In our previous piece (The Art of Buying and Selling a Business), we discussed some of the important issues you should consider when you want to sell or buy an existing business to maximize your value and minimize your risk. In this article, we consider the two most common ways one goes about buying a business — and the risks and rewards in each of them.
Why should I buy an existing business?
As many of you know, starting a business can be one of the most rewarding — and challenging — experiences of your life. Here at Law 4 Small Business, we’ve helped thousands of people turn their passion into a marketable business through our start-up and consultation services. That said, there are plenty of reasons to buy a business rather than start one. Maybe you’re looking to get into a business that has already gone through the growing pains of those first few years of operation, or maybe you want to get a business that’s time-tested and proven to be profitable. Maybe you’re friends with the seller and want to take the business off their hands so they can retire comfortably? No matter the reason, buying a business generally takes one of two different forms: buying the stock or buying the assets.
Option #1: Buy the Stock to buy an existing business
Buying the stock — or “ownership interest”, “membership interest”, “member units”, etc. — is often the simplest way to buy a business. Not only are you getting all of the property the business owns, but you’re also buying the business itself as a going concern. Buying the stock of a business usually means it keeps running as it did before you bought it, with its employees, contracts, and customer relationships all remaining intact. If you’re buying a business that’s already profitable, buying the stock is a common way to ensure continuity and continued profitability.
That said, if buying the stock is the easiest way to buy a business, why doesn’t everyone do it? There are a few reasons why a buyer might not want to choose a stock purchase, including:
The Tax Consequences
As you’re probably aware, businesses are treated very differently than most individuals for tax purposes. They get to deduct a portion of what they paid for their assets (their “tax basis”) every year through a process called depreciation until the entire basis has been written off and the assets are completely depreciated — usually over a period of between three and fifteen years. Once the entire basis has been written off, those assets can’t be depreciated any further and the business loses that tax deduction.
If you buy a business’ stock, you’re getting assets that have already been depreciated and often cannot be depreciated further. By contrast, if you buy a business’ assets themselves (more on this later), your tax basis in those assets is whatever you paid for them — meaning the depreciation process starts anew for those assets and you can enjoy the tax deductions you might not otherwise be entitled to. Depreciability of assets is one of the biggest considerations for mergers and acquisitions both large and small, and it may be reason enough to avoid a stock purchase.
When you buy a whole business by buying its stock, you’re not only buying its assets — you’re also buying its liabilities. If the business took out a loan from a bank that it hasn’t paid, or if it owes years of tax debt, or if it has caused someone harm for which they can be sued, the buyer in a stock purchase inherits all of these risks, many of which are unknown at the time of purchase. This is why it’s important to do your due diligence when researching a business you want to buy outright — and why it’s worth having an attorney write or review the indemnity clauses built into your Purchase Agreement. (For more on indemnity clauses, see our previous blog post: Contract Tip: What is an Indemnity Clause?)
Option #2: Buy the Assets
As we briefly discussed, sometimes it makes more economic or practical sense to buy the assets of a business instead of the stock. Usually, buying the assets frees the buyer of the acquired business’ liabilities (except, occasionally, tax liabilities — see Successor Liability – Even in an Asset Purchase for more on that). Buying the assets also gives the assets new depreciability, often resulting in tax deductions that offset a significant part of your purchase price. While these can prove to be compelling incentives for an asset purchase, sometimes an asset purchase can create more problems than it avoids. Some common pitfalls of asset purchases are:
Sometimes a company’s value is in its assets — especially if you’re dealing with intellectual property. Oftentimes, however, the value of a company is in its contracts and customer relationships. These contracts represent an ongoing source of revenue that the company can expect to enjoy for weeks, months, or even years into the future. Unfortunately, many sales and services contracts contain non-assignment clauses, which either severely restrict or prohibit altogether a sale of the contracts to a third party. A business’ contracts may be worthless in the hands of anyone other than the original contracting business. It’s probably worth noting that many contracts also contain “Change of Control” provisions that invalidate the contract when a business’ stock is purchased and its ownership changes. Those provisions tend to be far less common than non-assignment clauses.
It’s often the case that people mistakenly value a business as the total worth of all its assets minus any liabilities it has. There’s another factor that people tend to ignore: the business’ goodwill. Goodwill can be thought of as the name value and recognition of the business within its community and among its customer base. A company that has been in business for a century and is referred to as a pillar of the community can be said to have a fair lot of goodwill. When you buy a business’ stock and, consequently, the company itself, part of what you’re gaining is that company’s continued existence — and the goodwill that company has generated. That goodwill may be enough to keep customers coming through the door despite economic disadvantages like higher prices or lack of product variety. It might also be lost if you’re only purchasing the business’ assets for use in a different business.
How we can help you buy an existing business
Buying a business involves paying a lot of attention to the little details of what that business truly consists of. If most of its value is in contracts and ongoing customer relationships, buying the business’ stock might be the best way to preserve the value of what you’re buying. On the other hand, if the business is laden with intellectual property, machinery, or some other valuable assets, and if you don’t need that business to continue operating after the purchase, buying the assets might be a great way to avoid the trappings and liabilities of the business while also gaining some valuable tax savings. Over the years, we’ve helped countless people weigh their options and maximize the value of their business purchase, both through consulting and through drafting ironclad Purchase Agreements to protect your rights and interests. Whether you’re a seasoned professional or a first-time business owner, give us a call and see how we can help you get the most out of your next business purchase.