales
In addition, you can structure the deal as a sale of either assets or stock. As a general rule of thumb, buyers prefer asset sales, and sellers prefer stock sales.
Buyers generally prefer to select the most desirable assets and liabilities in a deal. Plus, asset sales offer a fresh start: The buyer receives a step-up in basis on the acquired assets, which lowers future tax obligations. And the buyer negotiates new contracts, licenses, titles and permits. But the seller pays capital gains on assets sold in an asset sale. If the seller is a C corporation, its shareholders also will pay tax personally when the company liquidates.
Sellers typically prefer to sell stock, not assets, because it simplifies the deal and tax obligations are usually lower. But stock sales may be riskier for buyers because the business continues to operate, uninterrupted, and the buyer takes on all debts and legal obligations. In a stock sale, the buyer also inherits the seller’s existing depreciation schedules and tax basis in the company’s assets.
Seek Professional Advice
Every deal is unique. In addition to helping the parties agree on a selling price, a valuator who specializes in M&As can help find a creative deal structure that best suits your financial objectives and tax considerations.
For more information, contact Doug Collins, CPA at (973) 298-8500.