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Return to: 1998 Feature Stories
CLIENT: CALIFORNIA SOCIETY OF CPAs
Dec. 16, 1998: Riverside Business Journal
Like many business owners in recent years, the thought of selling your business has probably crossed your mind. The idea of less responsibility, reduced stress, getting away from the rat race, playing golf, living at the beach or in the mountains certainly has its appeal. But how do you do it and what are the key issues to take into consideration? Some of these include:
. Determining the value of the business
. Selling price
. Credit quality of buyer
. Planning for after the sale
. Proper advice
If you're considering selling your business, the first step is determining its worth. Most industries have some kind of "rule of thumb" for valuing the business. For example, with a professional service, it's common to use a multiple of one times annual gross revenues. A manufacturing business is typically valued on a multiple of earnings or cash flows and can range significantly from industry to industry. There are, however, a number of methods today to determine value. Like the stock market, the underlying financial assumptions of these methods vary according to prevailing economic conditions. For example, the costs of capital and interest rates vary. Other key factors include the overall growth outlook for the economy and for your specific industry.
It is vital that you retain a qualified, independent professional such as a CPA who is certified as an independent business valuation specialist for your valuation as it can make a substantial difference in the selling price. The tax consequences from the sale of your business, for instance, can have dramatically different results depending upon how the deal is structured. As a general rule, the sale of stock produces capital gain to the seller. The sale of other types of assets including non-competition agreements may also result in ordinary income. Since ordinary income tax rates can be up to twice as high as capital gain rates, taxes must be carefully evaluated during the negotiations. It may even be possible to defer the payment of income taxes. One way to defer taxes would be a stock-for-stock exchange. If you haven't done this before, get professional assistance, as these transactions must be handled carefully to insure you do not run afoul of complicated tax rules. If your buyer is a publicly held company, for example, and you exchange for their stock, you will be left with stock ownership in the publicly held company. In this situation, the major benefits of a stock-for-stock exchange are tax deferral and the conversion of privately held stock into a publicly traded stock. However, one concern that could arise is managing the risk of holding a concentrated equity position. One useful and not widely known planning strategy is known as a "collar." Simply described, the strategy consists of selling a call option and purchasing a put option. Using both components, this strategy could be structured to incur no out-of-pocket cost.
The investment consequence of using the 'collar' approach is that the investor limits both the downside risk and the upside appreciation potential of the stock received. The time frame for a 'collar' is typically between three to five years. Pricing for the strategy may differ, depending upon the time frame. The transaction, subject to minimums, is usually handled by an investment banking firm, and is known as an "over the counter" option transaction. Unless one uses publicly traded options, the investor must be careful to deal with a firm of sufficient credit quality because the transaction is considered private.
For tax purposes, if the "constructive sale" rules were to apply, the investor would recognize any gain on the stock as if it had been sold when the collar was implemented. In brief, according to the recent changes enacted in the 1997 Taxpayer Relief Act, a constructive sale is deemed to occur if the taxpayer enters into certain types of transactions or has a related person enter into one of these transactions. However, if certain guidelines are followed, in some circumstances collars may be used without triggering the constructive sale rules. Other considerations in the strategy include:
Type of settlement (at expiration of the contract): cash or physical
Ability to borrow using the position as collateral
Liquidity of the underlying stock on the market
A sale of a business that calls for any form of deferred payments will in effect place the seller in the position of a creditor. This necessitates a thorough analysis of the "credit quality" of the potential buyer. At a minimum, the steps to be taken may include obtaining data from credit rating agencies, analyzing the buyer's financial statements, tax returns and business plans, and investigating the business and personal reputation of the buyer.
Selling your business can help you reap the financial rewards you richly deserve after nurturing and building it for years. But conversely, selling your business can also be a nightmare, fraught with tax and legal pitfalls if you don't know what you're doing or are unaware of the tax consequences depending upon the type of transaction made during the sale. And the proverbial 'bottom line'? Utilize the services of a professional such as a CPA to ensure that the sale is conducted properly and seamlessly. You'll sleep better for it!
Return to: 1998 Feature Stories