If your business is behind on its debts and you are getting ready to sell, someone has probably told you to bring in a turnaround firm first. But is that the right move? Before you even think about a turnaround, you need to know which debt will be part of the deal, and which debt will remain with you as a separate responsibility. That depends on how the sale is structured, and there are only two ways to structure it: as a stock sale or as an asset sale. Unless you know exactly how your sale will be structured, there is no definitive answer to whether you should hire a turnaround firm.
The Buyer Essentially Inherits Your Company’s Balance Sheet
In a stock sale, the buyer essentially inherits your company’s balance sheet. They take everything. In this structure, the buyer purchases shares of the corporation (or membership interests in the LLC). At closing the seller hands over stock certificates. For businesses selling for under $10 million, by one estimate, fewer than 5% are sold as stock sales. This structure is chosen when the buyer wants the benefit of existing leases or contracts that cannot be transferred as part of an asset sale. The catch is that you can’t sell the wonderful lease without selling the junk debt that sits behind it.
But hold it. There are three cases where liability stays with the seller after the sale of the stock in a company. In the first case, if you owe debt in your personal capacity, it stays with you. That debt doesn’t move to the buyer unless you specifically transfer it. Second, if you have a lot of debt and the buyer insists you pay it all off at closing. And in the third case, you can agree to assume the debt even though it remains legally an entity obligation, for example, in a lawsuit against the company.
Asset Sale
An asset sale is by far the more common scenario. Here the buyer usually purchases only the assets and excludes the liabilities (this is how the overwhelming majority of small businesses are sold). In an asset sale, the buyer and the seller can pick and choose what assets and liabilities they are getting. Usually, the buyer forms a new corporation or LLC, which buys the assets from the seller. The primary document that transfers the assets is a bill of sale. Most transactions are for the assets needed to run the business, while excluding the seller’s liabilities. The buyer acquires the asset called inventory but not the liability called accounts payable. Unless, of course, that liability is separately assumed by the buyer. Usually it’s not. Inventory is usually purchased. In inventory-intensive businesses, the price is calculated separately, and doesn’t include the inventory. Working capital is often included in bigger transactions, while accounts receivable is typically excluded. In an asset sale, the debt generally doesn’t go anywhere. It just stays behind.
Buyers prefer this structure mainly because of contingent liabilities, obligations whose amount can’t be known yet, such as pending litigation or product liability claims. When you do an asset sale, and you structure it correctly, the new owner doesn’t acquire any of those liabilities, at least in principle.
There are two wrinkles. If the owner personally leased equipment instead of having the company do it, then the lease has to be assigned separately, either in a stock sale or an asset sale. That might sound obvious, but the reality is that when the seller is the owner of the company, not the company itself, it’s easy for both parties to ignore the issue and fail to negotiate how to handle the equipment. It can be a problem.
The second wrinkle is successor liability. That means that even though the buyer isn’t assuming the debt, sometimes state law will let a creditor collect on it from the buyer, even in an asset sale. Some of the most common examples are product liability claims, environmental liabilities, employment law violations, and some taxes like sales tax. And the way that successor liability laws work varies a lot from state to state. And in some states, e.g. California, bulk sale laws can still apply. Expect this to come up in your negotiations, because the buyer knows about successor liability and they will protect themselves in some way. How does the buyer protect itself? By doing due diligence, asking for an escrow company in some states (like California), having the purchase agreement include reps and warranties and seller indemnifying the buyer for successor liability, and/or — in many middle-market deals — withholding some of the purchase price for a period after the closing. It’s always best to consult with local counsel on this issue.
At the closing table, debt gets dealt with in one of three ways. A seller might pay it off before the close; a buyer might assume it; or it might be paid off at the close, with the money put into escrow and deducted from the seller’s proceeds. Say you’re selling for $10 million and owe $2 million. The escrow company that’s administering the deal will use part of that $10 million from the sale to pay off your $2 million of debt. You get the rest.
Should You Use Turnaround Services Before Selling
So, should you use turnaround services before selling? You might want to clean up your debt before a deal, and you might not want to. But how can you make a decision without first knowing if the debt will go away once the deal closes, or if you (or someone else) will still be on the hook? For most owners of smaller businesses, the realistic assumption is an asset sale, with the debt staying with you, to be paid out of the proceeds or afterward. Once you (the seller) have an offer and know what the final settlement will be, you can work backwards and determine how much money needs to be spent in a turnaround in order to increase the value of your business. How does that cost compare to the value the turnaround could add to the business? In the end, it comes down to how much it costs to fix the business and how much cash the business generates when it’s fixed. Compare the cost of a turnaround and the benefits to doing nothing. You might find the value doesn’t exist and you should just sell the company as is.
