Selling a Business

San Jose Business Sale Lawyer Sharing Advice on What to Consider When Selling a Business in California

SELLING YOUR BUSINESS? PLAN AHEAD!

If you are thinking of selling your business one day, start planning now so you can maximize its price. The most successful sellers start laying the groundwork long before they put the business on the market.

Many owners of closely-held businesses spend years building up their businesses, and they become knowledgeable about the ins-and-outs of the industry. But when it comes time to sell their business, it’s typically a bewildering experience for them. They spend a few frenzied weeks or months entering into a contract and closing a transaction. But the parties they deal with often have more experience in these transactions, causing sellers to leave money on the table.

Even if you have no plans to sell the business ever, life is uncertain, and things can happen that require a sale. Most closely held businesses depend on the owners to operate successfully. For example, a business owner, even though young, may die unexpectedly in an accident. The business often can’t run well without the founder, and then the family has to sell the business. As your trusted California business sale lawyer, Richard G. Burt is sharing his advice below on how to maximize your price when you sell your business.

Hiring a Broker or M&A Consultant

For many business owners, the first step is to hire an expert to help them sell the business. For small businesses, this expert is often a business broker, and for larger businesses, it may be a mergers and acquisitions adviser or consultant (sometimes they go by the name of investment banker). For simplicity, I refer to the selling professional as the broker. The business owner signs an agreement with the broker and then looks to assemble a team of other professionals to help with the sale.

This seems logical, but it’s often a mistake! The broker will put forth its “standard” listing or consulting agreement, and many owners sign it to get the process started. But the listing agreement has been carefully written to protect the broker’s interest in getting a commission, often to the detriment of the seller. For example, in some cases, a seller can end up having to pay a commission even though no sale takes place. Or the seller can end up paying a commission on sales proceeds the seller never receives or on funds that that seller does not think are sale proceeds. In the worst case, the seller can end up paying two commissions!

So the first thing you should do in assembling a professional team to assist in the sale of your business is bringing in a business sale attorney who is knowledgeable and experienced in the sales of businesses and an accountant who can provide financial-reporting expertise. And before you sign a listing agreement with a broker, you should have it reviewed (and in many cases, modified) by a California business lawyer who is knowledgeable and experienced in the sales of businesses. The accountant can help you with making sure that you have financial statements in proper form.

Get the Accounting Right

Many closely-held businesses outgrow their accounting. What worked fine for a mom-and-pop business is often no longer adequate for the business that has grown substantially.
Not bringing the accounting system up to date can be costly at the time of sale.
A suitable accounting system gives the buyer greater confidence in the numbers the seller is showing. Not only will the owner have better reporting that allows the owner to manage the business better, but the owner as a seller will also be able to generate reports to provide information that the buyer may demand.

Owners usually don’t appreciate how time-demanding it is to provide a buyer with the information that the buyer needs to do its due diligence. Many owners don’t want employees to know that he or she is considering a sale of the business. But all of sudden the owner is asking for all sorts of financial reports that were never needed before. Something must be up! In some cases, to keep the employees in the dark about a possible sale of the business, the owner ends up developing the reports, diverting attention from running the business.

As the business grows in value, the methods of accounting become more important. Many closely-held businesses have outside accountants who are strictly tax-return preparers. They don’t audit financial statements or have expertise in financial reporting. The owner produces financial statements from QuickBooks, and the accountant prepares the tax returns. But that can obscure the true financial position of the business.

Business purchasers often hire accountants who are experts in financial reporting to help with the due diligence. The purchaser’s accountant reviews the books and the financial statements with a suspicious eye. Often the accountant discovers that the financial position is not as positive as the seller thinks because the seller’s accounting is off. Many a seller has been sorely disappointed when the selling price is reduced because the price in the letter of intent was based on incorrect accounting.

Another area in which an accountant can help is in the calculation of the net working capital for the business. In a purchase transaction, the parties often agree on a net working capital target, and the price is adjusted up or down based on the amount by which the net working capital at closing varies from the target. Knowing the net working capital before a letter of intent is even negotiated can result in a better deal for you.

Start Gathering Information

Sellers are often surprised by how much information a prospective buyer asks for before buying a business. This is known as “due diligence” information. The buyer wants to get as clear a picture of the business as possible before buying it.

Some of the information is readily available to the seller, but some of it will require time and effort on the part of the seller to compile. The seller is well-advised to get a head start on compiling this information so he or she can do it at leisure and at a pace that does not interfere with running the business.

If you have a business and would like to have an idea of the kind of information that buyers might ask for, email us and ask for Richard Burt’s free due-diligence information request. It will be sent to you free-of-charge and with no obligation. Take advantage of the advice an experienced San Jose business sale lawyer can give you!

Make an S Election

For many business owners, the most costly mistake they make is not electing S corporation status. The number one reason this is a mistake in the context of selling a business is that having a C corporation (which is what the corporation will be if no S election is made) can result in double-taxation in an exorbitant amount.

Double-Taxation

Say a business has assets with a cost basis of $600,000. And let’s say that a buyer is willing to pay $3,000,000 for the business. If the corporation sells its business for that price, the corporation has a taxable gain of $2,400,000. The corporation has to pay corporate income tax on that gain. Note that C corporations pay the regular tax rate on their capital gains.

The owner may figure that he or she will simply pay out the amount of the gain as a bonus, deduct it, and thereby avoid the corporate tax. But the IRS probably won’t let the owner get away with a bonus of $2,400,000! Both the IRS and the Franchise Tax Board will want to tax that gain, and each has the power to disallow the deduction for the bonus and tax the bonus as a non-deductible dividend.

Figure that the tax (federal and state combined) on the gain will be something like 28%. Thus, once the corporation pays the tax, what’s left to distribute is $2,328,000. When the corporation distributes that to the shareholders, they will pay tax on the distribution (the amount will depend in part on the cost basis for the stock). The distribution of $2.3 million will put the shareholder in the top tax brackets. Let’s say that the tax (federal and California combined) on the distribution is $800,000. The stockholder nets something like $1.5 million on a $3 million sale! And this doesn’t include the 3.8% net investment income tax.

In other words, in a case like this, the owner is lucky to receive half the sale price after taxes. So when it counts most, the C corporation shareholder is subject to wealth-destroying double-taxation. If you have questions or need more specific advice, don’t hesitate to contact Richard G. Burt, your trusted San Jose business sale attorney.

Drawbacks to Selling Stock instead of Assets

The solution might be for the owner to sell his or her stock instead of the corporation selling its assets. But many buyers won’t buy stock. They want to buy the assets. There are several reasons.

First, if the buyer purchases the stock, the buyer is subject to all the liabilities of the business, known or unknown. Even if the seller is completely honest, there may be liabilities that the seller doesn’t know about. For many buyers, that is the end of the discussion.

Second, if the buyer buyers stock, the buyer is deprived of write-offs that it would get in an asset purchase.

Third, if the buyer liquidates the corporation, then the buyer can get stuck with the double taxation.

There are buyers who will buy stock, but the seller often has to take a discount on the selling price compared to an asset sale.

You Can’t Wait to Make the Election

A buyer might think, “Well, OK, when I’m ready to sell, I’ll just elect S corporation status.” It’s not that simple.

If a C corporation switches to S corporation status, the corporation will be taxed on any assets that have appreciated in value at the time of the switch. The goodwill of the business is often the biggest asset, and it typically has a book value of zero. Thus all the goodwill of the business at the time of the switch will be subject to the “built-in gains” tax at the time of sale until five years have elapsed from the switch to S corporation status.

Careful Planning (aka “tax loopholes”)

Even though a sale might not be planned for a couple of years, which means that the “built-in gains” tax will have some bite, there are ways to reduce the bite. That can make it worthwhile to make the election even though the sale will take place in less than five years.
In addition, there are restrictions on which corporations can elect S status. But with careful planning, many corporations can reorganize in a way that an election can be made.

Other Actions

To maximize value, you should proactively address the issue that will arise when a purchaser conducts its due diligence. Some of the actions needed to maximize value and minimize the chance that a purchaser will make a claim on the seller need to be taken two or three years before putting the business on the market. Working with Mr. Burt, you develop an action plan for your business. Contact our experienced business sale lawyer in Sam Jose today!