Small business owners in the United States accumulate commercial debt all the time. When a business first opens, the debt starts out high because the owner must pay for the startup costs of their company. Business debt is typically in the form of bank loans, business lines of credit, or business credit cards. A bank loan is usually the first type of loan that a company starts out with to build their business. Then after the company has been in operation for at least two years and has annual reports which show profits for the business, it’ll be eligible for business credit cards and business lines of credit. These types of debt are used to expand the business with more advertising, inventory, real estate, unforeseen expenses, and so on.
A profitable business is one where its annual revenue is higher than its annual expenses. If a business were to have more annual expenses than annual revenue after a few years, then it likely means the business is failing for some reason. The owner of that business will then have to make a critical choice regarding the future of their company. They can either sell the company at a cheap price with the business debt attached to it or they can sell the company for a greater price and use the proceeds to pay off the debt before ownership is transferred to the buyer.
Related: Legal Steps to Sell a Business
What happens to debt?
In most scenarios, the owner will sell the business with the debt attached to it. Although the debt may be high, buyers are still interested in purchasing the business because they’re getting it for a discounted price. This gives buyers the opportunity to obtain ownership of that business quickly with the hopes of turning it around and making it more profitable than it currently is. Once they do that, they can take the profits and use them to make payments toward the existing debt of the company. As for the seller, they are happy to sell their business with debt attached to it because they can cash out of the business while leaving behind all the responsibility of running it and paying the debt that is owed. Although, this is not always the case. It depends on what type of sale was arranged between the owner of the business and the buyer.
Selling shares vs selling assets
For example, a large business which has stock shares traded on a public market will usually sell their business through what is called a "Stock Purchase Agreement". Instead of the buyer just writing a check for the agreed purchase price, the seller will transfer a significant number of the company’s shares to the buyer that are the equivalent of the purchase price. Once the buyer takes ownership of these shares, they will automatically own a majority of the company and will be able to make executive decisions as its owner. However, they will also be responsible for all the liabilities and debt that the company has as well. After all, business debt doesn’t stick to the person but rather the company itself. So, whoever owns the company will be accountable for the debt.
Small business owners, on the other hand, often do not have the option of selling their companies through a stock purchase agreement because most of them own private companies that aren’t traded on any public markets. This means if a small business owner wants to sell their company, they’ll do so through an asset sale arrangement. These types of sales will always vary based on the number of assets and liabilities that get transferred to the buyer. In many cases, the buyer isn’t purchasing the entire business but rather just some of the assets that the company owns and sometimes even a percentage of its accounts receivable. Meanwhile, the seller will retain a percentage of the accounts receivable and any existing debt that the company owes. Again, the exact agreements of asset sales arrangements are all different but the seller is usually the one that keeps a majority of the liabilities while the buyer receives a majority of the assets and accounts receivable.
Sellers don’t like to use asset sales arrangements because they are selling the assets which they’ve invested in and a percentage of their future profits. Since these sellers are small business owners, this is the only way they can make any money back if their business is failing. Sellers may use the funds they receive from the buyer to pay back some of their company’s existing debt and keep the business afloat. Otherwise, the lender who owns the company’s debt may decide to foreclose on them and ruin their credit. A small business owner would rather sell their assets to a buyer if it means they’ll get to prevent the business from going under. This may happen in times when there is a weakened economy and business is slowing down. But if the owner thinks that their business has the potential to turn around, they’ll sell their assets to keep it going until the economy gets better. Then once they start making money again, they’ll purchase new assets to replace the ones they sold as well as make payments toward their debt.
The only times when buyers might agree to purchase the liabilities too are if they’re getting a great deal on the assets. If a seller offers a deep discount on the assets, then buyers might factor that discounted price into the liabilities they are taking on and accept the agreement. But this type of arrangement will require the buyer to conduct a lot of research. Buyers need to understand the value of the company versus the amount of debt they are taking on through purchasing the assets or the stock of the company.
How does debt affect business value
Debt has a significant impact on the value of a company, especially if the owner hasn’t been making their debt payments and has ruined their company’s credit score. This is the kind of research that buyers will have to perform prior to making an offer to the owner. If it is their first time purchasing the assets of a company, they should consult with a financial advisor who can help guide them through the process and ensure that they’re not taking on too much liability that diminishes the value of the company.
Buyers aren’t the only ones who should get an advisor for a business sale, though. Sellers who are unsure of which assets and liabilities to include in their asset sales arrangement should consider getting an advisor who can show them their best options.