This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game (I will be back to regular posting next week). Today, I am re-posting a June 5, 2012 post on the issues in selling your corporation. This post is as pertinent today as it was three years ago when first posted (Note: I have updated any time sensitive numbers and tax changes).
I cannot stress how emotionally taxing the sale process is for someone who has never gone through it before. I dread when a client tells me they are selling their business, as I know the next few months will be very stressful for them (and indirectly me) as they just don't have the experience of going through the "sale dance". Hopefully if you are selling your business, some of the tips below can at least prepare you for the issues and tension to come.
Business and Income Tax Issues in Selling a Corporation
The sale of your business/corporation is typically a once in a lifetime event. Thus, in most cases, you will never have experienced the anxiety, manic ups and downs, legal and income tax issues, negotiating stances, walk-away threats and all the other fun that comes with the experience.
In order to navigate the sale minefield and to come up with a fair negotiated deal, you will require a team that includes a strong lawyer(s), accountant and maybe even a mergers and acquisitions consultant.
With all that to look forward to, I figured I would provide some of the meat and potato issues you will also have to solve and negotiate.
Assets vs. Shares
In general, the sale of shares will yield a better return for the seller than the sale of assets, especially if the vendor(s) have their $813,600 (indexed yearly for inflation) Qualifying Small Business Corporation (“QSBC”) capital gains exemptions available. However, the purchaser in most cases will prefer to purchase the assets and goodwill of a business for the following two reasons:
(1) The purchaser can depreciate assets and amortize goodwill for income tax purposes, whereas the cost of a share purchase is allocated to the cost base of the shares
(2) the purchaser does not assume any legal liability of the vendor when they purchase assets and goodwill; whereas under a share purchase agreement, the purchaser becomes liable for any past sins of the acquired corporation (of course, the purchaser’s lawyer will covenant away most of these issues as best they can).
Consequently, the purchaser typically wishes to buy assets whereas the seller wishes to sell shares and thus, the first negotiation point. Whichever way it goes, the buyer knows why you want to sell shares and will typically discount the offer when buying shares instead of assets.
Working Capital (“WC”)
The WC is a very esoteric concept at best and very hard for most sellers to grasp. Thus, it is vital to deal with this issue upfront and not leave it to the end where it can derail a deal, something I have experienced first-hand.
Most sellers have valuation multiples dancing around in their heads like little sugar plum fairies. However, most industries have standard valuation multiples. For most small businesses the multiple is somewhere between 2 and 4 times earnings, with a higher multiple for strategic acquisitions, especially where the purchaser is a public company, since they themselves may have a 15 to 20 multiple.
For many acquisitions, especially by public and larger corporations, the multiple is based on Earnings before Interest, Taxes and Amortization (“EBITA”). However, in addition to EBITA, there will be adjustments to the upside for management salaries in excess of the salary that would be required to replace the current owner (typically you are adding back bonuses paid to the seller in excess of their monthly wages and any other family wages). Occasionally the adjustment could be to the downside, but that is typically only in situations where the business is a technology company or similar that is just starting to make money or finalize a desired product, and the owners wages have not yet caught up to market value. Finally, there will be other additions to EBITA for things like car expenses, advertising and promotion, etc. that a new owner would not necessarily need to incur upon the sale.
Where a purchase is made by a private company, instead of EBITA, the price may be based on a capitalization of normalized after-tax earnings or discretionary cash flows.
In most cases, the purchaser will require the seller to stay on for a year or two to ensure a smooth transition. The owner will thus be entitled to a salary for that period in addition to the sales proceeds. The retention period can go several ways, some blow up quickly, some end after the year or two, but often the former owner stays on as the business is now growing due to additional funds or more sophisticated management and they enjoy remaining with their baby without the stress of ownership.
It is not uncommon for a purchaser to require that the seller maintain some ownership in their company so that they still have some “skin” in the game, especially when they will be staying on with the business. This is also the case where the purchaser is consolidating several similar businesses with the intent of going public. In these cases, we counsel our clients to assume the worst (i.e. that the new owner will make a mess of the business) and to ensure they receive proceeds equal to or only slightly less than they initially desired. We have seen several disasters in consolidation purchases where the seller ends up with minimal proceeds after keeping significant share positions with the lure of the consolidated entity going public and the consolidated company just does not have the expected synergies.
Where the deal is a share purchase, often the current corporate structure is not conducive to utilizing the QSBC capital gains exemption, especially where a holding company is in place or the company being sold has a large cash position. As I state in this post, the capital gains exemption is not a Gimme. It is thus vital to ensure at least some initial income tax planning is done so that if the deal moves forward, proper consideration has been given to the income tax planning and the planning is not a wild last minute scramble.
I have only touched on a few of the multitude of issues you encounter upon the sale of your business. As noted initially, it is vital to understand the process and how stressful it may be from the start, and to assemble the proper team to help you navigate through the sale process.
This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.