Updated: Aug 8, 2020
By Jigar Desai
The halt in the economy due to COVID-19 has forced many businesses to permanently close their doors and sell their business. This is often a difficult decision for business owners as they have worked their whole career for the business and did not anticipate that they have to sell it. While the sale of a business can be complicated, it is essentially a sale of the assets owned by the business owner to a buyer. The assets of a business help create the purchase price, so it is essential to identify the correct property and value for it. Oftentimes, a price of a business is sold based on a certain asset being sold. This includes physical assets and non-physical assets. We have created an article to give an idea of what exactly this means.
When selling a business, there is an option for an asset sale or a stock sale. A stock sale is where the business purchaser buys the equity of the business for a premium on the price per stock. The purchaser becomes the owner when it owns all the stock. An asset sale is where the buyer buys all the business owner’s assets and owns the company by virtue of having everything the seller owns. If your business is not incorporated, such as a sole proprietorship or partnership, your only option is a sale of assets. This is due to the fact that small businesses do not have stocks. A small business owner will find some relief to know that a sale of assets is much easier than a sale of stock, as there are less regulations and parties to deal with. A sale of assets also offers a simple way to determine the price of the business, as a business owner can add up the value of all the assets sold. So, what assets are sold?
A business usually sells all their assets to one buyer, but is not required to. In general, any asset can be sold, as long as it legal. The most common asset sold is physical property or tangible assets. Physical property can be broken down into three categories: plant, property and equipment. These categories can be further broken down into fixed and current assets. It is important to break down each asset into these categories as the IRS requires the categories to tax each item accordingly. This will likely require the business owner to seek help from an accountant if they do not already have one. Operating these tasks without an accountant can open the business owner to liability in the form of tax audits.
Tangible assets, such manufacturing equipment, real estate property and furniture are valued at the price they were bought for plus any depreciation or appreciation that the item has accrued since then. These are items that are recorded on a balance sheet and should be fairly easy to account for. The difficulty in pricing these items is determining the depreciation or appreciation on the item since the business owner originally purchased them. If the items are commonly used in the industry and there are recent sales of that item, a seller can use the items sale history as a benchmark for their sale. For example, if an oven for a pizza business is sold by other similar businesses for $100,000, the business owner should sell theirs around that price. A business owner can also seek to get their assets appraised by an appraiser. The Balance Small Business provides more information on asset appraisal.
It is common that the seller pays off the loans on tangible items by closing from the proceeds made from the sale. In regard to inventory, the inventory is typically counted once again on the day of the sale closing and the final sale price is adjusted according to the inventory change. This is common for industries that operate with perishable inventory, such as restaurants. For inventory that is not finished or fully manufactured, the seller and the buyer need to create a system for how they will price the unfinished inventory. This is common in industries that manufacture products, such as a business that manufactures clothes.
Lastly, keep in mind that assets that are not part of the business operations should not be listed in the asset list. Many small businesses’ assets are used for both business operations and personal use, such as a vehicle. A business owner must decide whether certain items are for sale or personal items, and should report them correctly to the IRS. If the owner does decide to sell their personal items that are used for business operations, they should remove their own sentimental value from the pricing of the asset.
When a business owner is selling their assets in the sale of the business, there are tax implications that are associated with it, such as a sale of a product. When a business owner sells tangible assets for a profit, they are required to pay taxes on the profit of the sale. If the business owner sells an asset that has only been used for less than one year, then they will have to pay income tax on the sale. This profit will be added to the overall income they made that year and is relatively high. This can be costly, and the business owner can lose significant profits that could have been kept if they held onto the asset for longer than one year. If the business owner has an asset for less than a year, it would be wise to keep the item for longer before selling it.
For tangible assets that have been owned for longer than one year, the business owner pays capital gain taxes. This places a tax on the asset at a rate of either 0%, 15%, or 20%. This is the desirable tax bracket to be in for business owners, as this is potentially much less than their income tax rate. Another thing to keep in mind is the tax benefit received from the depreciation on an asset. A business owner can write off the depreciation on an asset upfront or over the time of the asset’s use. If the asset depreciates by $10,000 over five years, the owner can write off the full $10,000 upfront or $2,000 per year. If a business owner does gain the tax write-off upfront, they are expected to use the asset over the stated amount of time. If a business owner ends up selling the asset before the stated time, they will lose the depreciation write-off regardless if they received it upfront. They will be required to pay back the rest of the depreciation write-off that they claimed. When pricing the tangible assets, a business owner should also keep in mind that the buyer is subject to state and local taxes. Similar to buying a water bottle at a grocery store, a purchaser is paying an additional tax for buying the physical assets the seller is selling. A seller should factor that into their pricing when trying to lure a buyer as these taxes are unavoidable when purchasing a small business. Chron provides more information on the tax consequences for the buyer and seller.
Intangible assets are assets that a buyer cannot physically grab with their hands. This does not include cash. These assets can make up a large portion of the purchase price of the business. In certain industries, such as the technology sector in Silicon Valley, the intangible assets can be the sole reason why a buyer is considering purchasing the owner’s business. Intangible assets can be broken down into intellectual property and other intangible assets. Intellectual property is human-made ideas and inventions that are registered and receive the same protection as physical assets. Intellectual property includes patents, trademarks, copyright and trade secrets. Investopedia provides more information and examples of intellectual property. Other intangible assets, often referred to as goodwill, include trained employees, brand reputation, and loyal clients. These assets can greatly separate a business from another but are not noticeable at first glance.
Valuing intangible assets is highly subjective and can get complicated. The worth of an idea varies depending on what the purchaser intends to do with it. Intangible assets are not listed on an accountant’s balance sheet and a price cannot be easily created, like for a tangible asset. The business owner will need to be aware of the market’s current price on similar intangible assets used in a manner that the buyer plans to use it for. For example, a business owner can look at how a similar business values their patents in their sale of business to a similar seller. A business owner should also factor the debt required to acquire intellectual property and factor that into the overall price. Factors, such as lawyer fees, filing fees and cost of research should be factored into the price of intellectual property.
For items such as brand reputation and a well-trained workforce, there are not many comparable in the market to draw from. This is where the business owner and the buyer will have to negotiate and decide what that value means to them. For example, the price of a business’s reputation for its high quality and its reliability cannot be calculated by equations. Its value can only be assigned by how much importance the buyer places on it. By understanding the business owner’s goodwill generated by their business, they can increase the price of their business. This starts by understanding what valuable intangible assets they possess and pitching those assets to the buyer, demonstrating that they can be valuable for them as well. For example, pitching to the buyer that the restaurant business has a fully trained staff that is experienced in generating high sales, can increase the price of the business by thousands as the buyer will see that they do not have to pay for additional training.
Overall due to the complicated nature of valuing intangible assets, a business owner should seek advice from a broker or valuator. BDC provides more information on the process conducted by a valuator. A valuator is a trained individual who can determine the intangible assets value to the specific buyer. The valuator uses methods, such as calculating the projected revenue the assets bring, the difference between purchasing the asset versus paying a royalty to use it, and the cost to develop a similar asset. These tools help give an intangible asset a specific value.
Understanding the method of selling a small business and what is being sold will help the business owner with the daunting task of selling their business. Creating an asset sheet and applying the methods above can help generate a price for each asset and in turn help create a price for the entire business. A business owner should lastly keep in mind the tax implications to avoid having to pay penalties.
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