Q. I am looking at selling my business within the next 5 years. What should I take, and how do I value the business? Are there tax implications I should know about?
While revenues and profits (historical and recent trend) and asset market values are the basic considerations for valuing a business, customer contracts, management depth, intellectual properties, and other factors can also affect a valuation. Also, in some cases, restructuring assets (sale-leaseback of business real estate, for example) and capitalization prior to a sale can increase the combined value of the assets and operations.
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Selling a business can have many important legal, business, and financial issues; therefore, you should plan to have independent representation by a lawyer and possibly a CPA to assist you with your business sale. Also, business owners often need to engage or consult professional business brokers or local financial professionals (accountants or CPAs) to help market their businesses and provide an independent appraisal or otherwise help them value their businesses.
Business sale considerations.
Selling a business involves several considerations, including the structure (asset or equity), marketing (by owner or broker), confidentiality, taxes, negotiating a price, contract preparation, due diligence, a business plan, and financing. The basic steps to selling a business are calculating the value, deciding on the most advantageous structure (assets or stock, income taxes, risks, etc.), deciding on how to market the business, soliciting and negotiating with prospective buyers, and completing the sale contract.
Businesses are sold through a variety of methods including business brokers, professional contacts (bankers, attorneys, CPA, etc), classified ads in newspapers and other publications, to an employee(s), and Internet websites. However, businesses are typically marketed in a confidential manner in order to preserve the business value while it’s offered for sale and maximize the selling price. To prepare for your business sale, you can begin by developing an understanding of the sales process.
Sales Process Resources
Business broker selection considerations:
In order to establish an asking price, you will need to value your business. Business owners engage or consult professional business brokers or local financial professionals to provide an independent appraisal or otherwise help them value their businesses, but certain industries have rule of thumb valuation factors, such as a multiple of revenues, cash flows (EBITDA), or net income. However, industry guidelines vary based on profit and cash flow potential and cannot always be applied to an individual situation because of asset values, rent and labor costs, financing, and other elements unique to that operation. Establishing the value of a business generally involves determining a) the value of the equipment, supplies inventory and other tangible assets and b) the value of the business customer list/contracts, sales/profit potential, and intangible assets like goodwill, etc. Also, the quality of your customer list and relationships may be a valuation factor. Historical operating results are one part of the valuation; however, businesses are generally valued more for the future potential than the past operations.
As to valuing a particular business, the best information generally involves determining the present value of future cash flows. The key financial statement is the statement of cash flows that will yield the “cash available to service debt.” The future cash flows are then discounted to present value using a discount rate that reflects the amount of risk inherent in the forecast assumptions. The key question is “How much would someone pay for the opportunity to earn $xxx of annual income.” The answer generally depends on how secure the income is and how easy it would be for the buyer to start from scratch without buying the business. If the business has growth potential, it may be worth 10 to 20 times earnings compared to 3 to 7 times earnings for a company with limited, or no, growth potential. Service businesses may sell from 40% to 150% of revenues, for example. Also, a consideration with a personal service business owned by one or only a few individuals is the value of the customer relationships and/or contracts.
Your local CPA or a professional business broker can assist you with a business appraisal and provide you with a fee estimate.
Also, for comparison purposes, you can review other businesses for sale at Internet websites like the following:
Business sale structure.
The two basic forms of business sale are stock (or equity) or assets. In an equity transaction, the acquired company’s debts and obligations remain. In addition, the company and new owner are liable for any unknown liabilities (vendor, taxes, etc.) that may arise in the future. In an asset sale, the acquiring company does not take responsibility for the debts of the acquired business; but rather, the acquired company uses the proceeds of the sale to settle all obligations of the business and is responsible for any future debts that may arise. Also, the seller generally gives written indemnification regarding the company’s debts and obligations. Sales of all sole proprietorships and almost all partnerships are asset sales. Also, due to the risks in an equity transaction, the sales of many corporations and LLCs are structured as asset sales so that the buyer does not have to worry about unknown contingent liabilities.
When selling a business, the buyer’s due diligence process can cover a potentially broad spectrum, from tax returns, to corporate status, to loan compliance, to employment issues, to customer satisfaction and everything in between. Due diligence typically includes review of financial information and the buyer will often want audited financial statements.
Price allocation, taxation and financing.
Business buyers often request that the seller finance all, or part, of the transaction. You should determine how much of the sale price you are willing to finance. Also, some important factors and considerations in a business sale transaction that can impact the taxable gain and tax liabilities are:
A. In an equity transaction, the stock, certificates of membership or other form of equity is sold to the buyer and the seller pays tax on the gain between the proceeds of the sale, typically the selling price of the equity, and the seller’s tax or adjusted basis in that equity. In an asset sale, the business assets are sold to the buyer and the seller pays tax on the gain between the proceeds of the sale, typically the selling price of those assets plus any additional liabilities assumed by the buyer, and the seller’s tax or adjusted basis in those assets. The proceeds from the sale are allocated to the various assets, fixtures for example, which are classified in seven IRS classes, such as inventory, other tangible property, and goodwill. The gain from property in some classes is taxed at ordinary income tax rates, while the gain from property in other classes is taxed at the long-term capital gain tax rates, if owned for more than a year.
B. The tax basis in the stock/membership certificates or assets must be accurately calculated to determine the taxable gain. For example, with a business structured as a corporation or LLC, your basis in the stock/membership certificates may be larger than you expect due to the basis adjustments for income, losses and distributions over the years; therefore, you will need to analyze the income, losses and other distributions since inception to calculate your stock/membership basis in the business. The following is a discussion on the tax considerations when selling a business:
C. The installment sale method would allow you to defer the gain over the term of the financing. Taking the money over time, a portion of each payment will be interest income, a portion will be gain on the sale (at the gain percentage) and a portion will be attributable to your basis. You can review IRS guidelines on installment sales at the following websites:
D. There may also be an opportunity to structure part of the cash to be paid to you as compensation. If, for example, you received a fee for non-compete or consultation, you may be able to shelter a portion of the income in a self-employed retirement plan. e. Asset sales can involve depreciation recapture and, as discussed above, create ordinary income rather than capital gains. Of course, you will want to structure the transaction in a manner that results in your income and gain being taxed in the most favorable tax bracket, which could be influenced by your anticipated future personal income from this transaction, investments, and other employment.
Business purchase/sale contracts.
The legal forms and potential regulatory filings to buy or sell a business vary based on the structure of the transaction (equity or assets), type of assets, type of debts and any on-going relationship with the seller, and other factors. The legal forms can include Confidentiality Agreements, Purchase/Sale Contracts, mortgage agreements, property Deeds, promissory notes, UCC forms, lien filings, releases, assignments, employment contracts, and consulting contracts.
When you pursue a sale, a business plan or comparable document will often be necessary to demonstrate the company’s business potential and how the company will provide a reasonable return to the new owner(s). If you need a business plan, GSB offers a Business Planning Software solution.
Third party business planning software enable business owners to economically complete a comprehensive and professional looking plan document; however, you may not need to buy software for a simple Business Plan. Many individuals simply use the sample plans and boilerplate examples, like those on our website, to prepare their own plans using word processing and financial spreadsheet software, like Microsoft Word and Excel. Every business must prepare its own unique written text content and financial information. Purchased plan software simply provides the format and outline for this content, which you can often do yourself efficiently with Word and Excel software.
As to other resources, the Federal Small Business Administration (SBA) sponsors Small Business Development Centers (SBDCs) that provide personal assistance with business plans and the volunteer Service Corps of Retired Executives (SCORE) offer small business services, but they will require you to do most of the research. You can find the SBDC and SCORE offices in your area at the following websites:
As we discussed above, professional business brokers or local financial professionals can help you value your business. Brokers can also help you sell and negotiate the sale contract. However, due to the complexity of the IRS code and the variables involved with personal taxes and business sales transactions, we recommend that you review any planned business sale and your personal tax situation with your CPA and lawyer in order to structure the sale to your best tax advantage and protect the legal interests of all parties.