John Maher: Hi, I’m John Maher. Today I’m here with Dan Doherty, an attorney and shareholder of MacLean, Holloway, Doherty, Ardiff and Morse, one of the most prominent law firms on the north shore of Boston, Massachusetts. Today we’re talking about buying and selling a business. Welcome, Dan.
Dan Doherty: Hi, John. How are you?
John: Good, thanks. So Dan, I’m thinking about buying a business. What issues should I be looking for?
Dan: The biggest issue that you need to think about is are you the kind of person that is cut out for running a business. A lot of people that come into the office, they’ve looked out. They’ve found a business for sale. They’ve gone to a franchise trade show. They’ve said “Look, I’m thinking about buying this business.”
The first question I ask them is “How much time do you think you’re going to have to spend running this business?” Once you own that business, it’s 24/7, 365 days a year.
Depending upon the kind of business it is, using my type of firm as an example…If the receptionist calls in sick, who’s going to answer the phone that day? If the pipes break, who’s going to get up in the middle of the night and deal with the landlord and getting those pipes fixed?
A lot of people, it’s amazing to me how much time they spend crunching the numbers and going through it, but they forget to think about the real obvious things. Can I make this endeavor worth the amount of time that I’m going to have to commit to managing it and dealing with it?
The other thing that a lot of people don’t really give a lot of consideration to is making sure that they have a team around them, whether it’s a lawyer or an accountant, to make sure that they don’t run afoul of the laws.
Are they properly treating employees as employees? Are they treating them improperly as independent contractors? Are they withholding the right levels of tax on their pay? Are they collecting and paying over sales and use taxes?
All of these things are things that require a level of sophistication that most people, once they learn the requirements, are capable of addressing, but because they don’t have the level of experience necessary…I really don’t care if this is an individual who is right out of college or someone who is a mid level manager at a Fortune 500 company. A lot of those people just don’t understand what goes into running the business.
The next really most important thing is valuing that. Am I going to be able to reap the rewards of all of my efforts? Does this business…is there a proof of concept? Is the business viable? Can I make money at this? For example, how many pizzas am I going to have to sell in the course of a week in order to pay the rent for my location? People just seem to not think of those things.
A franchise, when people come in and they’re looking at buying a franchise. Is that a good idea? It depends.
One of the strengths of buying a franchise is the proof of concept is there. You can look and you can see, most franchisors will have business models put in place. They’ll have reporting models put in place so that all of those things I just talked about, you would know about those. There’s a cost to that. A franchise fee. Some of those franchise fees are very expensive.
Franchisors, you provide all the capital of, one, buying the franchise, two, picking the location, setting up the location, outfitting the location. They’re transferring the capital cost onto you and in exchange, you’re paying them a franchise fee.
Does that sound inequitable? Maybe it does. That’s how you have to look at it. You have to do the numbers, and you’ve got to look at the facts.
John: What’s the difference between an asset purchase and a stock purchase?
Dan: Good question, John. Comes up a lot. Depending upon the circumstances, generally speaking, with an asset purchase, you are purchasing the assets, identified assets of the business. Those assets obviously include inventory, accounts receivable, furniture and fixtures, real estate, things that you can quantify and look at.
Why would you, as a buyer, want to purchase assets as opposed to the stock? With an asset purchase, you limit your liabilities. You are not purchasing liabilities. You may voluntarily select which liabilities you will assume, but you are not assuming liabilities that you have declined to assume.
The other benefit with an asset purchase is you’re paying a price for this business. This business could have been around for a number of years. The assets that you can identify and can look at, the plant equipment, the furniture and fixtures, likely those assets have been fully depreciated or depreciated where they have a minimal useful life left.
By buying those assets in an asset purchase, you get to step‑up the basis to the fair market value at the date of purchase, and depreciate those assets all over again.
With a stock purchase, you’re buying the stock, which means that you are just jumping in and taking over as a continuing shareholder. The business is staying intact. That means that the liabilities that associated with that business are staying intact. It includes liabilities that you can see on the balance sheet that are readily identifiable. It also includes those liabilities that aren’t on the balance sheet ‑‑ those unrecorded liabilities ‑‑ because it’s been undiscovered at this point.
For example, you’re buying a gas station. The seller insists on a stock purchase. What happens if three months after you purchase this, you’ve come to find out that one of the tanks, the underground storage tanks has been leaking for the last three years? There’s contamination, not only on your property but on your neighbor’s property.
Guess what? That responsibility belongs to your corporation that you just acquired. As the shareholder of that business, you’re looking at financial disaster. It could bankrupt that business, and therefore there goes your investment. That’s a simple example of the difference.
One of the other things with regard to taxes is that when you buy stock, you don’t get to step‑up the basis, the inside basis, of those assets. A shareholder of that business who’s looking to sell is going to try and push you toward a stock sell, because he or she receives capital gain on the sale of their stock.
If they sale assets, depending upon the type of business it is, if it’s an S Corporation, the Corporation reports the gain. That flows through to the individual shareholder.
If it’s a C Corporation, you have gain at the corporate level. Then the shareholder reports income on the dividend of those proceeds from the sale that are now in the Corporation, and have to be distributed out. There are potentially two levels of tax in a C Corporation on the sale of an asset, as opposed to sale of stock, which is simply a capital gain item.
John: What if the purchase price for the business is actually more than the value of the identifiable assets?
Dan: The Internal Revenue Code has rules on this. What happens is if you purchase the business, and you look at that asset, and you come up with a purchase price, and this could be whether it’s an asset purchase or a stock‑‑excuse me. This will really only apply in the course of an asset purchase.
You look at the assets. You see the value of the cash. You see the value of the inventory. You see the value of the plant equipment, and the furniture and fixtures, and accounts receivable, and any other kinds of assets that are on the balance sheet. Those come to a number.
The purchase price is in excess of that number. What’s next? The Internal Revenue Code requires a residual formula. The formula requires you to first identify the value of all the hard assets, and then whatever is left is goodwill or going concern value.
That goodwill intangible asset under Internal Revenue Code Section 197 is amortizable over 15 years. 15 years is a long time. If you’ve paid hard money for that, you’re not going to get a return on that money until it’s amortized out over that 15‑year period.
That’s the methodology. It works. Does it benefit the purchaser? Again, run the numbers. The purchaser has to look at it, and see how well that amortization is going to affect him. If there’s assets that we can look to that are hard assets that have more finite useful lives, equipment, and so forth, that are depreciated over a shorter period of time, that purchaser will have amortization or depreciation deductions, and that will allow them to reduce their tax liability on a year‑to‑year basis.
Look at it another way, John. 15 years out, you’re still depreciating or amortizing these intangible assets. You’re paying taxes, so you’re not getting the full value of the cost of that asset up front.
John: We’ve been talking about buying a business. What if I’ve decided I’m going to retire? I just want to get out of this business, and do something else. What’s the most important consideration in selling my business?
Dan: Assuming that you’ve gone through all of the pros and cons and the analysis of selling the business, and what it’s going to mean to you, what it’s going to mean to your family, and you’ve come to the conclusion that selling the business is the right thing, then the biggest concern is, “How am I going to get paid?”
It never ceases to amaze me how little consideration people give to that question. They bring in, maybe it’s an employee that they’ve had with them for a long period of time, and they’re going to sell the business to that employee. Can that employee run the business? Do they have the same level of skills that you possessed which allowed that business to be successful?
If that employee doesn’t have the capital to buy you out in one payment, then you are going to have to be taking back a note or a mortgage, commonly referred to as “taking back the paper.” That’s a risk.
You sell your business for a million dollars to an employee, and he has $200,000 to pay you in a down payment. He pays you the $200,000, but he signs a note with your for $800,000. What’s the likelihood that you’re ever going to get paid that $800,000? How long is that note going to last? Is it a 10‑year note? Is it a 5‑year note? How is it guaranteed? What kind of collateral? “I’ve secured it with the business assets.”
You’ve been out of the business for 5 years, it’s a 10‑year note. The person you’ve sold it to is unable to run the business, and now you’re going to foreclose on that business and get back into it. Can you get back into it? Can you salvage it? Have all your customers moved on to other businesses, competing businesses with you? You’ve been out of the game for awhile.
If you were to ask me, that is the most important question that a business owner who has decided to sell his business must ask himself. “How am I going to get paid? I need to do everything possible to ensure that I get paid.”
Now, I have had this in the past. The type of firm that we are, the size clients that we have, they tend to be the minnows. They get swallowed up by the whales. Whales could be publicly traded companies. A lot of those publicly traded companies will like to do stock acquisitions, where they will give you shares of their stock as the consideration. Maybe it’s part cash. Maybe it’s shares in their company.
Most often, those shares are restricted shares. So that if you receive those shares, you are restricted in the number of shares that you can sell in a given period of time. While you are holding those shares, the stock price of that company could be going up, and that’s great. If it goes up, you are certainly receiving more than the fixed number that happened on the closing date.
What goes up can also go down. What if that publicly traded business stock price declines? It could decline significantly. There goes your price. There goes what you expected, and you are powerless to sell out, because SCC Restrictions restrict you from selling those shares of stock.
You may think that, “Oh, boy! This is a great thing. I’m selling to this big publicly held company, and I’m going to get shares of stock.” Trust me, I’ve had enough clients over the years experience that in a negative way, and they need to think long and hard.
Cash is king! If that business will pay you cash as opposed to shares of stock, and most of my clients will tend to be rounding errors, when it comes to the value of that business as it relates to the overall balance sheet of that publicly held company.
Drive a hard bargain. Make sure you get cash, not stock.
John: Dan Doherty, thanks very much for speaking with me.
Dan: Thank you, John.
John: For more information, you can visit the firm’s website at MHDPC.com or call 978‑774‑7123.