In this article, we will discuss cash, debt, receivables, payables, raw materials, work-in-progress and finished inventory. For practical purposes, some of these items tend to default to a standard, but there are always exceptions. This article is a companion piece to the more comprehensive article called What is included in the sale of a business?
Does the Type of Transaction Determine What is Included in a Business Sale?
There are three main types of business for sale transactions. If a business is stopped, the owner will liquidate the assets in an asset liquidation sale. If a business is still running, the business can be sold as an asset sale or a stock sale. Note the similarities in the names of two very different types of transactions – an asset liquidation sale and an asset sale. The important thing to know is whether the business has stopped (asset liquidation sale) or is still in operation (either asset sale or stock sale). See this article for more in-depth discussion about the differences between an asset sale and a stock sale.
What is Included in an Asset Liquidation Sale?
In an asset liquidation sale of a stopped business, most of the questionable items such as cash, accounts receivables and accounts payables do not exist. There may be some debt or liabilities that the seller must address as no buyer would accept those in a stopped business. Any remaining inventory may or may not be included depending on its usefulness to the buyer, who may have other plans for the assets than to resume the previous business. A seller may attempt to sell all assets including inventory as a package, but may accept offers to purchase portions of the assets.
What is Included in a Stock Sale?
In a stock sale, you can think of a new owner sliding in and taking over everything. Typically the buyer assumes all liabilities, including payables, debt, lawsuits and potential future lawsuits based on events prior to closing. The buyer also assumes all assets including bank accounts, cash, receivables, and all inventory and outstanding orders.
There are certain hybrid transactions that combine the elements of stock sales and asset sales that we will not get into here. There are also exceptions. For example, the lender of the debt may not allow the loan to be assignable because of a personal guarantee attached to the seller. The expertise of an M&A attorney is required.
What is Included in an Asset Sale?
The rest of this article addresses what is included in an asset sale of an ongoing business.
Who Keeps Cash in the Business (Asset) Sale?
The seller keeps the cash in an asset sale since the cash was earned through their efforts or the cash was borrowed and needs to be repaid. This applies to cash in the bank, petty cash at the business, and cash equivalents such as bonds. Furthermore, taxes have been paid by the seller to net that cash or taxes are owed by the seller and will be paid with the cash.
What Happens to Outstanding Debt in Business (Asset) Sale?
Debt is a liability, and the seller typically keeps all liabilities in the transfer of an ongoing business via an asset sale. When the seller has considerable debt, they may net very little after paying off debt from the proceeds of the sale. If the seller is upside down, meaning they cannot fetch a high enough offer to pay off their debt, they may have to bring in extra cash to the closing table. Most upside-down sellers will not have cash from their personal accounts to cover the difference, and may not be able to sell. Furthermore, upside-down sellers are unlikely to be able to offer seller financing.
Exceptions include equipment leases and successor liability imposed by state law. In these cases, the buyer may have to accept liability even in an asset sale where the buyer did not agree in general to assume liabilities. Whenever there are exceptions, it is important to receive guidance from transaction attorneys.
Who Keeps Receivables and Payables in a Business (Asset) Sale?
Some businesses do not have receivables or payables which simplifies the matter. Typically the seller would keep receivables and payables since these items resulted from their efforts prior to closing. In larger M&A deals, buyers may require that the buyer keeps the receivables and payables when receivables are greater than payables. This net positive value contributes to the buyer’s working capital. In any case, receivables and payables are a package deal and one side or the other will keep both.
Things can get messy in larger transactions that involve more sophisticated financial buyers who assume and demand they keep receivables and payables. The small business seller who is not familiar with this convention may become highly disappointed once they learn that their net looks much different than what they expected when they first saw the offer.
I use the term “convention” loosely because while this method of treating receivables and payables may be convention to financial buyers of businesses of a certain size, it is not convention for smaller businesses. This can catch brokers off guard if they traditionally deal with main street transactions. The saying “everything is negotiable” often rings true.
Who Keeps Inventory and Supplies in a Business (Asset) Sale?
In the majority of cases, inventory is included in the sale of a business. The seller of a business is typically not interested in keeping inventory and supplies since they are leaving the business. Furthermore, non-compete clauses prevent sellers from competing within a certain geography and time period after closing. One exception might be if the owner owns multiple locations and can utilize the inventory for some of the other locations. However, the buyer typically needs that inventory and expects to receive it as part of the sale.
Inventory can be simple or complicated. In some businesses, it may be simply merchandise ready to be sold. In other cases, it may be raw materials, and finished parts. In other businesses, there may be work-in-process at various stages of completion. In each case, the buyer and seller need to agree on how the inventory is valued.
Is Inventory Included in the Price in a Business (Asset) Sale?
When advertising a business for sale, most business-for-sale website platforms allow the seller or listing broker to check a box indicating whether inventory is included or not. Some buyers will ignore or overlook this and assume inventory is always included. For the most part, the inventory is included in the transfer of the business, but the question is “Is it included at the list price or is it included for an additional charge?”
I bring this up because more than one buyer has made the comment “the inventory is always included” when verbalizing an offer, however the advertised price may have been without including the value of the inventory and this needs to be cleared up before a signed contract. In the purchase agreement, there should be a section that states whether or not inventory is included in the purchase price.
If inventory is raw material, or if it is procured and resold with no value add, the convention is to value that inventory at seller’s cost. Seller’s need to know this up front so they can price their business accordingly. Assigning value becomes trickier when there is value added to the work-in process or finished inventory. The seller has invested time, labor, materials, and perhaps even outside services to add value to components or raw materials. Work-in-progress or finished inventory could be valued at a cost that includes materials, labor, overhead, outside services etc, but this assumes detailed cost accounting and agreement from the buyer on those costs. Added value finished inventory can be valued easier than work-in-process. For example, finished inventory can be valued at wholesale price.
Once the buyer and seller agree on how to value different types of inventory, an adjustment is made for any changes in inventory between the time of the offer and the closing date. A physical inventory will be done at a time and date just before closing that is agreed upon by both parties.
What is Meant by Cash-Free, Debt-Free in the Sale of a Business?
Cash-free, debt-free means the buyer does not get any of the cash or the debt. The seller keeps the cash and pays off the debt before closing. This is assumed in main street business brokerage and often never discussed. It appears in the purchase contract and the buyer and seller and their attorneys really don’t challenge it or expect it to work differently.
It can work differently in larger M&A deals. Sometimes the letter-of-intent includes the phrase “cash-free, debt-free.” If this is not included, then it cannot be assumed. Even if it is included, it is prudent to verify. In some cases, the buyer will want the cash or some portion of it. The logic for larger M&A deals is that the buyer is paying for everything needed to run the business, including working capital.
Is Working Capital Included in the Sale of a Business?
Net Working capital is the difference between current assets and current liabilities. In a simple business, it is inventory plus payables minus receivables. In smaller business transactions, the buyer is typically responsible for working capital. If they are getting a loan, the SBA lender may include working capital financing.
M&A buyers expect working capital included when they make an offer. They will often ask for 12 months of balance sheets to determine the average working capital required to run the business. They will also analyze seasonality. Depending on what that 12-month average looks like, the M&A buyer may also want some cash.
Some businesses for sale fall in the gray area between upper main street and lower M&A. They may see interest from main street style buyers or M&A style buyers. These different buyers behave differently and are used to different processes. Intermediaries typically specialize in one or the other. Companies of a certain profitability that fall into this gray area, say $500,000 to $2,000,000 in adjusted net profits, should be aware of both processes and engage with an intermediary that understands both and who can engage with both types of buyers