Buying or selling a business, like any major financial transaction, is complicated and requires competent counsel. Careless mistakes can have very serious financial consequences for both parties. Take, for example, the recent sale, subsequent bankruptcy and pending lawsuit between the former and current owners of the storied Capitol Hill restaurant, Hawk n’ Dove.
Earlier this month, The Washington Business Journal reported on a law suit filed by William Sport, one of the former owners of a group that owned nine District of Columbia restaurants including The Chesapeake Room, Park Tavern, Boxcar Tavern, Hawk n’ Dove, Molly Malone’s, Pacifico, Senart’s Oyster and Chop House, and Willie’s Que and Brew. See the WBJ article here.
Sports and his partners agreed to sell the nine restaurants to Barracks Row Entertainment Group LLC in December 2012 for $19.3 million. According to his complaint, which was filed in federal district court in October of 2013, Sport is alleging that the Defendants falsely represented the ownership of the company making the purchase and fraudulently inducing Sports into a sales contract where he accepted a $4.63 million promissory note as partial payment. Sports also agreed to personally guarantee $5 million in bank debt carried by the restaurants, as well as to continue to personally guaranty the nine commercial restaurant leases. The named Defendants are Richard Cervera, Michael Hoi-Mingh Cheung, William J. Nimmo, and Halpern, Denny & Co., a private equity and venture capital firm. See the filed complaint here – Case 114-cv-01783-JEB.
As with most contentious litigation, it will be some time before this case is resolved. It nonetheless serves to highlight important issues that both sellers and buyers should keep in mind when entering into a sales contract. Below we’ve provided a general overview of the due diligence restaurateurs and entrepreneurs should undertake in any sales transaction. The list is by no means exhaustive and we highly recommend that each party consult with an experience business attorney when entering into any complex legal agreement.
Business for Sale – A Seller’s Prospective
1. Type of Sale – Asset sale or Stock Sale?
An owner can sell the company’s assets outright, or can sell stock in the corporation or membership interests/units if it is a limited liability company. Buyers will always want to structure the deal as an asset sale to protect itself against prior claims and liabilities of the business, as well as receiving a new tax basis in the assets, and higher depreciation and amortization deductions in the future. For the Seller, however, there are advantages to doing a stock sale. If the Seller’s company is a corporation, a stock sale usually results in a lower overall total tax bill than an asset sale. If necessary or the tax bill justifies it, the Seller may wish to consider adjusting the purchase price in order to persuade the buyer to accept a stock transaction rather than an asset sale.
2. Valuation – How to value equipment, inventory, and good will of your business
Whenever a sale of a business produces a capital or ordinary gain, the IRS will expect to receive its share and business owners need to take the potential tax bill into account when entering into a sales contract. In addition to the structure of the deal (asset v. stock sale), another factor the IRS will consider when evaluating the potential tax assessed for the sale of the business is the specific values assigned in the sale of the company’s assets. The gain or loss on the sale of different categories of business assets are taxed differently. Under the Internal Revenue Code, sellers and buyers must assign a specific value to each asset or groups of similar assets, and report a gain or a loss from the sale of each asset to the IRS. The sale of capital assets results in a capital gain or loss; the sale of real property or depreciable property used in the business and held longer than one year results in a gain or loss from a Section 1231 transaction; and the sale of inventory results in ordinary income or loss. It is important that a Seller value its assets accordingly to avoid higher tax classifications.
3. Tax Implications – Understanding capital gains tax and other tax consequences
The tax consequences of buying or selling a business can vary significantly depending on a number of factors, including the issues discussed above. Business owners should meet with legal and tax professionals beforehand to discuss tax strategies for making the company attractive to buyers, while minimizing their own tax liabilities.
4. Solvency of Buyer – Do you know who your buyer is?
In the sales transaction for Hawk n’ Dove, the buyer of the restaurants could not afford the full asking price of $19.3 million dollars so the seller accepted a $4.63 million promissory note as partial payment for the balance. Unfortunately, within a year, the Buyer filed for Chapter 11 bankruptcy which halted payments to the Seller on the note. The Seller also alleges that he did not know the true owners of the corporate entity that bought his restaurants. The circumstances of this case are a cautionary tale and reminder to any Seller that he or she must do sufficient due diligence when selecting a suitable buyer. At a minimum, the Seller should review the Buyer’s financial statements, Buyer’s credit history, the Buyer’s resume and business plan, and if possible, seek references or third party input with individuals or businesses who have dealt with the Buyer in the past.
5. Financing Issues – Seller/Owner Financing has advantages and risks
It is not uncommon for a portion of the purchase price to be paid over time, in the form of a promissory note. In essence, the Seller is financing part of the sales price for the Buyer. There are certain tax advantages to deferring payment but there are also substantial risks that the Buyer may default, file bankruptcy or otherwise fail to meet its obligations under the note. Therefore, it is important for the Seller to negotiate personal guarantees from the Buyers, file security interests on the business assets to be sold, or draft strong default provisions to prepare for worst-case scenarios.
These are just a few issues the Seller must consider when selling its business, and we highly recommend that each party consult with experienced legal and tax professionals when entering into a sales agreement. In a later post, we will discuss issues Buyers must consider when purchasing a business.
Doyle, Barlow & Mazard has experience representing buyers and sellers in the sale of a business.