Business Brokers: Advising Our Clients

As professional business brokers, advising our clients is the essence of what we do. But how we advise them and what topics we advise them on is not always clear. Every deal is different in structure and, as such, every deal entails its own risks and rewards for our clients. How is that so? Well, for starters, other than transactions involving the smallest “mom and pop” businesses, deal structure is rarely a straightforward matter of a buyer writing a check and a seller handing over the keys. Let’s dive into a few of the pitfalls your selling clients might face in any given deal – and how you might advise them.

Got Financing?

Again, other than the smallest “mom and pops”, most small and and lower Middle Market businesses will involve the seller participating in the buyer’s financing to one degree or another. Seller financing has its own value, above and beyond the value of the business. Our clients need to be prepared for the fact that they will likely be asked to help finance the acquisition of their own business – but that they should get paid for that help. Just as with a conventional lender, such value is generally paid for via the interest the lender – is our case, our client, the seller – will charge for providing that financing. And because the seller is not in the lending or financing business, the interest rate charged would generally be above the market rate (which we define as that charged by conventional lenders). How much higher? It depends on a number of factors including the credit-worthiness of the buyer, whether the financing will put the seller in a primary or secondary position, the ability of the business to support the requested financing as well as the overall deal structure. We generally advise clients to add a point or two to whatever the local going rate is or to the published Wall Street Journal prime rate. We often also advise that the rate be set to “float”, especially if the term of the seller financing exceeds two years, as it often does. When used in this way, a floating interest rate means that the note holder – the seller – will not suffer any erosion of value in the event interest rates rise during the term of the note. If rates WERE to rise, the interest rate paid to the seller would also rise.

What Are We Selling?

Does the seller know what he or she is selling? I’m sure that, if you asked them, their response would be “my business!” But is it? There are a couple of ways to sell their business insofar as they can sell the assets or the stock. It’s crucial to understand the distinction between the two. When assets are sold, certain liabilities – most notably those for taxes – stay with the seller. For example, if the seller withheld but failed to submit to the taxing authorities employment taxes for the past four years, that liability does NOT go with the business in a so-called “asset sale”. When the taxing authorities finally figure out that they’re owed $800,000 is withholding taxes, they will come after the seller, not the company or the new owner. On the other hand, if the transaction is structured as a “stock (or membership interests) sale”, that tax liability might often go with the business. This is why most knowledgeable advisors to BUYERS advise them to structure the deal as an asset purchase. We generally represent the sellers, of course, and this is a topic that usually comes up only when an offer to purchase the business comes in – at which point we can discuss the pros and cons of the deal structure with our client. And when this discussion begins, it is not uncommon for our client, the seller, to disclose that such a tax issue exists (if, in fact, one does). And it is at this point that a broker faces an important ethical test.

Business brokers and Ethics

In some areas of the world, business brokers are required to be licensed; in the U.S. and Canada, the required license, inexplicably, is a real estate license. Real estate law and the Code of Ethics of the (U.S.) National Association of Realtors both burden licensees with a fiduciary duty and a requirement that any “known defect” of a property be disclosed to potential buyers. It is my oft-stated opinion that professional business brokers should adhere to nothing less than real estate law and the Code of Ethics. As such, if our client discloses this tax liability to us – even in confidence – we are obliged to disclose it to any potential buyer. This is the basis of “fair dealing”. Our advice to our clients on this issue is straightforward and delivered before the ink on the listing engagement agreement is dry; “If there are any outstanding tax issues relevant to the business, discuss them with your attorney or accountant. Don’t mention them to us.”

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The Other Tax “Issue”

Withholding tax isn’t the only tax issue that our clients have to consider. As many of you know, it has been our experience that most business owners have not planned their exit thoroughly and one of the questions that generally remains unanswered when we get the call is whether the proceeds from the sale will be enough to fund the seller’s future plans. But that question has to be asked in the context of “after tax” proceeds. How is the deal structured? The amount of cash the seller receives in the year of the sale is taxable as a capital gain. As I write this, the U.S. election appears to be won by the Democrat party, the putative leader of which has promised to nearly double this tax. Our advice to our clients is to discuss this issue with their tax advisor because it will impact what is arguably the biggest question the seller has to ask: “Will the proceeds support the life style I’m planning post-closing?” In many cases, it may also impact how and over what time period the seller receives the sale proceeds.

The Bottom Line

There are several other significant issues that professional business brokers should be advising their clients on; whether to take equity in the acquiring company as part of the payout; the impact on the eventual payout of an “earn-out”; working for the new owner and, if so, for how long. Unless some urgent topic pops up beforehand, I’ll address them in next week’s post so stay tuned. If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast. I’ll be back with you agin next Monday. In the meantime, I hope you have a safe and profitable week.