Finding a willing buyer for your business is worth celebrating, briefly. In my experience, a majority of owner-negotiated “deals” fall apart before reaching the closing table.  In this post I will discuss several common deal breakers that I’ve seen, mostly involving differing expectations and poor preparation, and how you can avoid them.

But first I want to be sure you know what a Letter of Intent (LOI) is. An LOI is a non-binding agreement between a buyer and seller that memorializes major deal terms and steps to closing. It is entered in to BEFORE due diligence, legal documentation and escrow processes. Done properly, an LOI does a lot to align the expectations of each party, which is critical to consummating a sale. Deals also dissolve when a buyer negotiates terms with certain expectations, and later finds reality to be different.

So, what are these deal breakers?

Ambiguous Deal Terms

There is probably no larger risk to a deal than agreeing to ambiguous or contradictory deal terms. Writing an effective Letter of Intent can be tricky because it is negotiated early in the sale process, prior to disclosure of all pertinent information about the business. Nonetheless, the Letter should at minimum include assumptions used to negotiate deal terms, the deal structure with purchase price, a timeline and conditions to close. Additionally, it may include no-shop and confidentiality provisions and other terms to protect the buyer and seller’s interests. Regardless of the Letter’s content it should be clear, comprehensive and sufficiently detailed to anticipate future surprises.

Poor Record Keeping

The Due Diligence process provides an opportunity for the buyer to confirm that the information previously presented to them about the business is true and correct. A company with poor record keeping practices may have a difficult time providing evidence that they are in compliance with applicable laws, have enforceable contracts with suppliers and customers and accurate financial statements. Without accurate and complete records, buyers are uncertain of what risks they are acquiring and will be reluctant to close the deal.

This is particularly true for financial records. A seller should be prepared to provide prospective buyers with clean and verifiable financials for a minimum of the past three years. A special case is if the owner has claimed personal expenses that he has run through the business and wants to “add-back” as part of establishing the value of the business. These expenses should be well documented to be acceptable to prospective buyers.

Prior to taking the business to market it is well worth conducting a pre-due diligence exercise so that any weaknesses in record keeping are identified and corrected.

Misrepresentation of Facts

Business owners are anxious to sell the potential of their businesses. However their enthusiasm can lead them to put a positive spin on information at the expense of accuracy. The first time a buyer discovers something factually incorrect about an owner’s claims their suspicions will be triggered. If more inaccuracies are revealed, confidence in the deal can be eroded. Even if the exaggerations don’t add up to much, many buyers will walk away for fear there are larger surprises hidden in the shadows.

Unaddressed Business Risks

All businesses confront risks that a buyer will learn about either during due diligence or later. For example, a strong new competitor is entering the market or a key employee is retiring. If a buyer perceives that the seller is either not addressing or has not disclosed these risks they may lose interest in acquiring the business. An owner that confronts these risks head-on will be well regarded by prospective buyers and will improve their chances to close a deal. Even if an owner may not have had the time, people or cash to mitigate the risk, a buyer prospect may be able to bring fresh resources to the table and turn what was a problem into an opportunity.

Business Erosion

A buyer forms expectations about the future performance of the business based on the financial information provided to them. A buyer is generally willing to pay a fair price for the business based on those expectations. However, if between the time that a deal is struck and the transaction closes, the financial performance of the business suffers a buyer might get cold feet or want to renegotiate terms.

The sales process can consume a lot of time and energy. The role of the intermediary is to assure that the process stays on track while the owner remains focused on running the business and maintaining its performance.

Deal Fatigue

A deal that takes too long to complete is at risk of never being completed. Typically, upon signing a Letter of Intent there is a level of excitement about the prospect of a completed deal. The enthusiasm helps to carry the process during the emotionally challenging due diligence phase.

However, enthusiasm often fades if the process doesn’t continue to move forward. When either party is uncertain of the deal or is otherwise distracted they may be slow in responding to requests for information or completion of tasks. Deal fatigue can also occur when one party makes unreasonable demands or aggressively tries to renegotiate the terms of the deal. The most painful negotiators bring up the same points repeatedly. Eventually one party or the other will walk away.

There are effective strategies to combat deal fatigue: 1) screen buyers to assure that they are serious about and capable of completing the deal 2) disclose upfront material information about the business 3) write clear deal terms that don’t lend themselves to renegotiation 3) develop a deal timeline that compels both parties to keep the process moving forward.

The difference between a done deal and a busted deal is often a matter of setting and meeting both buyer and seller expectations. Employing an experienced intermediary to manage the sale process will help you avoid common deal breakers and address the inevitable biases and personal feelings of parties involved in a high stakes transaction.

Adam Wiskind is a Certified Business Intermediary in Exit Strategies Group’s North San Francisco Bay Area office. He can be reached at (707) 781-8744 or awiskind@exitstrategiesgroup.com.

In some cases yes!  Congress has long recognized that small businesses investment is an important driver of the U.S. economy.  Back in 1993, to encourage capital investment in small businesses, they created a rule that eliminates federal income tax on some (later revised to all) of the gain on the sale of certain C Corporation stock issued after August 10, 1993. This article introduces the Qualified Small Business Stock (“QSBS”) tax break for business owners who are contemplating a future sale.

QSBS Requirements

To qualify for this tax break, your stock has to be deemed Qualified Small Business Stock per Internal Revenue Code Sec. 1202. Here’s a summary of 1202’s requirements:

1. The business must be a domestic C Corporation
2. Is a small business, defined as assets of less than $50 million
3. The stock was issued after 8/10/1993*
4. The stock was acquired at original issuance
5. The stock has been held for 5 years or more at the time of sale
6. The business is NOT engaged in professional services that are dependent on the reputation or skill of one or more employees, financial services, farming, mining or resource extraction, hotels, restaurants or other similar businesses

*Depending on the issue date of the stock, 50%, 75% or 100% of the gain (up to $10 million) may be excluded from federal income tax. The gain exclusion is 50% (subject to a 7% Alternative Minimum Tax (“AMT”) add-back) for stock acquired between August 11, 1993 and February 17, 2009. Stock acquired between February 18, 2009 and September 27, 2010 is eligible for 75% gain exclusion (subject to 7% AMT add-back), and stock acquired after September 27, 2010 receives a 100% exclusion, without an AMT add-back.

Andersen Tax offers a more complete list of QSBS requirements.

The QSBS tax break was made permanent by the PATH Act (Protecting Americans from Tax Hikes Act) of 2015. In case you’re wondering, the recent Tax Cuts and Jobs Act of 2017 did not alter QSBS rules, but the reduction of the federal corporate tax rate to 21% affects the magnitude of the QSBS benefit relative to a sale of assets. It is my understanding that California’s Franchise Tax Board no longer allows an exclusion on the gain of QSBS.

M&A Perspective

When a C corporation sells its assets rather than its stock, Sec. 1202 doesn’t exclude the gains that occur inside the corporation. So, even if you hold QSBS stock, you may not be able to get off tax free.

Acquirers of private businesses generally prefer to buy assets, not stock. For buyers, buying assets reduces their future tax bills, improves their cash flow, and reduces potential legal liabilities. When asked to buy stock and forgo these benefits, buyers usually expect to negotiate a meaningful price discount. However, given the magnitude of the QSBS tax break, especially when eligible for 100% exclusion, a seller of QSBS could give a buyer a significant price discount and still come out well ahead (relative to selling assets).

Fortunately, the reduction in the corporate tax rate to a flat 21% under the Tax Cuts and Jobs Act of 2017 makes a C Corp asset sale more palatable. The corporation will have to pay 21% on the gains, but the shareholder, when they receive the remaining sale proceeds through a liquidating dividend, can use Sec. 1202 to avoid tax on that cash. The overall tax effect is closer to that of an asset sale by an S Corp or LLC.

Do you have QSBS?

The prospect of selling qualified small business stock is compelling; however determining whether your C-Corp stock qualifies as QSBS and claiming this benefit can be tricky.  Work with a CPA or tax advisor who is well-versed in QSBS requirements and who can calculate and compare your after tax proceeds under various deal structures. For another slick C-Corp tax maneuver, see my blog on personal goodwill.

If you intend to sell your business some day, please be aware that tax minimization strategies can have a big impact on how much money goes into your pocket. Some strategies can take 5 years to implement, so get your M&A and tax advisor involved early on.

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Exit Strategies Group’s M&A advisors are dedicated to staying abreast of tax minimization strategies for our business sale, merger and acquisition clients.  Al Statz, founder and CEO of Exit Strategies Group, is based in Sonoma County California and works with lower middle market companies throughout the U.S.  For further information on this subject or to discuss selling a company, contact Al at alstatz@exitstrategiesgroup.com or 707-781-8580.

The concept of goodwill in a business sale is familiar to most business owners. The more the better, right? Personal goodwill (versus enterprise goodwill) on the other hand is less familiar, and trickier to deal with. If your company is structured as a C-Corporation, you should know about personal goodwill and how its existence could put more money in your pocket when it’s time to sell. Here’s how this works.

The C-Corp Dilemma

Sellers of C-Corps prefer to sell the stock of their companies because it is more tax efficient than selling assets; yet the reality is that most business sales are structured as asset transactions. Why? Because, for buyers, buying assets reduces their tax bill, improves their cash flow, and reduces potential legal liabilities. Astute buyers that are asked to forgo these important benefits (i.e. when they are asked to buy stock) will expect a substantial price discount. Some will just walk away.

With an S-Corp on the other hand, which is a pass-through entity, selling assets (vs. stock) usually isn’t a much of problem from a tax perspective. In some cases, selling assets can even be to a seller’s advantage.

But for C-Corps, selling assets is a big disadvantage. Here’s a simple example. Assume that the combined federal and state C-Corp income tax rate is 29%, and that the combined individual capital gain tax rate is 28%. In an asset sale, for every $1.00 of transaction price (above book value of assets), C-Corp shareholders net only 51¢. Could this happen to you?

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Exit Planning Tip:  

If you own a C-Corp and your expected holding period is 5 years or more, talk to your CPA about electing S-Corp status so that you can avoid the possibility of being double taxed when you sell.

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Does the Goodwill Go Home at Night?

Goodwill value is that portion of a business purchase price that exceeds net tangible asset value. Personal goodwill (“PGW” for short) differs from enterprise goodwill in that PGW represents the value of an owner’s personal service to that enterprise, and is considered an asset owned by that person, not the business. PGW value is usually the result of an individual’s outstanding reputation and close personal relationships with customers or suppliers, or exceptional rainmaking or technical mastery, and other unique abilities that produce economic benefit for the business.

When PGW is present, the success and value of a business are largely dependent upon one or two individuals, usually the owner(s) in a small business. Without the key individual(s), the business may have little value. In other words, the goodwill goes home at night.

Personal Goodwill Presents a Tax Savings Opportunity

In asset sales of small owner-operated corporations, there can often be two sellers: (a) the business entity, and (b) an individual selling his or her personal goodwill. Selling PGW creates a tax savings opportunity for C-Corp owner-operators.

Using the same tax rates as above, for every $1 of purchase price that can be allocated to personal goodwill, the seller’s tax savings is 21¢. This is because the $1 allocated to PGW does not get taxed at the C-Corp level (is not “double taxed”). Suppose that in a $2 million transaction, $800K can be allocated to personal goodwill. This reallocation puts $168K more in the seller’s pocket.

NOT an Afterthought

Allocating part of the purchase price to personal goodwill has been an arrow in our quiver for the past decade or so; however, it cannot simply be a post-closing purchase price allocation. Rulings in multiple tax court cases demonstrate that PGW is under attack by the IRS.

When a C-Corp seller is considering allocating a portion of a purchase price to personal goodwill, these are some of the norms for supporting the existence of PGW apart from enterprise goodwill, and making it hold up to IRS scrutiny:

1. There should be a separately negotiated PGW purchase agreement. As brokers, we plan for this with the seller and buyer, before an offer is made, and coordinate with the parties’ attorneys, CPA’s and lenders.
2. The amount allocated to PGW should be based in economic reality. An independent personal goodwill valuation should be obtained to finalize the amount. This could cost $6-10k.
3. There should be a significant and separately paid for covenant not to compete with the seller personally.
4. The buyer should have a written employment/consulting agreement with the seller, for an extended term (say 18-24 months) with reasonable compensation. Otherwise, how could the seller’s PGW be transferred?

Selling any business with high personal goodwill is challenging. When goodwill goes home at night, valuation and marketability are generally reduced. Having a C-Corp structure adds yet another layer of difficulty and expense because of double taxation. Working with an experienced M&A broker, transaction attorney and CPA is extremely helpful when buying or selling this type of business.

Exit Strategies Group’s professionals dedicate themselves to staying abreast of tax strategies and potential pitfalls for private business owners as they plan and carry out business sale, merger and acquisition transactions. Don’t hesitate to call — the earlier we are involved the more impact we can have.

Al Statz is founder and President of Exit Strategies and is based in Sonoma County California. He can be reached at alstatz@exitstrategiesgroup.com or 707-781-8580.