So, you have decided to sell the business. Hopefully, you mean selling the business three to five years from now because that is the amount of time it may take to arrange the transaction in a way that benefits you most. Unless your small business is a C corporation or an S corporation, that also means an asset sale.
Why does it take so long? The reasons have to do with what sellers hate most about asset sales – the liabilities do not necessarily go away. What could be worse than transferring away an income-producing asset but being stuck with its potentially income-draining liabilities? There may be some ways to deal with this problem, however. Follow along, carefully.
Asset Sales 101
An asset sale is really a series of transactions in which a business transfers away the things it owns: the tables, the chairs, the real estate, the trademarks and other intellectual property. There is often a swirl of agreements between seller and buyer surrounding each of these assets. The business entity — the partnership, LLC or corporation that owned and ran the enterprise — continues to exist, as do all of its contracts, promises and other obligations. Those do not go away until the business entity is wound up, and the entity cannot be wound up until the obligations are satisfied, discharged or transferred away.
A successful asset sale is only partly a matter of getting the best price. It also takes shedding the liabilities. Sellers should probably not plan to decamp to the south of France until the liabilities are gone and the business entity is wound up.
Losing the Liabilities
The first step is to do an audit of risks. This should include not only existing contractual obligations, but any potential claims or lawsuits arising from environmental issues, employment agreements, product liability suits, taxes, and vicarious liability for actions taken by company personnel.
Step two is to reduce or eliminate some of these risks before the transaction is even contemplated perhaps by terminating contracts, eliminating a product line or changing business practices.
Step three is where we get to the swirl of side agreements, and the key concepts are assumption, indemnification and insurance.
- A buyer may agree, probably for a reduction in purchase price, to assume the seller’s obligations under a contract. If the buyer fails to follow through, however, the seller will still be on the hook. The seller could sue the buyer after the fact, but that might be useless if the buyer has insufficient assets. The moral of the story is that a seller must thoroughly vet the buyer’s financial ability to pay.
- A buyer might also agree, for a similar price reduction, to indemnify a seller for legal liability that might arise in any number of contexts, such as employment or product liability suits. The same caveat applies as with assumption agreements.
- A seller can also insure against risk or require that the buyer secure a promise to assume risks or indemnify against liability with an insurance policy. These are often hotly negotiated issues in an asset sale.
Don’t Forget the Taxes
The tax consequences to the seller in an asset sale can be complicated, especially when several different kinds of assets are being sold. Income from the sale of intangible assets may be taxed as capital gain, while income from the sale of tangible assets will be taxed as regular income. In most cases, the state and federal income tax rate is significantly higher than the capital gains rate.
Many financial advisers suggest that sellers have several years of mock returns prepared in anticipation of a sale just to fully grasp potential tax consequences.
And Don’t Forget the Employees
The usual practice in an asset sale is for the seller to terminate all the employees and for the buyer to then re-hire some or all of them when the transaction is concluded. If the talents of certain key employees are essential to the deal, the buyer may want to make sure that these employees will agree to execute employment contracts before the transaction actually happens. If the seller has existing contracts with employees who will not be re-hired, the seller will want to negotiate about the assumption of that contractual liability.
Asset sales can be complicated, but they are a fact of life for partnerships, sole proprietors and LLCs. They needn’t be messy, though. The secret to a tidy return with no lingering liability is advance planning.