Knowledge Base The most comprehensive, easy-to-understand source of information for selling a small to mid-sized business.
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by Jacob Orosz (President of Morgan & Westfield)
Executive Summary
It is essential to understand what happens to debt when a business is sold. In some instances, the debt is absorbed in the transaction as part of the sale. However, this is not the case most of the time.
The fate of any debt in the sale of a business is largely determined by how the transaction is structured. There are two ways to structure a deal — either as a stock sale or as an asset sale.
The overwhelming majority of businesses that sell for less than $10 million are structured as asset sales, in which specific assets and liabilities are individually transferred from the buyer to the seller at closing via a bill of sale. In contrast, in a stock sale, the buyer purchases shares or membership interests and assumes everything that the business owns or owes.
In the following article, we further explain the differences between a stock sale and an asset sale, and we discuss the various ways debt can be handled at closing.
Stock Sale
A stock sale occurs when the buyer purchases the stock (or membership interests for an LLC) of the seller’s entity (Corporation, LLC, etc.) and assumes everything that the entity owns or owes, including its assets and liabilities. Only a minority (in our estimate, less than 5%) of businesses that sell for under $10 million are structured as stock sales.
A buyer may decide to purchase the entity if they want to inherit something the entity owns that cannot be transferred if the sale is structured as an asset sale (e.g., a lease, contract, etc.).
For example, some contracts are specific to a corporation, LLC, or entity, and structuring the transaction as a stock sale would ensure these pass along to the new owner (assuming the contract does not state that a “change in control” requires the consent of assignment of the contract).
When structuring a transaction as a stock sale, you must determine what assets are being purchased and what liabilities are being assumed. At closing, the seller signs over the stock certificates to the buyer, and the buyer becomes the owner of that entity, making them an indirect owner of all the assets and liabilities that the entity owns.
There are three exceptions to when liabilities (i.e., debt) will continue to be the seller’s obligation after the closing of a stock sale:
- When the liabilities are personally “owned” by the seller, as an individual, unless those liabilities are separately transferred
- When the buyer requires that the seller pay all debt at closing
- When the seller agrees to be responsible for the debt post-closing, even though the entity may be legally responsible (e.g., a lawsuit)
Asset Sale
In an asset sale, specific assets and liabilities are individually transferred from the buyer to the seller at closing via a bill of sale. The parties pick and choose which assets and liabilities they would like to include in the sale. Most asset sales include all assets required to operate the business and exclude all of the liabilities associated with the business.
To affect the sale, the buyer usually forms an entity (corporation, LLC, etc.), and that entity purchases the assets of the selling corporation.
The following assets are sometimes included in the purchase price:
- Inventory: The buyer usually purchases all of the salable inventory, but it’s usually calculated separately from the purchase price in asset-intensive businesses.
- Working capital: Most larger transactions include the working capital, even if the sale is structured as an asset sale.
- Accounts receivable: Most transactions do not include accounts receivable.
Most small business transactions are structured as asset sales because of the possibility of contingent or unknown liabilities. The amount of a contingent liability is unknown — thus “contingent” — therefore, the buyer can’t calculate the amount of the liability. Examples include litigation or product liabilities.
Asset sales are more complicated than stock sales because the individual assets and liabilities must be purchased and sold, but we have discovered that this concept usually only applies to larger transactions.
In a stock sale, by contrast, all you have to do is sign over the stock certificates. All other assets should be transferred automatically unless they’re owned by the seller or the individual.
Exceptions to When Debt is Paid at Closing
There are a couple of exceptions to when debt may be paid at closing.
Exception #1 — Leased Equipment
If equipment is leased by an individual, that lease or asset would have to be transferred separately, regardless of whether the transaction is structured as an asset sale or a stock sale.
Exception #2 — Successor Liability
There is potential for successor liability in the purchase of a business, which means the buyer could assume the risk for certain liabilities. Successor liability occurs as the result of state law and may allow a creditor to seek recovery from the buyer for liabilities, even if the sale is structured as an asset sale and even if the buyer did not specifically agree to assume those liabilities.
Successor liability is most common in the areas of product liability, environmental law, employment law, and payment of certain types of taxes, such as sales tax. Successor liability is a function of state law, and the laws may vary significantly from state to state.
Additionally, you could be subject to claims from creditors in states in which the bulk sale law is still in effect (e.g., California). As a result, regardless of the transaction structure, the buyer should perform extensive due diligence to avoid the possibility of successor liability.
Additionally, the buyer should consider using an escrow company in certain states (e.g., California) and include representations and warranties in the purchase agreement that require the seller to indemnify the buyer in the event of successor liability. Many middle-market acquisitions hold back a portion of the purchase price for a period of time after the closing to protect the buyer against the possibility of losses due to successor liability.
Options for Handling Debt at the Closing
There are three options for how to handle debt at the closing.
- The seller could pay off the debt with cash prior to the closing.
- The buyer could assume the debt.
- The debt could be paid at closing through escrow out of the seller’s proceeds before they are released to the seller.
For example, if you’re selling a company for $10 million and you have $2 million in debt, escrow will deduct $2 million from the proceeds at closing, and the remaining $8 million will be paid to you at closing.
