Selling a Business: A Real Estate Problem
10 October 2022: Selling a Business: A Real Estate Problem
Selling a business requires, as this blog has flogged for years, a valuation. But an accurate valuation requires good numbers. In our more than 20 years of brokering businesses, one of the situations where we see problems arise FAR too often is a situation where the business owner/seller also owns the real estate that the business operates in.
When such a situation exists, there is no shortage of potential complications but there is one specific issue that we, as business brokers, must be aware of. That is, how is the business paying for its space?
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First Things First
The first thing we must determine is who owns what?
Is the business a legal entity such as a corporation or limited liability company (i.e., LLC in the U.S.; GMBH in Germany; SRL in Spain, etc.) or partnership, etc.? Does the business own or lease the space in which it operates? Does the owner of the business own the real estate personally or through a separate entity?
If the business owners also owns the real estate – or even if the real estate is owned by the business – we know we have to counsel our client that he or she has two assets to sell.
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Don’t Miss Out on the Coming “Silver Tsunami“!
Clarity of ownership is important from three standpoints:
- Getting to an accurate valuation
- Knowing what you’re selling
- Knowing how to market what you’re selling
Because “knowing what you’re selling” is discussed in an earlier post – and because we’ve long counseled clients and the brokers we train that separating the business from the real estate is usually the best way for the seller to reap the highest value for each – this post focuses on situations where the businesses and real estate are owned by separate entities and both entities are owned by the same owner(s) – where the business pays rent to the entity that owns the real estate.
The Rent Expense
One of our U.S. clients operates a very successful service business. Her business is located in a building owned by a limited liability company – let’s call it Freedom, LLC – that’s owned by her and her husband. Her business pays rent to Freedom LLC.
One strategy used by the owners of successful businesses to reduce the tax liability of their successful business is to execute a lease with the owner’s real estate company at a rate that is marginally higher – sometimes significantly higher – than the market rate.
For example, our client’s business is paying rent of $18.50/ft in a market where comparable space is available for $15.00/ft. What this does for the company is that it reduces the net income on which its tax liability is determined. What it does for Freedom, LLC is increases the rental income – essentially allowing the owner of the business to pull money out of the business, nearly tax free.
How is that?
Tax treatment of real estate income in the U.S., as in many other jurisdictions, favors real estate investment. In the U.S., depreciation, maintenance, etc., are all expensed. The depreciation itself shelters a significant amount of the income – income that the owners of Freedom, LLC, can reinvest. Maintenance, insurance and other expenses associated with the real estate can, in a properly drafted lease, all be the responsibility of the tenant; the business.
But from a business broker’s standpoint, when recasting the earnings of a business with this type of related party interest, we have to be aware of not only how the ownership is structured but also whether the rent paid by the business accurately reflects the market rate.
In this case we advised that the business owner execute a new lease with Freedom, LLC, this time at market rate. This will reduce her rent expense, thereby increasing discretionary income – in turn, increasing the value of her company. Granted, this will reduce the revenue to Freedom, LLC, but our objective is to get the highest value for the business.
The Flip Side
But this situation works in two ways.
Another client of ours owned a retail business that was only marginally successful. Our client also owned the real estate the business operated in. Being aware of how such ownership structures can provide many incentives to manipulate rents, when we did our valuation, we looked closely at this relationship and discovered that the business was paying rent at a discount to market of about 40%. This was, it turned out, the only reason the business was “marginally successful”.
Our business valuation report had to include considering what the business’ financial condition would be if it was paying market rent. We had to explain to the owner that the only way to get the value suggested by the current discretionary earnings is to sell the business at the current rent – a below-market lease rate. Doing so, of course, results in the real estate being valued significantly lower than it would otherwise be.
The Bottom Line
There is tax “evasion” and tax “avoidance” – and I’m not suggesting that business owners are or should be doing anything that can get them in hot water with the taxing authorities. But my many years of business experience has led me to believe that most business owners feel a strong sense of ownership of the money they make – and a completely justified belief that they are much better equipped than some bureaucrat in Washington, Paris, Madrid, London or anywhere else – to figure out how to best use that money
Business brokers have to be aware of all sorts of financial machinations in order to arrive at a defensible business valuation. It’s our job to make sure the numbers are correct – and to explain to our clients what impact certain decisions have on value.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at joe@WorldwideBusinessBlog.com.
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 again next Monday. In the meantime, I hope you have a safe and profitable week.
We’ve just been contacted by a small investment company looking to acquire U.S. West coast IT services and software services with minimum DE/EBITDA of $1.5 million.
If any of you know of something that might fit, please let me know.
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 500 in the world. He can be reached at joe@WorldwideBusinessBlog.com