Crucial questions to ask before selling your business

Baby Boomers are selling their businesses in record numbers. In fact, six out of 10 business owners plan on cashing out within the next 10 years.

Those formulating an exit plan, the so-called “silver tsunami,” include 2.9 million businesses in this country, according to a 2020 report by the Small Business Administration and Project Equity.

If you own a business, the equity in your company likely makes up one-third of your nonfinancial wealth, second only to your home, according to the Federal Reserve.

The proceeds from a business sale will probably also be a primary source of your retirement income. So, this could be the most significant financial negotiation you will enter into in your lifetime.

Yet, according to the valuation research firm IBIS, 98% of business owners do not know the value of their company, and few owners take the necessary planning steps to increase their after-tax profits from the sale.

This makes sense since most people will sell an average of six cars and three homes in their lifetime, but unless you are a serial entrepreneur, this is probably the first time you’ll sell a business.

So, how much is your business worth? You can ask several brokers and experts for their opinions, but you will likely obtain different answers from each one. Just like when you have an appraisal done on your house: The value in the report may or may not approximate the selling price. The sales price and terms ultimately will be what you and the buyer agree to.

Your goal in the negotiations is to maximize the sales price and, more importantly, your net (after tax) profit on the sale. So, before you call a broker, spend the time to ask yourself some critical questions.

First, what are you actually selling?

Everything is negotiable

If you are a sole proprietor or single-member LLC (and file a Schedule C with your individual tax return), you will be selling the assets of your company. Not all assets sold are taxed alike.

Taxes are apportioned among the asset classes (i.e., inventory, equipment, customer list, goodwill). Assets held in the short term, like inventory, are taxed at higher ordinary tax rates. Assets held long-term are taxed at lower capital gains rates. Part of your negotiation will be to allocate the sales price to assets taxed at a lower rate.

The sales price will generally be worth more than the assets on your balance sheet. For instance, a broker opinion I recently reviewed valued a very profitable company based only on the value of assets on the depreciation schedule. They undervalued the company by $1.5 million because they appraised the business as a liquidation sale and not as a business that was going to continue.

Again, the sale price is based on what the buyer agrees to pay and what you are willing to accept. So, the next question is, who is your intended buyer?

Different buyers will pay different amounts

If you have a smaller business, especially with few or no employees, the buyer is probably looking to work independently and is buying themselves a job.

They want to know that the small business they are buying will provide them with a stable source of income for many years. There will be a downward pressure on the sale price since the buyer will likely have to pay for the debt they incurred to purchase the business while earning enough to support themselves.

If your company is larger, your buyer will likely be purchasing your company as an investment. The buyer is seeking the best possible return with the least risk. An investor will probably have a firm number in mind for the purchase price. If the terms are not agreeable, they will invest elsewhere.

One of your customers who would like to eliminate the middleman (you), your biggest competition, or a larger company buying up smaller companies like yours will pay “synergistic value,” which is often higher than what other buyers will pay. Synergistic value arises when combining two or more interests to create a new interest with a higher value than the sum of the individual interests. In other words, buying your company is something they really want. Keep your options open to sell to a synergistic buyer.

Finally, the price your kids or key employees would pay to take over may have less to do with the market value of your company and more to do with how much they can afford to pay you for the business. Often, a sale of this type will result in a lower price than a synergistic sale but offers more flexibility and tax planning opportunities. It can also personally be more rewarding.

Regardless of who you are selling to, a question often overlooked that can lead to tragic consequences is, what are the tax ramifications if I sell?

The taxes can be more than 50%

This question is significant because the taxes you will pay the IRS on the sale can range from zero to over 40%, in addition to state taxes (13.3% top rate in CA). Without proper planning, over half of your proceeds may go to paying taxes.

For example, suppose your company is a C Corporation (and files Form 1120 each year). In that case, you might not have to pay any federal taxes on the sale if the stock is Qualified Small Business Stock (QSBS). Depending on when the stock was issued, you could exclude 50-100% of the gain up to $10 million. (Several technical requirements exist under Section 1202 of the Internal Revenue Code, and not all C-Corps are eligible.)

If you operate as an S-Corp (file 1120-S each year) or as another type of entity, don’t despair, you still might qualify for the exclusion. If you are not planning to sell within the next five years (the minimum QSBS holding requirement), it is probably worth considering changing how your business is structured so you can still take advantage of the gain exclusion. Seek the advice of your CPA or tax attorney to determine how you can become eligible for this and other tax planning opportunities.

In fact, if you are contemplating selling your business now or even within the next few years, seek out the advice of professionals you already trust and consult with succession planning specialists.

As bestselling author Alan Lakein put it, “Planning is bringing the future into the present so you can do something about it now.” Planning long before you sell will result in a higher price, better terms, and, most importantly, the greatest possible proceeds after taxes.

Michelle C. Herting specializes in tax planning, trust administration, and business valuations. She has three offices in Southern California.

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