When working with clients who are buying or selling a business, some of our most frequent questions involve the financial aspects of the deal. We address some of these common questions in this article, including:

• How to determine business valuation and purchase price.
• How to fund a business purchase.
• Explain some common terms in M&A transactions, such as “earnout”, “working capital”, “escrow”, and “assets”.
• Tax issues and strategy in M&A deals.

Whether you are buying a neighborhood restaurant, a regional services company, or a mid-sized manufacturing operation, the deal’s financial terms are front and center. The attorneys at G & G Law can guide you through the process and help with all your questions along the way.

Frequent Financial Questions in M&A Deals

Buying or selling a business is often a big process with a lot of terms to work out between the buyer and the seller. One of the biggest terms is often financial – the purchase price and how it gets paid. Like most parts of the transaction, financing isn’t one-size-fits-all.

There are several ways to structure how a deal is funded, and the right approach depends on your goals, the business, and the level of risk you’re comfortable with.

Below are answers to some of the most common questions we hear about financing in M&A transactions.

How is the purchase price, or valuation, determined in a business purchase?

There are a lot of different methods that buyers and sellers can use to determine a purchase price. For example:

1. Valuation Services. There are companies that specialize in performing business valuations. These can be costly and are subjective, but are frequently a good starting point, especially in larger deals. But they may be less appropriate for a small business that is primarily service based.
2. Formulas. There are some common formulas used to determine pricing, such as the discounted cash-flow method or disposable earnings model, although these often don’t take the specifics of the business into account (such as whether the business is a service-based business). An online search will turn up many business valuation calculators. BizBuySell, Aquire.com, and some bank websites are a few examples. If you try several of these, you’ll likely get very different results based on different formulas and factors such as different multipliers of revenue and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
3. Comps. If similar businesses in the area have recently sold, comparables can be helpful in determining valuation.

However, the truth is that the value of a business, like most things, is what one party is willing to pay, and the other party is willing to accept.

What types of financing are common for business purchase deals?

There are a lot of financing options for individuals looking to purchase a business.

• Cash: The business can be paid for fully in cash, in which case the buyer typically transfers the purchase price to the seller at closing, though sometimes a portion of the purchase price is held in escrow for a period after closing.
• Seller Financing: The business can be paid for with what is called “seller financing” or a “seller’s note”, which means the buyer pays the seller over time. Oftentimes, this is treated as a loan from the seller to the buyer, with personal guarantees and/or the business being used as collateral to provide the seller some security for the financing. The benefit of these loans is that the terms can be negotiated between the buyer and the seller so things like interest rates and the length of the repayment period can be flexible.
• Loans: The business can be paid for with third party financing, which typically comes from a bank. In this case, the buyer would take out a loan from a bank to pay for the purchase, and would pay back the loan over time. Banks often require personal guarantees and/or use the business as collateral for the loan. There are also some organizations that can help a buyer obtain financing, or provide better terms for the loan, such as the Women’s Business Development Center (WBDC) , the Small Business Administration (SBA), or Allies for Community Business. SBA loans in particular are very commonly used for business purchases.

The purchase price can also be paid using a combination of the above.

What is an earnout?

An earnout is an optional contingent payment structure where the seller can receive additional compensation if specific, agreed-upon performance targets are met after closing the sale of the business.

Sometimes, parties can’t agree on one price. This can often happen if the parties have different expectations for how the business will perform in the future. In those circumstances, the parties can negotiate something like an earnout, where the seller gets more money if the business hits certain targets in the future. The goal is for the purchase price to more accurately match the growth potential of the business.

What is working capital?

Working capital is money in the business accounts that is not distributed to sellers pre-closing, but kept in the business’s bank account to cover operating costs of an ongoing business.

The amount of working capital included with the business purchase is negotiated between the buyer and seller. It may be a fixed dollar amount or a formula based on specific factors.

If the agreed-upon amount of working capital is not enough to cover the business’s operating costs, it is common for the buyer to invest funds or obtain sufficient financing to cover the operating costs of the business for a period after closing.

What is escrow and how is it used?

Escrow is an amount of the purchase price that is set aside or held back for some amount of time to cover unexpected contingencies caused by the seller, but not apparent to the buyer until sometime after closing. Some examples of these potential contingencies could be an HVAC system failure, an undisclosed leak causing major water damage, or an unexpected tax liability. If no such contingencies arise, the seller will receive the funds at the end of the escrow period.

The escrow funds are usually funded by the buyer but held in an account by an escrow agent. The agent may be the buyer or seller’s attorney or a third-party agent. If an expense comes up after closing that the seller agreed to be responsible for in the purchase agreement, the buyer can then make a claim to the escrow agent to be reimbursed. The purchase agreement will detail the terms of how the buyer can make a claim to recoup funds from the escrow account and when and how funds will be released to the seller.

How is the purchase price allocated among the assets purchased?

In a business purchase, the purchase price will be allocated to various parts of the business (typically tangible assets versus intangible assets) for tax purposes. The buyer and the seller usually negotiate the allocation of the purchase price. But the allocation needs to be based on general accounting principles to avoid having the IRS question it. Generally, the tangible assets, including cash, inventory, equipment, etc., involved are identified and valued, based on Fair Market Value (FMV). That amount is then allocated from the purchase price. Any remaining amount of the purchase price is typically allocated to the intangible assets, known as goodwill. We recommend also working with a CPA or accountant throughout the M&A deal to ensure the purchase price allocation aligns with tax planning goals.

What assets are generally included or excluded from a business purchase deal?

In most business purchases, all business assets are included with a few exceptions. However, in an asset purchase (versus a stock purchase), the buyer has the option to choose which assets to take or leave. As an example, if you are buying a children’s dance academy business and you don’t want the storage room full of old costumes, you can specify that the seller keeps those. You can read more about the difference between an asset purchase v stock purchase here.

The seller usually keeps a few things, including:

• cash
• cash equivalents and short-term investments
• minute books, ownership documents and similar records
• company seals
• personnel records
• other records that seller is required by law to keep in its possession
• contracts that are specifically excluded from the deal

Who pays the taxes in a business purchase?

Typically, the seller will pay for any taxes up to the sale, and the buyer will pay for any taxes after closing. Some taxes may arise from the transaction as well, which are typically paid by the seller, including any bulk sales taxes in an asset purchase and/or income taxes based on the net proceeds from the sale.

Taxes can influence allocations (see our “How is the purchase price allocated among the assets purchased?” Q&A above) and whether buyers and sellers prefer an asset versus a stock sale. For example, sellers in stock sale pay taxes on any gain from the sale, but do not pay bulk sales taxes.

It’s a good idea to include a CPA or accountant in the deal for strategic tax planning and compliance.

What is bulk sales tax and what are the requirements related to it?

Bulk sales tax applies in an asset purchase. It is a tax on businesses whenever the business sells substantially all, or the bulk, of its assets outside of the ordinary course of business. It requires that either the buyer or seller notify the Department of Revenue of the transaction and provide a copy of the purchase agreement. The Department will then issue a Bulk Sales Notice that requires the purchaser to withhold a portion of the purchase price to cover the bulk sales tax amount. This amount is usually placed into an escrow account. The seller is then responsible for that tax, unless otherwise negotiated. Once the seller pays the tax, the parties receive a release from the state allowing the amount to be distributed to the seller.

Ready to Buy or Sell a Business?

If you are considering a business purchase — whether you’ve already identified a business for sale, received a letter of intent, or you’re just beginning to explore your options — G & G Law is here to help.

We represent buyers and sellers in business acquisitions of all sizes. We bring substantive M&A experience to every client and the focused attention that your transaction deserves.

Whether you are buying a neighborhood restaurant, a regional services company, or a mid-sized manufacturing operation, the fundamental structure of a business purchase transaction is the same: LOI or term sheet, due diligence, purchase agreement, and closing. What changes at different deal sizes is complexity, different balances of cost/benefit analysis throughout the process, and sometimes which advisors (and how many) you may need.

We also know that every deal is different, and a lot can vary that will change how you want to approach this. For example, experienced operators adding to their portfolio will want to approach due diligence very differently from an employee looking to buy the business they’ve managed for 10 years.

You need counsel who is experienced in business acquisitions, understands the specific dynamics of small and mid-market deals, and will treat your transaction and your business with the tailored attention it deserves.

Are you looking to learn more about the process for buying or selling a business? See below for additional resources. Also sign up for our newsletter and follow us on social media to stay updated on newer resources.

• What is the process for buying a business?
• What is the process for selling a business?
• What is involved in due diligence?
• What’s better for my deal: an asset purchase or stock purchase?

Reach out today if you’re ready to see how G & G Law can help with your business acquisition or sale.