In my last column, I described a situation where a widow had several attractive offers from buyers to purchase her husband’s business for cash, but she was considering holding out for an installment contract. Why? To defer income taxes. I suggested it might make sense for her to “take the money and run.”
There are a number of non-tax considerations that go into selling a business, especially when the terms are other than for cash at the time of sale. I’m specifically referring to situations where the seller wants to sell the business, as a stock rather than asset sale, to an outside party. A key consideration is a good installment sale shouldn’t be measured by price alone. We are all used to the concept of “buyer beware,” but I’d suggest there are reasons a “seller beware” as well.
Valuation: We start with the issue of who is the buyer and what is really being offered? In some cases, there is an intermediary such as an investment banker or business broker. In order to lock in the listing, there is the possibility the intermediary may value the business at a premium and entice the seller with an unrealistically high asking price. The intermediary’s hope is that after the upfront work and inevitable delays, the seller will settle for a reduced price when lower offers are made. The intermediary may require an exclusive listing agreement, knowing this effectively takes the business off the market during that listing period. Further, when an offer for a business is made, the sale typically involves a “due diligence” period where the business is once again off the market. A risk is an intermediary or buyer may try to leverage this time to identify so-called defects in the business and use these to justify a reduced offering price. I’m not suggesting all buyers and their intermediaries resort to such tactics. I’m simply saying the seller needs to carefully assess the motives of the intermediary and buyer, and be wary of any initial valuations.
Earnouts: Sometimes an earnout provision is used where the installments can be reduced if earnings turn out to be lower than expected. The buyer typically controls how earnings are measured for purposes of the earnout, and I’ve seen situations where the seller ends up receiving far less from the sale than anticipated. Indeed, I once had a buyer’s advisor call me asking how to lower ongoing earnings so the buyer could reduce his payments to the seller. Needless to say, I declined the opportunity to answer his question. The seller must be diligent in ascertaining exactly how the earnout provision will be measured and executed.
Security of the buyer: By agreeing to installments, the seller is tantamount to a minority partner – this in the business he or she once owned. If the terms of the buyout are attractive enough, this change in status may be acceptable, but keep in mind that a major risk to the seller is the buyer’s ability to pay. The seller should think like a third-party financial institution that is making a loan. What additional considerations should be incorporated into the agreement to cover the risk of buyer default? For example: a credit report, collateral, personal guarantees or spousal involvement.
Covenants not to compete: State law varies on this issue, but generally covenants not to compete must be reasonable as to time and distance. When such a provision exists, an added risk for the seller in an installment sale is who controls the money. If a legal dispute arises over a covenant not to compete following a lump sum buyout, the buyer has to pursue the seller for reimbursement. If, instead, there is an installment sale, the seller has the risk of the buyer withholding payments until the legal dispute is settled.
Other liabilities: In addition to the above legal issue, there may be other liabilities that continue after the sale of the business. A seller must be careful to understand not only what potential liabilities remain, but also whether the installment payments can be affected by these issues.
A Reality Check
Installment agreements may have hooks that can be detrimental to you as a seller. Still, if the buyer is offering a high interest rate on the sale, and if you feel the buyer is an adequate security risk, an installment sale may be warranted. You know the industry, the business and the buyer. And, frankly, you may not have a better place to invest the proceeds. Further, the party you may be selling to is either your management or your competition. In such cases, you are effectively financing your own buyout and this would mean you have no choice but to sell for installments. There are reasons, well outside of taxes, that suggest the terms under which you sell your business. Just be sure you know the consequences of those terms.
Steve Parrish, Contributor 5/06/2014 @ 3:56PM
