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The Business Advisor

Selling a Business:
The sale of assets.

by Mary Hanson

Many, or even most, sales of small businesses are accomplished as an "asset" sale rather than a stock sale. Any business owner planning or hoping to sell a business needs to be aware of the issues involved in the asset sale. If an asset sale is not acceptable to you as a potential seller, then very long term planning must be done to make the business attractive for buyers to purchase as a corporation or other entity.

In the sale of assets, all the tangible and intangible assets to be transferred to the buyer are normally separately identified. The buyer's assumption of liabilities, if any, must be carefully provided for. The sale of assets does not relieve the seller of obligations under contracts, obligations to employees, tax liability, product liability or potential liability for past services or other activities. Every particular asset, contract, employee, obligation, liability, and risk, and the various consequences of each, must be separately reviewed and considered. All taxes arising from such a sale must also be separately considered.

The sale of assets is in contrast to the sale of stock, in which all assets and liabilities of the entity represented by the stock are transferred as part of the sale of stock. The entity remains in place, and so do the assets and liabilities. Only the ownership of the stock itself is changed in such a sale. The typical shareholder selling stock walks away from many risks, unless separate commitments are contractually made to the buyer. In addition, the seller faces only the tax on the capital gains on the sale of his or her stock.

In an asset sale the seller (whether a corporation, another type of entity, or an individual) remains liable for actions and obligations prior to the transfer, including ongoing obligations under contracts, and that burden is only alleviated by the contractual promise of the buyer to cover those liabilities and obligations. Taxes imposed on the seller will be on the selling individual, or corporation, LLC, or partnership, if there is one. The effect of those taxes, and the imposition of additional taxes on the shareholder, member, or partner level, must be considered.

The seller's insulation from liabilities depends upon the contractual obligation of the buyer, and the ability of the buyer to adequately operate the business in a manner that minimizes liability and generates funds with which to meet its contractual obligations to handle liability. The buyer will have the business and the personnel to handle such matters. The seller often will not.

Addressing Liabilities

The seller considering an asset sale should attempt to identify and quantify the risks involved in such a sale. To do so, each type of risk must be considered separately. These risks include any potential claims and lawsuits arising out of contracts, environmental issues, employment, product liability, taxes, and actions by company personnel. Management must avoid fixating on one issue, such as an environmental liability or tax consequence, while overlooking other types of liability. It is important to carefully consider every type and category of liability, how it would arise, how long each type of claim can be made (what would be the likely statutes of limitations?), how great the liability could be, and how it could be handled by the buyer.

After identifying and quantifying these risks, the seller should find ways to place these risks on the buyer in order to reduce the possibility that the selling corporation and its shareholders might later bear the cost of these risks. Will the buyer agree to indemnify the seller against these risks? Is the buyer financially strong enough to meet the obligations and handle the risks? Can insurance be affordably obtained to protect against the risks? Is there any way to reduce or eliminate risk now (terminating contracts, eliminating a product line, changing a business practice, etc.)?

Each type of risk has different issues that must be addressed and considered. For example, the seller needs to be aware of the risks arising from contracts that have only been assigned to the buyer. An assignment of contracts to the buyer and assumption of the obligations by the buyer does not release the seller from liability under those contracts. Under most state laws, a release from the other party to the original contract is required if the seller of the business is to be relieved of liability under a contract. It may be necessary to have the buyer enter into a new contract in order to relieve the seller of the contractual obligations.

The asset purchase agreement can provide that the buyer indemnifies the seller and its officers, directors, shareholders, and employees against liabilities. This offers important protection to those indemnified. However, the negatives as well as the positives must be considered. The indemnification is like an insurance policy. The intent of an indemnification provision is to have the indemnifying party (the "insurer") pay any covered claims from third parties before the indemnified party (the "insured") must pay them, or reimburse the indemnified party for payments made on claims that are covered. The indemnification provision must define what liabilities are covered. If the definition is quite specific, the selling party may face many claims that are not covered by the indemnification provision. Another concern is that the buyer and the seller may disagree on whether the indemnification provision applies to a particular type of claim. Another risk is that the buyer may be financially unable to pay third party claims it agreed to cover in the indemnification provision.

The seller must recognize that, if the buyer refuses to pay or is unable to pay claims that are covered under an indemnification provision, the seller only has the right to sue the buyer under the indemnification provision. The seller is still stuck with the claim.

Too often, a seller views a buyer's commitment as solving the problem. It does not make liabilities go away, it merely provides a mechanism for handling liabilities as they arise. That mechanism can fail.

Issues to Consider

The following is a list of issues and points the seller should consider for an asset sale:

Is there any concern about environmental matters, arising out of property ownership at your manufacturing location or arising out of the use of your product? Will the buyer accept such risks? Is insurance available to cover the risks? This area of liability poses problems because environmental liability cases are notorious for ignoring the separation of shareholders from the corporate entity and holding individuals liable.

Has every contract of the business been reviewed and considered? What are the obligations? These remain obligations of the seller. Will the buyer assume those obligations? Can new contracts be signed between the buyer and the other parties to those contracts? Are there permits, licenses, taxes, insurance, or anything else associated with the contracts that need to be considered? Do the contracts by their terms permit assignment?

Each tangible asset to be transferred must be considered. What product liability does the company face from those assets (whether products sold or products leased out)? Have all types of liabilities and applicable laws of every jurisdiction been considered? Is there insurance that covers these risks? What risks are not covered by insurance? (There is always some risk not covered by insurance. This must be considered). Will the buyer accept a portion of the risk? These are risks to be covered in the indemnification provision.

Have applicable taxes been considered? The sale of inventory generates ordinary income. Sales taxes are applicable on many types of assets. Will the buyer agree to pay the sales tax? The sale of depreciated assets triggers taxes on depreciation recapture. The sale of assets over the seller's tax basis results in capital gain to the seller. If the seller is a corporation, these taxes are on the corporation. If it is a regular ("C") corporation, capital gains taxes will be paid by the shareholders when proceeds of the sale are distributed to the shareholders. The two levels of tax on an asset sale by a C corporation absolutely must be considered in the earliest planning stages.

One of the most important things a seller should do is to have the tax consequences of the sale identified and calculated to the extent possible. I recommend that an accountant be asked to prepare "pretend" tax returns for the year of sale and also for a future year after the sale, for the selling corporation and for the shareholders, in order to flush out any unanticipated issues. Even if the numbers are very rough at this stage, there is tremendous value in having additional issues flagged upon preparation of such returns. The accountant's tax preparation program may flag issues that would otherwise be overlooked.

In an asset sale, the total purchase price must be allocated to the various assets transferred. Since this allocation affects all calculations of taxes, whether income taxes, sales taxes, or capital gains taxes, the seller must carefully determine what allocation of the purchase price is best for the seller.

Have past tax issues been considered? In an asset sale, the seller corporation (or other entity) continues to exist and may be audited. The selling shareholders need to be aware that such liabilities will continue for some period of time.

How will transfer of employees be handled? If the buyer wants the seller to terminate all employees, the seller will bear the burden of that termination. Will the buyer commit to hiring all employees? If any employment claims arise, whether related to hours, treatment, discrimination, compensation, etc., who will cover those claims? Will the buyer accept that risk?

Has management anticipated the warranties, representations, and indemnifications that the buyer may request from the seller? Sellers need to be aware of the risk of entering into an agreement because the main terms seem right and the price is acceptable, and later finding that the burden of warranties and indemnifications in the formal agreement reduce the potential proceeds of sale to an unacceptable level. Some typical warranties are that the books and records shown to the buyer are accurate, that the equipment is in working condition, that the seller owns all assets free and clear of liens, and that there are no undisclosed legal liabilities facing the business, such as lawsuits pending or threatened. If liabilities arise that are covered by the seller's indemnification, or that were warranted by the seller, the buyer may demand payment from the seller for such liabilities. The seller may believe that the business is clear of liabilities, and agree to such warranties and indemnifications, only to find that financial burdens from audits, employee complaints, and product liability claims that are brought after the sale must be covered by the seller.

Has the sale been structured to address the possibility of the buyer's breach of its obligations? Is there a significant down payment? Are the buyer's payment obligations secured by collateral and guaranteed by other parties? It is important that the seller of a business understand that obtaining a contractual promise from a buyer does not assure action by the buyer. The seller wants and expects to get paid. The seller wants and expects the buyer to meet its contractual obligations. The words in the contract do not make it so. There is always the risk that the buyer will be unable to make payments or otherwise unable to perform. There is the risk that the buyer will not pay third parties or complete contracts or take other actions as agreed to in the sale agreement.

Conclusion

The seller of assets must make sure the terms of an agreement are acceptable AND consider the possibility that the contractual obligations won't be met by the buyer.   There is no substitute for careful consideration of all the issues and different possibilities.

2001 Mary Hanson. All rights reserved.