How Debt is Treated in Business Sales

Debt Assumption in Business Sales

Corporate debt is borrowed money on a long term basis that is used to serve a financial need that can not otherwise be met. This differs from a company’s accounts payable (A/P) which represents short term liabilities owed by a company for products or services purchased on credit. Long term corporate debt (along with A/P) is typically not assumed by the buyer in business sales for under $10M or so. Most business transactions are conducted on a ‘cash free debt free’ basis where the seller keeps their cash and pays off all corporate debt at closing. This allows a business to be valued for its intrinsic value as a function of its future cash flow absent debt servicing costs. Buyers almost never want to assume a seller’s debt and liabilities (both known and unknown) which is why over 90% of business deals are structured as asset purchases.

Stock Purchase v Asset Purchase Business Transactions

In a traditional asset purchase deal, the buyer creates their own corporate entity and buys the individual assets of the acquired company. This way, the buyer avoids taking on the risk of being held responsible for the seller’s debts or liabilities. In rare cases (less than 10% of small business sales), the buyer may purchase the shares or membership interests in the seller’s corporate entity via a stock purchase deal. Here, the seller’s corporate entity – along with its debts and liabilities after the sale – remains intact and is taken over individually by the buyer. As a practical matter, the assumption of most corporate debt may only occur with a stock purchase deal since lenders restrict the assumption of debt by a third party. Even if using a stock purchase deal, the parties may negotiate the pay off of the debt by the seller prior to closing.

Enterprise Value

When contemplating the possible assumption of corporate debt by the buyer in a business transaction, it is important to understand the concept of a company’s enterprise value. The enterprise value of a business refers to the value assigned to its intrinsic worth minus its cash and plus its debt. In a traditional ‘cash free debt free’ transaction, the enterprise value of the business assets being sold is identical to the purchase price. If debt is to be assumed by the buyer, however, then the enterprise value increases by the amount of the debt. This affects the valuation of the business since the buyer is being asked to assume the debt and will invariably require the price paid for the business to be reduced by a corresponding amount. Thus, a seller wanting a buyer to assume the corporate debt will rarely gain any real value at the closing table.

Exceptions for Debt Assumption

A business with a large amount of working capital requirements (for cash, inventory, and accounts receivable) often takes on corporate debt in order to meet its funding needs. This type of general purpose (often unsecure) corporate debt is rarely assumable. On the other hand, some businesses use debt to finance its tangible assets such as vehicles and equipment. This type of debt is often secured debt backed by the physical or tangible assets (not just a corporate guaranty). In some cases, the buyer may be better off in assuming the vehicle or equipment debt at closing. So long as the lender may be convinced to transfer the debt under similar payment terms (and the seller is released fully from the debt), the buyer may be better off assuming vehicle or equipment debt rather than including their full costs in the purchase of the business assets.

Debt Servicing Costs

  • The measure of profitability used to value most businesses is the annual adjusted owner benefit or Seller’s Discretionary Earnings (SDE).
  • Calculating the adjusted owner benefit begins by taking the business’s annual pretax operating profits and then adding back the debt servicing costs and the depreciation/amortization charges (non-cash accounting charges taken against the previous purchase of fixed assets and intangible assets).
  • This is known as the EBITDA (Earnings Before Interest, Depreciation, and Amortization) of a business.
  • Note that the EBITDA adds back interest (or debt servicing costs) to reported profits.
  • Adjusted owner benefit goes even further than EBITDA by also adding back the owner’s salary, personal expenses of the owner that flow through the financial statement, and other required adjustments to get a true picture of a company’s normalized economic profits.
  • Since EBITDA assumes the company is debt-free (by excluding debt-servicing costs), business valuations using EBITDA (and adjusted owner benefit) also assume that the company is sold on a debt-free basis.
  • The valuation of the business (or the enterprise value) and the measure of profitability used to value the business both assume that the company is debt free.
  • If company debt is expected to be assumed by the buyer, then the business valuation should not add back the debt servicing costs.
  • The seller may attempt to list their business for sale with the understanding that the buyer will assume their debt.
  • But in such a situation the valuation of the business must then include the debt servicing costs when deriving the adjusted owner benefit.
  • Buyers should also be told in advance that the company debt is expected to be assumed by the buyer and that it has already been factored in to the business valuation.

Business owners should always assume that their business is to be sold on a ‘cash free debt free’ basis unless there are unusual circumstances. While vehicle and equipment debt may be assumable compared to other corporate debt, lenders often restrict its assumption by a third party. The preference among buyers for asset purchase deals as opposed to stock purchase deals generally makes the assumption of the seller’s debt by the buyer very rare in small business sales.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.