Buying a Business - Making an Offer, Part I

If you haven't read my previous post on break even analysis, please read it before reading this one.  It teaches determining whether you are going to make an offer to purchase a particular business.  In this post, you'll learn about putting together your offer.

You have a few decisions to make when putting together an offer to purchase a business.  First is whether to buy the assets of your target business or the business entity itself.  This is a critical decision.

If you are buying the business entity, you are buying all of the assets and all of the liabilities, known and unknown, of your target business.  If your target business is a corporation, you are buying the stock of the business.  If the business is an LLC, you are buying the actual LLC.

At first, you might wonder, "Who in his right mind would take on the possibility of unknown liabilities?"  Sometimes, however, if makes perfect sense to buy the entity, and you can mitigate the possibility of getting stuck with unwelcome surprises.

If you seek a federal government contracting company with existing contracts, buying the entity is pretty much the only choice.  Federal contracts are not assignable.  To get the contracts, you have to buy the entity.  You can't purchase the contract as a separate asset.

You do not, however, have to buy a business entity to get a valuable existing business name.  The name is a separate, valuable asset that can be purchased.

When you purchase the assets of a company, you get to pick and choose exactly what you are buying.  You can, for instance, buy the customers, inventory, and hard assets of a company without buying the accounts receivable.  You can leave those with the existing owner to collect.  If the receivables are bad, that is the previous owner's problem.  You don't have to take any of the liabilities at all.  However, if you take the receivables, the existing owner will probably insist that you take the payables that produced the receivables.  But, all of this is subject to negotiation.

Let's look at the tax differences between purchasing the business entity versus purchasing the business assets.  When you buy the entity, you get no immediate tax deduction.  Your purchase is like buying Ford Motor Company stock.  If and when you sell the stock in either Ford or your new business, you'll get capital gains tax treatment on the sale.  If fact, your seller gets this treatment as well if you buy the entity.  Sellers prefer to sell their entities for this reason.  They get lower tax bills on their sales.

When you purchase the assets of a business, each type of asset has a separate tax treatment.  For the hard assets, such as equipment, vehicles, and furniture, you get a depreciation deduction.  For inventory, you get a deduction when you sell it.  Thus, purchasing assets is typically a better tax deal for a buyer even before you consider that you don't have to risk getting unknown liabilities.

If the seller wants an entity sale, but a buyer wants an asset sale, what factors determine which happens?  To capitalize on the tax advantage of an entity sale, most sellers will accept a slightly lower price for an entity sale.

A buyer can mitigate the potential danger of unknown liabilities by setting aside some of the purchase price in an escrow account.  That amount typically runs between 10% and 25% of the purchase price.  The money is released after a period of time sufficient to determine that no unknown liabilities have arisen, typically three years.

So don't completely discount the idea of purchasing the business entity, but be aware that the escrow account ensures you'll still be dealing with the previous owner until the escrow money is disbursed.  The seller and the business aren't yet completely divorced during that time period, and like an ex-wife, he'll be hanging around to make certain you give him his money.

Almost all small business sales are done as asset sales, because they are less risky for the buyer from a liability standpoint and provide for a clean split from the previous owner.

If you decide to make an offer for a business in the form of an asset purchase, you next have to determine what assets you are buying.  For small businesses, the seller typically keeps the cash, accounts receivable, and all liabilities.  The buyer gets the business name, customers, hard assets, inventory, and can choose whether to accept an existing lease.  The seller also normally agrees not to compete with you for a period of time within a specified mileage range of the business.

While you decide which assets you want to buy, you absolutely need an attorney to write the formal offer you will present.  Do not allow the seller's business broker to write YOUR offer.  As with real estate, the broker represents the seller's interests, not yours.  Most broker written boilerplate documents also have lots of legal issues.  It's your offer.  Get your representative to write it.  Paying an attorney now is way cheaper than paying one later to unwind a poorly written document.  I know from painful personal experience.

My next post will cover determining how much to offer for your target business.

As always, thanks for reading!  Your comments are appreciated and helpful to others reading the posts.  For real tax and accounting advice, please visit the main S&K web site at www.skcpas.com.  Also, please like the "How to Screw up Your Small Business" Facebook page.  I post business tips there several times daily.

Until next time, let's do it to them before they do it to us.