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Accounting for Transition

QUICK SUMMARY

Once you’ve decided to sell your company, there’s still a lot of work to do before you can put it on the market. The first step is to put together your transition team and plan.

Next, you’re likely to speak with your appraiser about the process for valuing your business. To get an accurate result, the appraiser will need to examine your books, facilities, equipment, personnel, pending legal issues, and so forth. As it happens, this is nearly identical to the due diligence process that buyers will go through as they prepare to make you an offer. Getting your books in order at this early stage will be entirely to your advantage throughout the sale process.

As you structure the deal, one key question will be whether you are selling your business as a tangible asset or in the form of equity, or stocks. Experts say that deals tend to have a stronger emotional component when you are selling an asset as opposed to stocks. There are pros and cons to both approaches. In most cases, the driver of this decision will be taxes. That’s because IRS regulations provide different ways to treat these two types of transactions.

Because there are so many variables involved, buyers are often skeptical that the business will continue to perform as expected after the transition. To overcome this risk factor, many deal structures include provisions called “earn outs” and “contingent payments.” Basically, these mean that part of the purchase price is held back, contingent upon the business earning at a level that justifies the full selling price.

Do Your Due Diligence

Sell-side due diligence is largely a matter of anticipating buyers’ most likely information requests and assembling the documents in a way that presents all the data in a clear, accessible format. Experts advise that you should always disclose as much as possible. If there are defects, you should try to fix them in advance of putting your business up for sale—or else disclose them in a forthright way. That’s because every successful deal is built on a foundation of trust.

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Getting Your Books in Order

Getting your books in order may be an actual accounting exercise or it could go a lot deeper. In the first case, if your accounting system is one that works for you but isn’t quite standard, you’ll want to bring in a CPA to normalize it. If the buyer will be financing the deal with a bank loan or other outside investor, having a standard set of books will be an important factor in making the sale go smoothly.

It’s also possible you will want to “clean up your balance sheet” by making structural changes to the way you run your business. In many cases, owners of closely held businesses use a tax minimization strategy. However, prospective buyers usually prefer to see higher profit levels. It takes a while for a shift of this type to show up on your balance sheet, so try to implement the new strategy well before putting your business on the market.

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What Are You Selling? Assets or Stocks?

This is a tax issue that affects buyers and sellers differently. Buyers prefer an asset sale because they get better tax treatment on assets when they go to resell them. Sellers usually hate asset sales because they may be subject to double taxation and have to pay all or some of their taxes at the individual rate for ordinary income.

Sellers prefer equity sales because they are simpler and net proceeds get taxed at the more favorable capital gains rate. Buyers, of course, are reluctant to give up the favorable tax treatment they receive when buying assets.

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Earn-Outs and Contingent Payments

Earn-outs are a bridge for buyers and sellers who want to make a deal, but just can’t reach agreement on a fair selling price. Generally speaking, the buyer would hold back a percentage of the selling price—for example, 40%—on a contingent basis. As the seller, you would agree to continue running your company for a specified period of time after the transaction. If you hit the specified earnings numbers (or other targets), then you “earn-out” the contingency, and receive the remaining 40%, or some portion of it—depending on the specifics of your agreement.

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