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Positioning your business for sale

Financial Planning

Business owners have many possible exit strategies, including selling to the company’s management team or to a third party. This article summarizes the strategies and details how owners can use them to enhance and preserve the value of their business and realize the best possible price. It also looks at the tax implications of selling and explains how an employee stock ownership plan can help owners transfer a business.

Focus on value enhancement and tax reduction

If you own a business, it’s probably your most significant asset, so you’ll want to take steps to maximize its value when preparing for your eventual departure. There are many possible business exit strategies, including selling your business to a third party, selling it to your management team or transferring it to family members. Regardless of which strategy you choose, enhancing and preserving the value of the business will increase your chances of success. It’s also important to consider the tax implications of a sale.

What's it worth now?

The first step is to determine the value of your business today, ideally with the help of a qualified business valuation professional. Avoid the temptation to rely on industry rules of thumb, such as multiples of sales or earnings. These formulas can provide a rough indication of value, but they’re no substitute for a company-specific analysis by an experienced advisor. Prospective buyers usually evaluate businesses based on more sophisticated discounted cash flow or market comparison analyses, so it’s a good idea to use similar techniques as a starting point.

Make sure your forecasts or projections of your business’s future financial performance are solid and the underlying assumptions and calculations are accurate and well-documented. Consider obtaining a quality of earnings report to assess the accuracy and sustainability of reported earnings and the achievability of forecasted results. These reports, for example, distinguish earnings that are sustainable in the future from those that are attributable to factors such as nonrecurring revenues or below-market owner compensation.

How can you enhance value?

Conducting a valuation does more than provide an indication of what your business might sell for. It can also help you understand the factors that drive your business’s value and identify weaknesses that can diminish it. Armed with this information, you have an opportunity to make changes that can increase value — and your business’s selling price.

For example, a valuation professional might identify risks that reduce the value of your business in the eyes of prospective buyers or investors. Perhaps your management bench is thin or relies too heavily on your talents and ability. Maybe your information technology systems are outdated or your equipment is becoming obsolete. Or perhaps business is concentrated in a few large customers. With enough lead time, you may be able to mitigate these risks by bringing in new management talent, modernizing your technology and equipment, or diversifying your customer base.

What are the tax implications?

A complete discussion of the tax implications of a business sale are beyond the scope of this article, but there are a few things you should start thinking about. For one, if your business is organized as a corporation, selling stock is usually preferable from a tax perspective because stock sales are taxed at more favorable capital gains rates. An asset sale, on the other hand, may produce a combination of ordinary income and capital gain.

Plus, if your business owns a significant amount of depreciated equipment, an asset sale can result in depreciation recapture at ordinary income tax rates. With C corporations, asset sales can trigger double taxation, first at the corporate level and again when proceeds are distributed to shareholders. Keep in mind, however, that most buyers strongly prefer to acquire assets, since doing so generates larger depreciation deductions and makes it possible to avoid assuming the seller’s liabilities. Similar considerations apply to businesses structured as LLCs or partnerships, although the tax rules can be complex.

Purchase price allocation is another issue to consider. In an asset sale, buyers and sellers have some leeway to specify how the purchase price is allocated. As a seller, it’s preferable to allocate as much as possible, within reason, to assets that produce capital gains, such as goodwill and certain other intangible assets. (Note that buyers may have conflicting interests.)

To support your allocation, be sure to document the value of goodwill and other intangibles. If your business is a C corporation, you may be able to avoid some double taxation by demonstrating that a portion of the business’s value is attributable to its owners’ personal goodwill. Personal goodwill can be transferred directly from owners, bypassing the corporation.

Start Early

To enhance the value of your business and ease the tax burden on an eventual sale, start the planning process early. These strategies can take time to implement. Talk to a Lenox advisor with experience in mergers and acquisitions.

Consider an ESOP

If you’re an owner of a corporation, one exit option worth considering is an employee stock ownership plan (ESOP). This is generally a qualified retirement plan that invests in your company’s stock. An ESOP can allow owners to:

  • Start cashing out while still maintaining control over the business,
  • Defer capital gains on the sale of stock to the ESOP, and
  • Generate valuable tax benefits for the business.

For example, a company can deduct ESOP contributions used to buy stock. And if your company is an S corporation, income passed through to stock held by an ESOP avoids federal (and often state) taxes. Just be aware that ESOPs can involve significant expense, including annual valuations of the company’s stock.