Structuring a Transaction: Winning Strategies for Both Sellers and Buyers

By | November 3, 2003

So what is the going rate for agencies nowadays?” is the question we often hear from interested buyers and seller of agencies.

Our answer always includes that the price paid is not directly related to the net proceeds, since terms of the deal can change both price and net proceeds. Price, terms and taxes dictate the net proceeds to the seller and thus the “final value” of the firm.

In negotiating a deal, both sellers and buyers must consider all elements of a transaction, not just the price, but also how the acquisition will be financed and how payments will be structured. There are some common payment and financing structures that all business owners should know about and understand, even if they are not currently in a selling or acquisition mode.

Asset vs. stock sale
The first step is to determine whether the deal will be an asset purchase or a stock transaction. The tax code has pitted buyers versus sellers in this decision and it primarily affects only “C” corporations. Most buyers will prefer to buy just the assets of a business since it limits liability and the buyer can amortize the purchase over a 15-year period.

If the deal is a stock purchase the buyer is possibly exposed to old corporate liabilities and will not have the same write-offs as an asset purchase. However, the buyer can use the purchase price of the stock as a basis if they sell the stock of the acquiring company in the future.

In the case of the sale of assets from a “C” corporation, the seller is subject to a double tax situation—first corporate tax on the net proceeds from the sale and then capital gains on the return to the stockholders. Although capital gains rates have been reduced, the tax burden could still be quite significant. When the stock of a “C” corporation is sold, the seller pays only capital gains taxes in most cases.

For “S” corporations both asset sales and stock sales are taxed as capital gains. If the entity is a sole proprietorship, LLC or partnership the sellers are usually taxed at the capital gains as well since they are “pass-through” entities. A good tax attorney or CPA needs to be involved with any transaction to provide the latest advice.

Cash vs. terms
The price of $1,000,000 in cash is not equal to $1,000,000 with terms. Deferred payments such as an earn-out based on retention can significantly affect the final price of the company. For instance, the buyer might agree to a higher multiple of commissions if the seller accepts an earn-out based on retention of business so that the risk is shared. If the seller requires an all-cash deal, then the buyer might discount the price because account retention is not certain.

Also, buyers might be willing to pay a premium through a consulting agreement if the seller stays on with the company to assist the transition. The buyer benefits from the seller’s expertise and continuity of relationship and management. Lower employee turnover can also result by keeping the seller during the transition and that can be essential to a company’s continued success.

The size of the down payment will vary from deal to deal. Typically it is 10 percent to 30 percent of the sale price. Internal sales tend to have low down payments and terms stretched over seven to 10 years. This is because the seller is willing to offer favorable terms in order to sell the business to a child or loyal employees. Internal purchasers often have very little cash for a down payment and must rely on the cash flow to pay off the seller.

Sales to an outside party tend to have higher down payments and terms paid out over three to five years. In this case, the buyer usually is already in the business and might be able to realize economies of scale and improved cash flow.

Sellers should also consider the benefits of deferred payments in the form of installment payments or deferred compensation for consulting. A seller who can wait to accept payments until a time when his or her income is relatively lower can realize substantial tax savings.

A good professional CPA or tax attorney can use great creativity in working out terms to the advantage of both parties in minimizing taxes paid. For example, a buyer that needs immediate strong cash flow can offer the seller a slightly higher price for the business while lowering the interest rate on a note offered to the buyer. Or the seller might extend the length of the repayment period. The buyer gains lower monthly payments, while the seller enjoys more money in the future.

How to finance
In many cases, sellers are willing to “take back” part of the purchase price in the form of a note to assist a sale. Buyers can even finance the sale through vehicles not designed explicitly for that purpose such as consulting agreements, which might have added tax benefits to the buyer.

Aside from the seller financing the loan, the traditional source of financing many buyers go to is the local commercial bank. Banks however might be reluctant to finance an acquisition of an insurance agency, since there are no real hard assets as collateral. The Small Business Administration sometimes offer favorable terms to businesses run by women and minorities.

In the past many insurance companies have offered financing for acquisitions, perpetuation plans, automation equipment purchases, etc. to their agents. This source dried up a few years ago, but seems to be resurging. Safeco is one of the companies that is currently assisting some of their agents in financing acquisitions and other needs as well.

Always allow a cushion of cash flow. For a leveraged buyout, large and reliable cash flow is mandatory to cover payments on the debt from the acquisition. The debt coverage ratio measures a firm’s ability to repay principal and it is also an indicator of the firm’s ability to take on additional debt. A rule of thumb for an ideal cash flow ratio is 2-to-1 (free cash flow to debt payments).

Plan the timing of debt service by taking into consideration future expenses and income. If a large balloon payment coincides with some other expense, such as the purchase of a new computer system, there may be a big problem. Also, anticipate higher interest costs in the future.

Other tricks and advice
• Consult with a CPA or tax attorney regarding the proper allocation of the purchase price for consulting agreements and non-compete agreements in addition to the price paid for the book of business. Consulting agreements can be expensed as paid by the buyer while non-competes are amortized over 15 years. Both are treated as income to the seller. Also, a reasonable allocation should be made for fixtures, furniture and equipment that are sold along with the business.
• Buyers should look into purchasing an annuity for the seller. The buyer would pay a discounted cash price, while the seller could enjoy the tax benefits of payments spread over a number of years.
• If the buyer is purchasing the stock of a “C” corporation, the buyer should negotiate a discount in the price since the seller will not be double taxed and the buyer does not get to write off the purchase.
• “C” corporations should consider electing subchapter “S” status ASAP. The full time period for the conversion is 10 years before the double tax problem goes away. However after the conversion, the double tax only applies to the value of the business at the time of the switch. Any increase in value of the business during that time is taxed as an “S” corporation.
• If the seller is remaining with the agency after the sale, look into the feasibility of providing a rich perquisite package as part of their compensation plan.
• Buyers need to pay attention to cash flow.
• Sellers should seek a fixed price, while buyers should pay based on retention of the business. (Here is where negotiating skills are tested and honed).
• Everything is negotiable.
• Both parties need to work together to minimize taxes.

A final thought
The merger, sale or acquisition of any business needs to be well thought out. Take time to look into all options available. Perform extensive due diligence to look into the other party’s situation. Money can be saved by doing the leg work yourself. Money can be lost by not hiring competent professionals (consultants, attorneys and CPAs) to review the plan.

From This Issue

Insurance Journal West November 3, 2003
November 3, 2003
Insurance Journal West Magazine

Professional Liability/E&O/Reinsurance

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