Many business owners don't put a lot of thought into what happens to their company's debt when they sell their business. While there are cases where the debt is absorbed in the transaction as part of the sale, it is wrong to automatically presume that it will be cleared of all debt just because the business is being sold.
Knowing what typically happens to business debt when selling a business is a critical part of the exit planning process and largely depends on how the transaction is structured. The two most common sale structures are stock sales and asset sales. Let's take a look at how each format recognizes debt at closing.
In a stock sale, the buyer takes over everything that an entity owns; including all assets and all liabilities. For instance, if a business is sold as a stock sale and at closing the business owes money, the new owner would now be held liable for that debt.
Generally speaking, stock sales are only used for larger transactions as it can be quite time-consuming and costly to investigate the risk(s) associated with each and every liability a company has. Since most small business buyers either don’t have or can't justify the time and resources required to do this level of forensic due diligence, most smaller deals are categorized as asset sales.
Contrary to a stock sale, an asset sale is specifically the transfer of selective assets and liabilities between a buyer and seller. In other words, some assets and liabilities may be transferred, while others may not be. The combination of the two may vary and are subject to negotiation.
As alluded to earlier, most small businesses are sold as an asset sale due to the unknown risk(s) that comes with taking over all the liabilities associated with the selling company. To hedge against any unwanted surprises, most small business buyers pick and choose specific assets and liabilities so they know precisely what they are inheriting. To effect a sale, the buyer forms a corporation and that newly formed corporation purchases agreed upon assets of the selling corporation.
As you may surmise, asset sales require a clear understanding between buyer and seller around which assets and which liabilities are being transferred. While there are countless combinations, most transactions take place on what is called a cash-free, debt-free basis.
This simply means that when the buyer buys the company, it will be structured such that the buyer will not assume any of the debt on the seller's balance sheet and will not get to keep the cash on the seller's balance sheet. That is to say that at the time of closing, the seller gets to keep existing cash on their balance sheet (generally with exception to an agreed-upon amount of “operating cash" that is considered the minimum threshold amount the company requires to keep its operations running smoothly). Consequently, the seller is expected to pay off any debt obligations with the funds available after the sale.
Let's take a look at an example:
A buyer is interested in acquiring Company X and values the company at $1 million. Company X has $200,000 in debt on its balance sheet as well as $100,000 in cash on its balance sheet. Let’s assume the buyer and seller jointly agree to consider $10,000 of the company’s cash as essential "operating cash" to be included in the sale.
Since the buyer is going to pay $1 million for the value of the business, the seller will receive $1 million and pay off $110,000 in net debt ($200,000 offset by the excess cash of $90,000). The seller walks away with $890,000.
Ultimately, company debt affects how much the seller stands to personally earn from a sale. It is therefore not safe to believe a buyer will assume your debts or that your lenders will allow someone else to assume your debts. When looking to plan an exit, sellers must assess their business's debt situation and educate themselves on the different sale structures available to them to affect the sale they want to make happen.