Transition Team

Financial Report Preparation

Most businesses track their income and expenses by one of two methods: cash or accrual. The same income and expenses can produce a different amount of profit for a given period depending on which method is used. With the accrual method, the income is reported in the tax year earned, whether or not received and the deductions are claimed in the tax year incurred, whether or not paid. Essentially, you could have paid a bunch of expenses at the end of the tax year but still have not received the income those expenses produced until the next tax year. This distorts each year’s profitability.
For business valuation purposes, the accrual method provides a better window of understanding of business profitability. If you are using the cash basis of accounting, Snake River Business Brokers, in consultation with you and your accountant will need to make some adjustments to make sure income and expenses are closely related so that it is easier to visualize the profitability of the business over a given period. Many owners do not regularly prepare balance sheets or if the accountant prepares them, they do not pay attention to them.
Every buyer will want to see three years’ worth of balance sheets. They are not asking for this document because they believe it will be an indication of the business’ worth. They request this document because when paired with the P&L statement, the information helps them understand the financial story of the business. Often, they use common business ratios taking numbers from the P&L statement and the balance sheet to evaluate the business. If they look at current assets and current liabilities (Current Assets/Current Liabilities) and the ratio reflects that for every $1 of current liabilities, the company has $.99 of current assets, that would not be a good thing.
Common efficiency ratios are sales to assets, return on assets, and return on investment. Common profitability ratios include gross margin and net margin. Buyers evaluate the stability of the business using balance sheet ratios such as Current, quick and debt-to-worth. They look at the working capital cycle through ratios that measure inventory turnover, accounts receivable turnover, accounts payable turnover, and more.
In an ideal situation, a business owner uses the monthly financial statements to manage the business, but it is not at all uncommon for the financial statements to be used primarily for the preparation of income taxes. Many business owners keep a running tab in their head of what is in their bank account, and they are so busy working in the business that there is never time to look at the big picture. It never occurs to them to see their accountants as an advisor who could help them understand what their financial statements are telling them so they can run the business more strategically.

Taxes Owed on Sale

Most accountants do an excellent job of minimizing your taxes when you are running your business. You may recall them discussing the advantages of depreciating or amortizing certain business assets. What comes as an unfortunate surprise to many business owners is that the IRS sometimes wants to “claw back” some of those deductions when it comes time to sell your business. The term the IRS uses is called “recapture.”When a business owner sells their business for a profit, portions of the proceeds may be taxed at capital gains rates and portions may be taxed at ordinary income. It is important that your accountant be on the business transition team beginning in the earliest states of a contemplated sale to help ensure that the final walk away proceeds that you obtain at sale are what you are expecting.

Asset vs. Stock Sale

The most common way businesses are sold (Main Street or lower Middle Market) is through an asset sale. In an asset transaction, the buyer enjoys the following advantages:
  1. The assets receive a step-up in basis.
  2. The cash flow is enhanced by the step up in basis for depreciation and amortization purposes.
  3. Reduced risk exposure.
  4. The buyer can choose the type of legal entity structure (e.g., LLC, Corp, etc.)
  5. The buyer does not have to assume unwanted liabilities.
  6. The buyer does not have to buy unwanted assets.
  7. The buyer can allocate the purchase price among the acquired assets.
Most Main Street sellers move forward with an asset transaction, but both attorneys and accountants can help advise those sellers who would face especially disadvantageous consequences from using the asset transaction. For example, if the seller converted his/her company from a C-Corp to an S-corp. within the last 5 years, the IRS would want to impose a built in gain tax on the conversation. That could be painful. If the seller’s business is structured as a C-Corporation, double taxation may occur. In these and other instances, your tax or legal professional may advise a stock sale. Your accountant may also suggest other ways to defer taxes..

Allocation of Purchase Price

When purchasing a business in an asset transaction, the purchase price must be allocated among the assets, tangible and intangible, transferred from the seller. Snake River Business Brokers believe it is important to have this allocation in a written agreement prior to sale. The buyer and seller will each have to report the sale to the IRS on Form 8594. Inconsistencies in the tax treatment of the purchase/sale price by the Buyer and Seller can raise a red flag to the IRS. If the buyer and seller are following a written agreement with oversight from their business exit transition team, that is a much better plan. It is less likely to be challenged by the IRS.

Financial Statements Do Not Equal Value

One area that most accountants are not prepared to do is prepare an estimate of value or take the lead on the sale of the business. They may know your financials well, but a buyer always looks beyond the financials and few accountants have real world experience in business sales. A buyer does not look at a balance sheet and conclude that is the value. A buyer does not conclude value from a profit and loss statement or owner’s tax return. Instead a buyer considers the competition, the potential for growth, the risk of customer concentration, the quality of the work force and whether they will stay, the value of the existing lease, the risk of environmental contamination (if applicable), the potential for seller financing, the quality of the equipment, the cost of equipment or technology upgrades, the value of the inventory and much more.

Attorneys for Seller

Under ideal circumstances the seller will engage a business transaction attorney who has experience in business sales. The attorney will need to review a dozen plus documents and draft representations and warranties and other contract provisions to protect the seller’s interests both pre and post sale. The approach an attorney takes with the buyer’s attorney can make or break the transaction. Each side must do an excellent job of protecting their client’s interests while not contaminating the sense of camaraderie and budding trust that the buyer and seller created that lead them to a decision to work together on the sale. The negotiations between buyer and seller should never resemble a bitter divorce. Rather, the negotiations between them should resemble an engaged couple working out a prenup agreement with relationship preservation in mind.

Common Documents an Attorney Might Draft or Review

  1. Non-compete agreement
  2. Purchase and escrow agreement
  3. Assignment of customer contracts and accounts
  4. Consent of landlord to lease assignment
  5. Non-lien affidavit
  6. Seller’s Disclosure statement
  7. Purchase price allocation worksheet
  8. List of Vendor’s/Deposits
  9. Any seller financing docs
  10. Corporate resolution
  11. Affidavit of Transfer of Fictitious Name
Fortunately, because Snake River Business Brokers uses a vault system for documents, the seller does not need to be transmitting numerous documents back and forth with their transition team. The vault serves as a central repository that the transition team will have access to. A plan for communications with the transition will take place at the start of the engagement. This leads to more efficiency in the use of the transition team’s time and less money spent on consultants.