Stock vs Asset Sales – Advantages Disadvantages

Stock vs Asset Sales - Advantages Disadvantages

Asset Sales vs. Stock Sales: What’s The Difference?

Advantages and Disadvantages for Property Management Deal Structures

 

Deciding whether to structure your property management disposition as an asset sale or a stock sale is complicated because the parties involved benefit from opposing structures. Generally, buyers prefer asset sales, whereas sellers prefer stock sales. This article highlights some primary differences between the two structures.

An asset sale is the purchase of individual assets and liabilities, whereas a stock sale is the purchase of the owner’s shares of a corporation. While there are many considerations when negotiating the type of transaction, tax implications and potential liabilities are the primary concerns.

If the business in question is a sole proprietorship, a partnership, or a limited liability company (LLC), the transaction cannot be structured as a stock sale since none of these entity structures have stock. Instead, owners of these entity types can sell their partnership or membership interests as opposed to the entity selling its assets. If the business is incorporated, either as a regular C-corporation or as a sub-S corporation, the buyer and seller must decide whether to structure the deal as an asset sale or a stock sale.

 

Asset sales

In an asset sale, the seller retains possession of the legal entity and the buyer purchases individual assets of the company, such as equipment, fixtures, leaseholds, licenses, goodwill, trade secrets, trade names, telephone numbers, and inventory. Asset sales are almost always completed on a “cash-free, debt-free” basis. The sale does do not include cash and the seller retains the long-term debt obligations. Normalized net working capital is also typically included in a sale. Net working capital often includes accounts receivable, inventory, prepaid expenses, accounts payable, and accrued expenses.

 

Buyer’s Viewpoint

Within IRS guidelines, asset sales allow buyers to “step-up” the company’s depreciable basis in its assets. By allocating a higher value for assets that depreciate quickly (like equipment, which typically has a 3-7 year life) and by allocating lower values on assets that amortize slowly (like goodwill, which has a 15 year life), the buyer can gain additional tax benefits. This reduces taxes sooner and improves the company’s cash flow during the vital first years. In addition, buyers prefer asset sales because they more easily avoid inheriting potential liabilities, especially contingent liabilities in the form of product liability, contract disputes, product warranty issues, or employee lawsuits.

However, asset sales may also present problems for buyers. Certain assets are more difficult to transfer due to issues of assignability, legal ownership, and third-party consents. Examples of more difficult to transfer assets include certain intellectual property, contracts, leases, and permits. Obtaining consents and refiling permit applications can slow down the transaction process.

 

Seller’s Viewpoint

For sellers, asset sales generate higher taxes because while intangible assets, such as goodwill, are taxed at capital gains rates, other “hard” assets can be subject to higher ordinary income tax rates. Federal capital gains rates are currently 20% and state rates vary (Missouri is currently 6% and Kansas is 6.45%). Ordinary income tax rates depend on the seller’s tax bracket.

Furthermore, if the entity sold is a C-corporation, the seller faces double taxation. The corporation is first taxed upon selling the assets to the buyer. The corporation’s owners are then taxed again when the proceeds transfer outside the corporation. In addition, if the company is an S-corporation that was formerly a C-corporation, and if the sale is within the 10-year built-in gains (BIG) tax recognition period, the S-corporation’s asset sale could trigger corporate-level BIG taxes, under IRS Sec. 1374.

 

Stock Purchase

Through a stock sale, the buyer purchases the selling shareholders’ stock directly thereby obtaining ownership in the seller’s legal entity. The actual assets and liabilities acquired in a stock sale tend to be similar to that of an assets sale. Assets and liabilities not desired by the buyer will be distributed or paid off prior to the sale. Unlike an asset sale, stock sales do not require numerous separate conveyances of each individual asset because the title of each asset lies within the corporation. A stock purchase is simpler in concept than an asset purchase. Few distinctions (between wanted and unwanted assets or between assumed and un-assumed liabilities) need, or can, be made.

The Acquirer buys all the stock of the Target and takes the corporation as it finds it. All of the target corporation’s assets remain subject to all its liabilities. Most contracts, lease, and franchise rights and permits remain in place (and in effect transfer automatically), although some sophisticated pre-existing agreements with third parties may require their consent to continuation after a transfer of control of the corporation.

 

Buyer’s Viewpoint

With stock sales, buyers lose the ability to gain a stepped up basis in the assets and thus do not get to re-depreciate certain assets. The basis of the assets at the time of sale, or book value, sets the depreciation basis for the new owner. As a result, the lower depreciation expense can result in higher future taxes for the buyer, as compared to an asset sale. Additionally, buyers may accept more risk by purchasing the company’s stock, including all contingent risk that may be unknown or undisclosed. Future lawsuits, environmental concerns, OSHA violations, employee issues, and other liabilities become the responsibility of the new owner. These potential liabilities can be mitigated in the stock purchase agreement through representations and warranties and indemnifications.

If the business in question has a large number of copyrights or patents or if it has significant government or corporate contracts that are difficult to assign, a stock sale may be the better option because the corporation, not the owner, retains ownership. Also, if a company is dependent on a few large vendors or customers, a stock sale may reduce the risk of losing these contracts.

 

Seller’s Viewpoint

Sellers often favor stock sales because all the proceeds are taxed at a lower capital gains rate, and in C-corporations the corporate level taxes are bypassed. Likewise, sellers are sometimes less responsible for future liabilities, such as product liability claims, contract claims, employee lawsuits, pensions, and benefit plans. However, the purchase agreement in a transaction can shift responsibilities back to a seller.

The deal structure of any transaction can have a major impact on the future for both the buyer and seller. Many other factors, such as the company’s structure and the industry, can also influence the decision. It is important for both parties to consult with their business intermediaries, legal counsels, and accounting professionals early in the process to fully understand the issues and reach a decision that will produce the desired results.

 

Ratio of asset sales to stock sales

How common are asset sales versus stock sales? Based on an analysis of marketplace transactions from the Pratt’s Stats database, approximately 30% of all transactions were stock sales. However, this figure varies significantly by company size, with larger transactions having a greater likelihood of being stock sales.

 

Advantage of Asset Purchase over a Stock Purchase

 

  • A major tax advantage is that the buyer can “step up” the basis of many assets over their current tax values and obtain ordinary tax deductions for the depreciation and/or amortization deductions. For example, if the seller has equipment worth $500,000 but the equipment is fully depreciated for tax purposes, a transaction that is treated as a stock sale cannot “step up” the basis to $500,000 for tax purposes since the seller has already depreciated the equipment.
  • Goodwill, which is the amount paid for a company less its tangible assets, can be amortized on a straight-line basis over 15 years for tax purposes in an asset transaction. In a stock deal, just like if you were buying shares of a company like IBM, the goodwill cannot be deducted until the stock is sold by the buyer.
  • The buyer can dictate what, if any, liabilities it is going to assume in the transaction. This limits the buyer’s exposure to liabilities that are either unknown or not stated by the seller. The buyer can also dictate which assets it is not going to purchase. This is often advantageous if the seller has a lot of accounts receivable that the buyer does not believe will be collected.
  • Because the exposure to unknown liabilities is limited, the buyer typically needs to conduct less due diligence.
  • Minority shareholders that don’t want to sell may be forced to accept the terms of an asset sale.
  • The buyer can select which employees they want to offer jobs without impacting their unemployment rates.

 

Disadvantages of Asset Purchase Compared to Stock Purchase
  • Contracts – especially with customers and suppliers – may need to be renegotiated and/or novated.
  • The tax cost to the seller is typically higher, so the seller may want a higher purchase price.
  • Assignable contract rights could be limited.
  • Assets may need to be retitled.
  • In California and most other states, the seller should obtain a bulk sales certificate. Otherwise, the purchaser could become liable for any unpaid taxes.
  • Employment agreements with key employees may need to be rewritten.
  • The seller still needs to liquidate any assets not purchased, pay any liabilities that have not been assumed, and negotiate any leases that need to be terminated.

 

Advantages of a Stock Purchase
  • The acquirer doesn’t have to bother with costly valuations and retitles.
  • In most cases, buyers can assume non-assignable licenses and permits without consent.
  • Buyers may also be able to avoid paying state and transfer taxes.
  • More simple and common than an asset acquisition. For example, hedge funds are known for conducting M&A transactions, particularly in the form of a simple stock purchase.

 

Disadvantages of a Stock Purchase

 

  • The main disadvantage is that an acquirer receives neither the “step-up” tax benefit nor the advantage of handpicking liabilities.
  • All asset and liabilities transfer at carrying value.
  • The only way to eliminate unwanted liabilities is to contractually sell them back to the target.
  • Securities laws can complicate situations involving a large number of shareholders.
  • It may be difficult to convince some stockholders to sell their shares.
  • Goodwill is not tax deductible.

 

IRC Section 338 allows the buyer to purchase the stock but the transaction is taxed as if it were an asset purchase. However, the seller has to pay the tax bill that arises from the step-up on the basis of assets, which occurs under asset purchase transactions. We often see this election used in purchases of service companies where the customer contracts may be difficult to novate or where the seller has leases and/or other contracts that the buyer does not want to renegotiate.

As you can see, there are many factors to take into consideration when weighing your acquisition method and the decision may not be an easy one. An advisor who is experienced with mergers and acquisitions can assist the buyer and/or seller throughout the process and help provide clarity.

 

This post intended for informational purposes only. It is not intended to constitute legal, tax or investment advice. There is no guarantee that any claims made are accurate or will come to pass. ManageVisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.

 

 

Q/A with Scott Raymond Mynd PM Seller

Q/A with Scott Raymond Mynd PM Seller

How One Savvy Owner Sold His Property Management Company
Excellent Interview With a PM Pro Who’s Happy With His Decision To Sell

In January 2020 the founder of the Value Builder System, John Warrillow, posted a terrific podcast interview with Scott Raymond, who sold his property management company to Mynd Property Management in Northern California. I highly encourage any property management professional who’s considering selling their business to take a listen. We’ve excerpted the highlights here and provided a link to the full podcast below.

Scott Raymond never intended to get into property management. In the 1990’s he struggled finding third party management companies who did a good job with his buildings. So he started his own.

He eventually built a PM company with 25 employees and $2 million in annual revenue when an acquirer approached him. MYND Property Management is a venture-backed company in the Bay Area that was impressed with what Raymond had built. Their initial offer was too low, he felt, but he kept working with MYND. He helped them understand why they should pay more for his company.

A year after the sale, Raymond was thrilled with his decision because the sale allowed him to focus on his passion, which is real estate investing.

 

INTERVIEW HIGHLIGHTS

Scott Raymond:  We focused primarily on residential real estate, including single family homes, duplexes, triplexes, fourplexes, 10-unit buildings, 20-unit apartment buildings. Our largest was a 100-unit apartment community. We had a few commercial office buildings, but it was mostly residential rentals. At the time we sold, we had about 1500 units under management throughout three or four regions in Northern California. We probably had 250 clients. So we got 1500 units, 250 clients, the average client owned four units or five units, whatever the math is. Some just owned one, some owned 10 buildings and units.

John Warrillow:  So what prompted you to think about selling?

Scott Raymond:  Well, my real passion is on the real estate investment side, frankly. I build a management company really out of necessity initially, and then it just kind of took a life of its own. I did get a lot of satisfaction growing a business. The satisfaction of servicing clients well and being appreciated. The satisfaction of building a real recognizable brand in the Sacramento region. The satisfaction of watching margins go up. The satisfaction of changing employees lives through offering healthcare and career advancement, and all that stuff was very satisfying. But at the end, it didn’t really satisfy my core. My core is just really in the investment side of things.

John Warrillow:  And so you were approached by potential acquirers. Under what sort of conditions were you approached? Was it under the guise of let’s have a peer-to-peer conversation? Did they use the word strategic? Did they come right out and say, “We want to buy you.” How did they sort of couch the conversation in the beginning?

Scott Raymond:   No. So the memory’s a little bit vague on the initial conversations, but it was something like a phone call. “Hey, we’re in the market to acquire a management company. Would you consider selling?” I mean, it was a pretty basic right between the eyes kind of pitch, which I like. I’m not one to mince words. That was followed up by a lunch and then some more discussions and then an LOI and then off to the races.

John Warrillow:  What made you decide these guys were legit? Because a lot of our listeners would get those calls all the time, right? And sometimes they’re real, other times they’re a bit shaky. There’s some investor who thinks he can cobble together some money. How did you know these guys were serious?

Scott Raymond:  That’s an easy one. Unfortunately, it probably won’t translate to a lot of your listeners’ “real-world” experience. The company that came to us was founded by two pretty well-known entrepreneurs and had already built a company and took it public. Now this was their next mountain to climb. So very recognizable guys in the business world, in the real estate world. Furthermore, they were backed by some pretty substantial venture capitalists. So obviously we went and met with them a number of times. We talked to other companies that had been bought by them, and we talked to their VC guys as well.

John Warrillow:  And this company you’re referring to is called Mynd, is that correct?

Scott Raymond:   Yeah.

John Warrillow:   So Mynd approaches you, these kind of all-star entrepreneurs at the end of it. So you figure they’re legit. Did you have any sense of what you thought the management company was worth?

Scott Raymond:   Yeah. So when I started, and this might be helpful to the listeners too. When I made the decision to start my own management company, before I did that I actually went out to try to possibly acquire somebody because I didn’t know how long it was going to take to organically grow my company to profitability. So I had some capital resources, and I went out to a couple other companies to do what Mynd did with me. This was 10 years ago. So I went out and approached a couple other companies to see if I could buy them, and during that process, we got pretty close with one of them. Close enough that we did a business appraisal. During that business appraisal, I was able to really look under the hood on how a business appraiser was looking at their business. The owner of that business wanted far more than I was willing to pay, far more than the appraiser gave them value for. So that never went anywhere. But that was kind of my first glimpse on how to value my type of business.

Throughout the course of the 10 years that I’d built Raymond Management, we had acquired a couple of other small… When I saw small companies, the way property management companies generally do M&A, is the new company will not necessarily buy my corporation or shares in my S Corp. What they’re buying is the rights to my management contracts. So I still own the name Raymond Management. My S Corp is still active if I ever want to do something else with it, even though I’m under a non-compete. They really just bought the contracts, the rights to the contracts.

So I bought a couple of smaller portfolios, 100 units here, 50 units there from small, independent, one-off property managers who were looking to retire. So I had a little bit of an experience of doing M&As from the buyer side as well and kind of seeing what other management companies thought their companies were worth. So I had a pretty good idea.

John Warrillow:  So how were they valued? What is the formula by which you value a property management company?

Scott Raymond:  So we also had another buyer looking at us, which is important for your listeners. When we were approached by Mynd, we went out into the market to see if there were any other companies like them that were looking to acquire because we wanted to get two people bidding for us. And anybody considering selling, I would try to do the same thing. Obviously two buyers is better than one for your price. I only bring that up for that point, but I also bring it up because both of these companies looked at valuation differently. Mynd was looking at EBITDA. They were looking at gross management fee, and they were looking at a gross multiple on annual contracted revenue. Whereas the other company was looking more at a multiple on earnings.

John Warrillow:  What were you thinking was a fair multiple of either EBITDA or revenue, depending on how you and your partner were thinking of what was a reasonable kind of multiple?

Scott Raymond:   Without getting into details of my exact transaction, what we were seeing from the marketplace was gross revenue multiples between one and two, and we were seeing EBITDA multiples between three and seven.

John Warrillow:  The offers that you got I’m assuming were sort of in that range. You felt that they were fair based on what you were experiencing.

Scott Raymond:  Yeah. Initially they weren’t, so the negotiations stalled for quite a bit. But ultimately I think we came around. We ultimately got a deal done. So I think that both sides thought it was a win-win.

John Warrillow:  What stalled the negotiation?

Scott Raymond:  Mainly valuation and terms. We were looking for all cash deal, and a lot of companies in the space weren’t wanting to do cash deals. They wanted to do part cash-part shares in their company, drag the sale installments out over time, and then ultimately the price. So those were kind of the main thing. Then which revenue we were getting credit for. The primary revenue for management company is the monthly management fee. If you have a house that you and your wife were renting and you hire my company, I’m going to charge you $100 a month roughly. That’s $1,200 a year. That’s the bread and butter. Where we make a bunch of ancillary revenue is if the house goes vacant, we have to lease it up. We charge commission for that. If a water heater blows out, we got to send a guy out, we make a markup on that maintenance guy for scheduling him. We keep late fees if your tenant pays late. So there’s all these different fees that we earn. It can really, really add up over time. We’d also get a brokerage commission if the property owner used us to sell their property.  So it was a matter of negotiating which of those income streams were going to get valued into the multiple equation as well.

John Warrillow:  Wouldn’t they all be valued as part of the equation?

Scott Raymond:  No because what the companies that are trying to acquire in my space are looking for is that sticky recurring revenue. Take the leasing commission, for example. If I lease your house out, that person may not move for five years. So I can’t guarantee when the next time is I’m going to earn that leasing commission. Your tenants may never pay late. I can’t guarantee when that late fee is going to come in.

John Warrillow:  Got it. What was the duration on your management contracts?

Scott Raymond:  Generally one year. We played around with one year contracts and month-to-month contracts. The benefit of the month-to-month contract is that it’s easier to fire a bad client, easier to make changes to your terms to adjust to the market or to your own margin requirements. But there’s also a much more transitory risk of management clients leaving and firing you. The one year contract provided a little bit more stability, but that’s the problem with a management company. That’s why multiples may not be as high as other types of businesses that have stickier, longer term relationships.

A company that acquires my contracts at the most is going to get a guarantee of a year’s worth of contractual revenue. But if they don’t end up providing a good enough service or the same quality service my customers were expecting, then that client may not renew at the end of that year. So they just paid me for a year’s worth of revenue. They just basically paid for a year’s worth of revenue.

John Warrillow:  Got it. So let’s get back to the negotiations itself. So you’re in this. You got two kind of potential suitors. Your first is not meeting your expectations on either points, valuation or terms. So I think a lot of our listeners would really resonate with that experience or that situation where they’ve got an offer. Maybe they get low balled and feel like they’re not getting value for what they’ve created. What’s the secret to kind of nudging the acquirer up without being so standoffish that you kind of piss them off or they turn away and say, “This guy’s totally unreasonable.”

Scott Raymond:  Yeah. So you get contacted by somebody who wants to buy your company, and assuming you’ve done some level of vetting and you feel comfortable with these guys, you sign a nondisclosure agreement, confidentiality agreement. Well, first of all, it starts with good books. You’ve got to have good books. Really tight financials. I looked at a company the other day on behalf of Mynd to acquire, and the guy was only booking a half year’s worth of his revenue. He was taking the other half under the table for tax purposes. You know what I mean? That guy’s not going to get a good price for his company. So you got to have really good books.

So if I’m trying to get them to value all of my different revenue streams, then I want to have two, three solid years of historicals to show them what the averages are over those three years. So I want to make the case as tightly as possible in financials of how much money I’m making and how sticky and continuous that revenue is. It starts with that.

I know a lot of owners may get calls, and they don’t want to just start throwing financials out to just anybody. So I get that. I get there’s a reluctance to share your information. But once you can get over that hump, that’s really how you choose the valuation is to really, really get under the hood of your financials with the buyer and make your case of why perhaps your company’s worth a higher multiple than the guy next door because of longer term clients or higher end properties or more loyalty or better brand recognition or whatever.

John Warrillow:    You’re trying to make this case almost… Sounds almost like a lawyer would make a legal argument in front of a jury.

Scott Raymond:   Yeah, kind of. Yeah.

John Warrillow:   Kind of plead your case.

Scott Raymond:   You’re selling your business. Even though I got approached, I went into full on sales mode. I was selling my services. Property management is not a high margin business. The buyers’ approach to it was to try to squeeze margins out of more efficient deployment of personnel through the use of technology. So they’re really taking a heavy technology approach. So for me, the sales pitch was really about how efficiently I was running the business, how I was able to manage perhaps more units per person, per employee than the average management company, how we were able to use technology to staff maintenance guys more efficiently. These sorts of things.

John Warrillow:  Doesn’t that kind of make the opposite argument though? Meaning you were already so efficient in squeezing so much juice that there wasn’t much incremental they could squeeze if they bought you guys?

Scott Raymond:   Good point. But they had some other technology that we didn’t. They had some proprietary technology that was going to allow them to squeeze out even more margins. What they liked about us specifically is they didn’t have any exposure in Sacramento, and we were a pretty major regional player. So they could just come in and plug and play with us. They didn’t have to hire a bunch of new employees or what have you. It was really just a really synergistic move for them.

John Warrillow:  Got it. So you were approached by Mynd, but then you did a great job of getting a second offer on the table. How did you get that second offer? What was your pitch to the second company to bring them to the table?

Scott Raymond:  Frankly, I’m surprised they didn’t approach us because they were out actively looking for companies as well, similar strategy to Mynd. We had just heard about them through the trades that they were out trying to do the similar thing. So we just called their CEO and said, “Hey, look. We’re in play. Do you want to come to the table?”

John Warrillow:  What was their reaction?

Scott Raymond:  Yes. We’re interested. Send us your financials.

John Warrillow:  Where did it go from there?

Scott Raymond:   We got really close. I mean, at the end of the day, it was almost a coin flip to be honest with you. But at the end of the day, I felt what Mynd offered my partner and my employees was a better cultural and long term career fit.

John Warrillow:    I love to talk about employees because you had in your own admission sort of 25 employees, many of whom you were… I was reading between the lines. Correct me if I’m wrong, but you felt like you were giving them an opportunity that maybe they wouldn’t have had without your company in some cases.

Scott Raymond:  Yeah.

John Warrillow:  Maybe talk a little bit about the team you built and then how you sort of shared the news with them and involved them in the process.

Scott Raymond:   I was a big proponent of hiring from within. There’s a lot of very basic kind of menial tasks that are required for property management company. So when you’re going out and you’re hiring people, you may be hiring people that don’t have college degrees. You may be hiring people who are new to the workforce, maybe don’t have a tremendous amount of skillsets, but they can satisfy kind of the basic lower level requirements of a management company’s needs. Then when you see their work ethic, their reliability, their skillset, their intelligence, as other opportunities present themselves, you have great opportunities to move them up through the company and that happened to a number of my employees. They started out in very, very basic tasks, and ended up in pretty serious critical path tasks, positions for my company. That builds a lot of loyalty, a lot of trust between you and the employees.

That’s what made selling really, really hard. We had set up a pretty friendly, loving family type culture with Raymond Management, and now I had to break the news that we were going to a company that had plans to take over the world, based in another city. So I did it the best I could with multiple kind of group presentations, and I brought the new guys in and let them kind of introduce themselves to everybody. We had a lot of off-site kind of team building, combined team building experiences.

In the transition, I think we only lost one employee that said, “I came to work for you, Scott. I don’t want to work for these other guys.” That only happened one time.

John Warrillow:  What was your timing around telling them? Did you have the check in hand from Mynd by the time you told them?

Scott Raymond:  We pretty much did. We pretty much told the employees first, after the deal was closed, and then we had to tell my clients. I wanted to tell the employees first before I told my clients because I didn’t want the word to get out to my clients before I had a chance to tell them. So the sequence was very important. I wanted to make sure I had a contract and a check in hand. Then I told the employees, then I told the clients.

John Warrillow:  What was the reaction of the employees?

Scott Raymond:  A lot of shock and awe. A lot of nervousness. It happened around the holiday time too. It was the holidays at the end of 2018. So in some ways that was a good time because everybody was kind of winding down for the year, getting into happy, family mode. Our business kind of slows down a lot during that time, so that was a good time. But it was a lot of hand holding. A lot of, “Things are going to be good. I’m going to still be involved.” And I was. I was involved very, very carefully. Very much in the transition for the first year. Just hand holding.

John Warrillow:   I was going to ask you, if you could redo that announcement meeting, if you had a mulligan and you could have a do-over where you brought everyone together and shared the news, what might you do differently?

Scott Raymond:  I think we pulled it off as best I could honestly in hindsight. We rented out a big kind of coworking space. We had a presentation, Dan and I. Created this slideshow that took us back to some of the beginnings when it was just Dan and I working out of basically a condo unit. All the way up to 23 employees and hundreds of clients and great brand recognition. And then we transitioned into, “Where do we go from here?” So it was really a beautiful, well-done, empathetic, compassionate presentation with a lunch afterwards and a lot of Q&A. And then a second one, a second one where we brought the new guys in and just kind of carried on with that. I always made my office open for questions and these sorts of things.

The other thing that helped, which was part of the negotiations, is that the employees… Nothing was going to really change right away for the employees. Their comp if anything was going to go up. They got better healthcare. They got some better perks. They certainly got better career advancement because I had really taken the company as far as I could take it or wanted to take it. So all those things helped a lot in getting them over the initial fear of change.

John Warrillow:  What was the reaction among customers?

Scott Raymond:  Some reluctance and some concern. Like, “Okay, Scott. We’ll see how it goes. We hired you. We hired you because we like you. We hired you because we know when we call you, you’re always going to answer the phone and take care of our problems. So we’re happy for you. We want the best for you, and if this is the move you need to make, Scott, then that’s good. But we’re going to watch very carefully that the balls don’t get dropped in this transition.”

John Warrillow:  You mentioned that you were trying to get as much of your money up front. I’m assuming there was some type of earnout you accepted, right?

Scott Raymond:  Yeah.

John Warrillow:  Can you give us a sense of how big a nut that was for you?

Scott Raymond:  Without getting into my specific details, the earnout was an important negotiating point because obviously the buyer wants as little churn as possible, so they want as big a churn penalty as possible in case they lose clients. If they lose clients, that’s money lost, so they want to create as big a penalty as possible to reduce that risk. So that’s a big, big negotiation and one that your listeners should pay very, very close attention to. And lawyer’s can be super helpful for that because what ends up happening is even though my employees are still servicing the needs of the clients post-sale and I’m still involved from a client relation standpoint, we are losing a certain amount of control over the service. It’s now a new way of doing business. So there’s certain aspects that I don’t have control over anymore, and if a client leaves because they’re unsatisfied with the new things, that isn’t necessarily anything I was responsible for. So how much should I get penalized for that is a very negotiable point.

John Warrillow:  Yeah. What proportion of a total deal, total sale of a company would you say is sort of reasonable to expect an earnout for versus what would you say is too much for-

Scott Raymond:  In my industry, it’s anywhere from 10-50%.

John Warrillow:  10-50. That’s a big range.

Scott Raymond:  Yeah. I mean, that’s what I’ve seen in negotiations. And when you’re talking… So I don’t know if we’re talking about the same thing. So when I think of earnout, I’m thinking of what I was able to negotiate was any new business because we had a pretty powerful, organic lead generating pipeline. So I wanted to get credit for that in the valuation for some period of time. So that was negotiated into it. Then any client loss I negotiated a floor on that, and that’s where my 10-50% comes in. It could be as little as 10. If they buy 100 contracts, a good deal for the seller would be if you lost one of those contracts or 10%, that’s the maximum they could take off the price. A bad deal for the seller would be 5 contracts, that example. Where your valuation was cut in half basically because you lost those clients in the transition. That churn usually lasts a year. If you can negotiate a shorter churn, like three months of six months, that’s great. If you can negotiate a churn somewhere between 10-20%, I think you’re doing well.

John Warrillow:  Yeah. That makes sense. Of course that varies quite a bit by industry. We seen some industries, marketing communications where the earn out can be much longer, like five years, seven years. I’d guess the typical is three years.  One of the things I wanted to ask you about, Scott, is your name was on the door. It was Raymond Management. How did the acquirer react to that, that your name was on the door?

Scott Raymond:  I don’t think they were caught up in one way or the other about my name being on the door because their strategy is to rebrand any company that they acquire. I think they were more impressed with what that brand represented in the marketplace. Our name was associated with quality properties, quality services, was very recognizable logo and colors. One of the unique things about property management is when we have a new building that we manage, we immediately put a sign in front of the building. Even if we’re not trying to lease it, even if it’s fully vacant, we’ll put the sign there just to let people know. So we had these little billboards all over town. So we got a lot of business from that as well.

So yeah, that name wasn’t that important one way or the other for them. Where it is important is when you’ve got an organic lead generation pipeline, social media, internet, Yelp, these kinds of things. That’s where a lot of our leads came through. It’s very important how you manage that kind of social media/online transition. We were getting probably five leads a week from Yelp. Well, you don’t want to just shut down your Yelp the minute you close, but yet they need the leads to start going through their Salesforce system. So you’ve got to really think through how that’s going to work. Do you do a cobranding thing? Do I keep the website up, and do I keep my Yelp up? Do I keep my Google AdWords up without any changes, or do I start to incorporate their name? Do you just go cold turkey right to their systems, which I wouldn’t recommend because then you’d lose all your organic leads.

John Warrillow:  How did you personally feel about their decision to rebrand?

Scott Raymond:  In hindsight, I probably wouldn’t have named it after my last name. There was really no ego tied up in that. It was really almost lazy. Having to think of some creative name, it was just easier to go with my name. So I didn’t really have any ego tied up in my name honestly. So I had no problem. I had no problem with those signs going away.

John Warrillow:  It’s been a year I guess or so since the transaction went through.

Scott Raymond:  Yeah.

John Warrillow:  How’s the decision sitting with you now a year on?

Scott Raymond:  Couldn’t be more thrilled.

John Warrillow:  Why?

Scott Raymond:  I think we made the right choice with this company. I think the employees are happy. I think the clients are being serviced. I’ve gotten myself personally to exactly where I wanted to be.

John Warrillow:  Where is that?

Scott Raymond:  Not involved in the management company anymore. But knowing that my employees and clients are being cared for.

John Warrillow:  What was it about that sense of freedom? Maybe I’ll use that. Why was that so important to you? What is that feeling of freedom is giving you?

Scott Raymond:  The management business is a very maintenance intensive business in terms of managing clients. You’ve got on any given day, you’ve got owners calling you about reports that they can’t understand or tenants calling you with toilets that don’t flush. You know what I mean? It’s just one of these things. Employees that are trying to get vacations or want their next raise or dealing with issues with other employees. These are daily things. I’m not an operations guy. Those things don’t fire me up in the morning. What fires me up in the morning is looking to real estate deals and buying real estate deals and rehabbing real estate deals. So stepping away from the management company just gave me the freedom to do that and not really have to deal with all that.

John Warrillow:  Speaking of real estate investing, do you think the days of outsize real estate opportunities are beyond us? I mean, will there be another great recession level of buying opportunity in our lifetimes?

Scott Raymond:  I’ve seen what I’m going to call two generational real estate opportunities in my life, and I’ve been following real estate since I got out of college in the early ’90s. The first one was the S&L crisis of the early ’90s.

John Warrillow:  Savings and loans crisis.

Scott Raymond:  The savings and loans crisis, and it was during that time where you had an absolute complete destruction of real estate value across the country. You had a credit system that was fundamentally flawed, and real estate got crushed. That was a tremendous, once in a generation buying opportunity. The next one was the great recession. Everything in between were just kind of minor, the dot com bubble, this, that or the other. You can find good buying opportunities in those markets, but they’re like once in a lifetime opportunities. The S&L crisis in the early ’90s and the great recession in ’07 and ’08.

There’s going to be another one because people forget about the past and lenders get a little too aggressive. Credit markets get out of whack and real estate prices get out of whack. But I can’t tell you if it’s going to be… I mean, we’re already 10 years past the great recession and no signs of it. The lending systems are much better than they were back in 2007. But human nature works in cycles. There will be another one, but it may not be for another 10 years. So right now, yeah. For example, I haven’t bought anything of any substance in really two years because I haven’t seen the values.

John Warrillow:  Scott, I appreciate you taking the time to spend with our listeners. Thanks for doing it.

Scott Raymond:  Wonderful. Thanks so much.

Episode:  https://www.builttosell.com/podcast/how-to-make-peace-with-your-decision-to-sell/

Excerpted from Built To Sell Radio

 

This post intended for informational purposes only. It is not intended to constitute legal, tax or investment advice. There is no guarantee that any claims made are accurate or will come to pass. ManageVisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.

 

How to You-Proof Your Property Management Business

How to You-Proof Your Property Management Business

How To You-Proof Your Property Management Business
5 Quick & Easy Steps To Getting Your Business To Run Without You

It’s easy for property management owners to hyper-focus on problem-solving and operational efficiencies. Ours is a tough business. Lots of fires to put out.

There are many ways a PM owner can increase the value of the business. One super-critical component is making the company “you-proof.” Can the place run okay without you there? Can you pass the ‘3-week vacation” test?

One of the ways we help to prepare a business for sale is to shift the owner’s gears a bit. Instead of focusing on sales, operations, leads and problems, set aside time to get the shop working without you. A lot easier said than done, right.

How about making your primary goal over the next 3 months in making the company more owner-independent?  A business not dependent on its owner is the ultimate asset to own. It is infinitely more valuable to buyers knowing the show can go on without you.

It allows you complete control over your time so that you can choose the projects you get involved in and the vacations you take. When it comes to company value, a business independent of its owner is worth a lot more than an owner-dependent one.  

Here are 5 ways to set up your business so that it can succeed without you.

 

  1. Develop Easy-to-Read SOP’s

Standard operating procedures (SOP’s) come in all shapes. Some PM companies have employee manuals. Others take the time to write, illustrate and bind a group of tasks and functions spread over multiple departments. We’ve found the best examples are the SOP’s that are most visual. Screenshots make a huge difference. Links to helpful websites can add a ton. Write the procedures in an informal, instructional tone that guides a new person through tasks which may be new to them. Emphasize way to decrease or eliminate repetitive tasks. Lay out ground rules for how to solve problems. You’ll be amazed how many pages you’ll need to walk through some steps and properly explain things. But once you’ve got it down, you can use it for onboarding and training purposes for years to follow.

 

  1. Give Them A Stake In The Outcome

Jack Stack, the author of The Great Game of Business and A Stake In The Outcome, wrote his books about creating an ownership culture inside your company. It can start with something as simple as letting employees know how the business is doing. Let them know specifically, with numbers. Let them know about bad months as well as good months. Don’t let ego get in the way of transparency. Your staff needs to know when things are going well and what they’re doing right. They also must understand where improvement lies. With numbers.

 

 

  1. Get Them To Walk In Your Shoes

If you’re not quite comfortable opening up the books to your employees, consider a simple management technique where you respond to every question your staff brings you with the same answer, “If you owned the company, what would you do?” By forcing your employees to walk in your shoes, you get them thinking about their question as you would. It builds the habit of starting to think like an owner. Another successful owner I know uses the phrase “don’t bring me a problem unless you’ve got the solution to go with it.” Pretty soon, employees are able to work through issues on their own.

 

  1. Automate. Automate. Automate

The joy of automation is independence. It takes time to integrate new systems and turn them into coherent and consistent procedures. If you’re not comfortable seeking out software solutions or finding vendors, go to Fiverr.com and search for experts who can walk you through things. There is an amazing number of talented folks out there who are willing and able to improve your company for a very small fee. You don’t need to be involved in every collection dispute, maintenance request and lease rate discussion. If you are, fire yourself as the company problem-solver and find automated solutions wherever possible. 

 

  1. Rate Your Operation

Be brutally honest with yourself. Look over your online reviews. Review recent complaints. Do an honest assessment, on a 1-10 scale, of where your PM business is humming and where it’s struggling. All shops have weaknesses. You may be a 9 or 10 in leasing and tenant retention but only a 3 or 4 in maintenance speed. Find a diplomatic way to share your impressions with your staff, without creating animosity. Commit to making improvements and then repeat the process every quarter.

You-proofing your management business has enormous benefits. It will allow you to create a company and give you back some of your life. Your business will be free to scale up because it is no longer dependent on you, its bottleneck. Best of all, it will be worth a lot more to a buyer whenever you are ready to sell.

 

How To Calculate Your Management Company’s Earnings

How To Calculate Your Management Company's Earnings

Addbacks – How To Calculate Your Management Company’s Earnings

How Property It’s Actually Pretty Easy To Figure Out Your Cash Flow – Here’s How

 

It’s a pet peeve of mine. Business brokers and M&A advisors absolutely love making the business valuation process seem complicated and difficult. I guess we’re always looking for ways to justify our fees.

Well guess what? It isn’t really all that difficult to determine your earnings. If you’ve got accurate financial statements (a BIG if) you should be able to knock this out in 90 minutes or so.

There are three common ways to measure a company’s cash flow when selling a property management business. All three have distinct advantages and purposes.

  1. Seller’s Discretionary Earnings – SDE is the most common number in small business sales. It will almost always be employed when valuing companies with less than $5 Million in revenues. That’s because smaller company’s are usually owned by an individual or couple as owner/operators rather than a corporation with multiple shareholders. It answers the question “what is the total return of cash and benefits flowing to the owner?”
  2. Earnings Before Interest, Taxes, Depreciation & Amortization – EBITDA is used for valuating a company based on the return on investment. It answers the question “what is the return to the owner for a cash purchase of the business, after a market rate of compensation for work that the owner performs in the business (or for hiring someone else to perform those functions) has been subtracted?”
  3. Discounted Cash Flow – DCF analysis uses the “time value of money” concept to determine company value based on future income streams. It is typically used to measure the attractiveness of much larger companies, say with revenues of $100 Million or more.

All three methods pull numbers from your Profit & Loss Statements. We valuation specialists also look critically through your Balance Sheets and Cash Flow Statements to reach value conclusions but those are not directly utilized in our earnings calculations.

Unless your management company is doing $25 Million or maybe $50 Million in revenues, you’ll want to focus exclusively on figuring out your SDE. It will be the broadest and most favorable calculation available. Your earnings for SDE will be larger than your earnings for EBITDA so it makes your company look better to investment buyers.

Don’t be confused by various terms people throw around for Seller’s Discretionary Earnings.  It can be called recast earnings, normalized earnings, seller’s discretionary cash flow, adjusted cash flow or adjusted net income. SDE is the official terminology advocated by the International Business Broker’s Association (IBBA).

 

SDE Definition

The IBBA has defined how SDE is to be calculated. A business’s overall SDE is calculated as an average of the SDE for the 2 or 3 most recent full years, plus the current year in progress. If there is a strong trend in the earnings (up or down), much more weight will be placed on more recent years. 

SDE is calculated for each year based on information from the business tax returns, the profit and loss statements and owner estimates. All of the following categories are added together in the SDE calculation. Here is what it includes:

  • Pretax net income. This is the bottom line number on your P&L. PLUS…
  • Owner’s total compensation. This includes one or two salaries paid to the owner plus profit sharing income paid to all the owners. If there is a second salary being paid to a spouse or family member, you must subtract whatever salary amount would be needed to replace his/her workload. WARNING: These salaries must be stated incomes appearing on your P&L and tax return. They can not be funds sucked out of the business through draws and distributions. PLUS…  
  • Employer portion of payroll taxes paid based on the W2 salary of one owner. PLUS…
  • Business interest expense (because business debt is a “non operating expense” and assumed to be paid off). Do not plug in expenses for mortgage interest. PLUS…
  • Depreciation and amortization (non cash expenses). PLUS…
  • Discretionary expenses or personal perks paid by the business but which really benefit the owner. Common examples include the owner’s health insurance, personal use of automobiles, personal travel, personal meals and entertainment, etc. PLUS…
  • Adjustments for extraordinary, non recurring expenses or revenue (e.g., expenses incurred in a one-time lawsuit or damage from flood or fire would be added back. Revenue and expenses from a major discontinued product would be removed. PLUS…
  • This can get tricky. If you are enjoying rental income that your buyer will not, you must make a negative adjustment and subtract it from earnings. If a new owner’s rent will be different from yours, you must make an adjustment, either positive or negative. For example, if your business currently has two leased locations but only one is necessary to run the company, you can addback the rent you’re paying on the second office. On the flip side, if you’ve been operating from a home office and the business cannot reasonably be run without a physical space, you’ll need a negative adjustment for a fair market rent expense.

 

What Precisely is a Discretionary Expense?

Discretionary expenses are defined to be ones that the business paid for but are primarily of a personal benefit to the owner.  Typical expense categories (places to check on your tax returns/ P&Ls) are owner medical or life insurance, travel, automobiles, meals and entertainment, dues and memberships.

To qualify as discretionary, each expense must meet all 4 of these criteria:

1) Benefit the owner(s)

2) Not benefit the business or the employees

3) Are paid for by the business and expensed on tax returns and P&Ls

4) Be documented and verifiable by a prospective buyer as discretionary.

Illustrative examples of expenses that would NOT qualify would include:

  • Medical benefits for an employee
  • Counting all meal & entertainment expenses as discretionary even though dining with clients is a critical way of building relationships
  • Counting all travel as discretionary, even though some travel is necessary for business (such as to a trade show)
  • Counting all auto expenses as discretionary even though the vehicles are used to deliver products or by employees
  • Any marketing or promotion related expense even if it “didn’t work and it wouldn’t be done again”
  • Expenses for a Rotary or club membership if any clients are gained through such memberships
  • Counting unreported cash sales unless the buyer has a straightforward means to verify such sales
  • Counting dozens of personal purchases on a credit card where the card is also used for business purchases, or where the expenses are buried in a much larger expense category or several expense categories and therefore nearly impossible for a buyer to verify.

It is better to be conservative in your estimates than aggressive.  If buyers believe you are exaggerating the discretionary expenses, they will conclude you are untrustworthy and likely making other misrepresentations. Worse, if they purchase the business based on your misrepresentations, you may be guilty of fraud.

 

So What Are Non-Operating  & Extraordinary Expenses?

Extraordinary expenses are defined to be ones that 1) the business paid for 2) are truly unusual or exceptional in nature and 3) documented and verifiable as extraordinary.  By their nature there are no “typical” extraordinary expenses.  Examples might include expenses associated with natural disasters, a move of location, or a lawsuit out of the ordinary course of business.

Examples of expenses that would not qualify would include a marketing campaign that failed, headhunter fees to replace a manager that quit, research and development of a product or service that was later scrubbed. Keep in mind, most businesses list nothing in this category so you need to be conservative and cautious in your calculation.

Non operating revenue is unrelated to the business operations, such as interest revenue, rent from a property owned through the business or sale of equipment or part of the business.  Non operating expenses might include those to repair or fix up a building owned by the business.

 

The Question To Ask Yourself

In trying to figure out addbacks and adjustments to reach an accurate earnings number, ask yourself this question – if another guy owned my business right this minute, and operated it in the exact same way, in the same place, with the same employees and clients, what income and expenses would be different for him? Those are the adjustments you need to make to your net income figure on the profit and loss statement.

Very often, addbacks are not 100% of an expense category. For instance, your company’s annual automobile expenses may be $10,000. The business does own a couple cars but you also run  your personal car’s gas, repairs and licensing through the company. So you’d call that a 25% addback, or $2,500. Maybe you expense $15,000 for bookkeeping and accounting but included in that is your own personal returns and tax help. That could be a 50% addback. Do your best in making an accurate estimate of what is a personal benefit to you versus a business benefit to the company. 

Once you finally have an earnings number for each year, the fun starts. You now have choices to make. Do you claim your management company has an SDE based on last year’s numbers? Or do you use an SDE that’s averaged over three years? Or do you use a 3-year weighted average, where last year’s earnings are given greater weight than those from two and three years ago?

Depends on who’s asking. Most will rely on a Trailing 12, an SDE calculation based on the last 12 months in which monthly reconciliations were completed. They will compare the Trailing 12 performance to previous years and draw opinions about how to treat it.

One reason the property management industry is very popular with business buyers is that revenues are typically rather consistent, without roller coaster rides seen in many other industries. Even if their clients’ properties are struggling with vacancy, maintenance or delinquency issues, the management company’s revenue will remain pretty consistent. New clients come, old clients go but the income stream is often stable.

If there isn’t a great deal of difference between your Trailing 12 and last year’s P&L, lenders and valuators will use last year to calculate the SDE number. Lenders always go back to the tax returns to underwrite a deal.

Once you have your earnings number, now you need to figure out how to use it in calculating the value of your company and the price a buyer may be willing to pay. That’s the next part of the valuation game. Check our site to pick up the process from here.

 

This post intended for informational purposes only. It is not intended to constitute legal, tax or investment advice. There is no guarantee that any claims made are accurate or will come to pass. ManageVisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.

 

Earnouts – They Aren’t All Bad

Earnouts - They Aren't All Bad

Earnouts & Clawbacks – They Aren’t All Bad For Sellers

How Property Management Owners Can Benefit From These Structures

 

I call it the E-word. Ask any small business owner if they’d be interested in a purchase structure that involves an earnout and you won’t get pretty looks. Somewhere between “no way” and “probably not” is a small space where sellers should spend some more time.

Earnouts are not always a bad option for property management business sellers. Especially when you consider they are an integral component in achieving a higher selling price for your company.

An earnout is a contingent future payment based on performance milestones. For example, in a simple earnout arrangement, an extra payment of $50,000 to the seller may be earned by growing the company by an additional $500,000 in revenue in the first 12 months after closing. A clawback is a contract provision where the seller must return a portion of the sale proceeds if future benchmarks are not met or relationships die off.

Earnouts become a sizable point of negotiation when there is a difference of opinion on what future earnings will look like. I’ve had many seller clients tell me they would never accept an earnout. Some sellers will dismiss any purchase offer that includes one, even strong offers from viable buyers.

On the other side, I’ve have many buyers say they’d never buy a company without an earnout in place.

In the sale of management companies I see earnout structures as fair, reasonable and sometimes, a lifesaver to a deal. They often bridge a divide that has no other solution.

Ours are service businesses with usually no tangible assets beyond office equipment. What we are selling is a reliable income stream. One built on the foundation of recurring revenue. The buyer is purchasing property management contracts, maintenance contracts, property owner relationships, brand identity, employees, vendor relationships, a host of other intangibles.

From the buyer’s perspective, there is a ton of risk involved. The buyer is banking on the hope that property owners, employees, vendors, marketing professionals and many others will all remain in place upon a change of ownership. As we’ve seen in many deals, that often does not happen.

This is where earnouts and clawbacks can help PM business buyers mitigate enough risk that they feel comfortable moving ahead and closing a transaction.

An earnout can not only make the seller more money in the purchase. It can also ensure that they actually get a deal done. That’s a huge argument in their favor.  

Here’s one tidbit I’ll share from my 15 years of brokering deals. You might be surprised how few negotiations break down or fail due to price differences. Sure, the price is critical. But all the deal points that wrap around trust, transferability, continuity, verifiability and scalability are typically what make or break a transaction.

 

How do earnouts come into play?

Earnout clauses are not typically used for companies selling for under $2 Million or $3 Million. Smaller businesses usually have much shorter transition periods, where the owner sticks around for 30-90 days and then makes his exit. Plus, most buyers want to come in, operate the company independently and in their own way, keeping the good while throwing out the bad. Smaller businesses often have unaudited books or poorly organized financials, which makes measurements for an earnout difficult.

The primary advantage of an earnout is how it bridges the pricing expectation gap between the buyer and seller. In some negotiations the earnout simply dissapears from discussions when both sides realize it will be too cumbersome.

They work best when the earnout period is not terribly long. In industries like manufacturing, IT, health care or medical supplies, you’ll commonly see earnouts last 18 months to 3 years or longer. The timeframe is usually tied to how long the outgoing seller remains active in the business.

In property management business deals, the timeframes are shorter, usually from 6 to 18 months. During this time the seller wants to retain some control to make sure the earnout targets are met. Most sellers resist having their earnout payments tied to company performance if they aren’t actively working there anymore.

The amount of the earnout can go anywhere from 5% to 50% of the sale price. Most common is a 10% or 20% earnout. In a $1 Million sale transaction, a 20% earnout means the seller will receive the last $200,000 over the given period.

The earnout can be tied to many different performance indicators, such as gross revenue, gross profit, net income, EBITDA, number of management contracts retained, number of new properties signed.    

We recommend to sellers the earnout be linked to revenue. It’s the cleanest and easiest number to guide from. Buyers often want to tie it to earnings since that’s what they care about, in the end. But sellers have tremendous fear they will lose control of the company, profits will slip and their earnout amounts will suffer.

Lawsuits are quite common when a post-closing dispute arises over earnings. So tie it to revenues whenever possible.

When Is An Earnout Warranted?

So how do you know if an earnout is justified when selling your property management business? Always remember what the investor is actually buying. They are buying a future income stream and everything that creates it. They are buying the future by looking back at the past and assessing the present.

If the company has stable revenues, consistent earnings, a large number of contracts in place and the owner is making modest and reasonable projections about future growth, then an earnout is likely not warranted. The buyer’s risk is low and so is the need for an earnout.

In cases where the company is experiencing good growth in revenues and earnings, sellers are apt to make highly optimistic projections for the future – and want to get paid for that growth. This is where inflated seller expectations can drive up asking prices and create more need for an earnout. If a seller is dead-set on achieving a certain price, earnouts are often the best way to get there.

In some cases, especially with the coronavirus impacting many businesses, earnouts are used as a means to “emergency-proof” a sale transaction. A buyer might use them as protection during economic downturns or if a company is experiencing difficulties.

In property management sales, discussions often revolve around the number of management contracts and whether they will remain in place after the business is sold. After all, property owner/clients don’t know the buyer or his/her people or his/her way of doing business.

So the earnout becomes a powerful incentive for the seller to make sure that relationships are continued smoothly, with as little interruption as possible. It also incentivizes the seller to work hard in transitioning the staff, software, maintenance functions and all major operations to the new company.

 

One Frustration I Have

 Some PM owners occasionally want to straddle both sides of the earnout fence. On one hand, they are completely opposed to earnouts or clawbacks in their purchase agreement. But on the other, they are making incredibly rosy projections about revenues and earnings for the next year or two. So their demands for a high price are based on earnings that haven’t happened yet.

In that scenario, without an earnout or clawback, a reasonable buyer does not see a way to reach that price or mitigate risk. It’s important for sellers to know that if they estimate enormous future growth, they’d better expect earnouts.

Clawbacks became more common in business sales following the financial crisis of 2008. They usually involve a repayment as well as a penalty. Property management buyers ask for clawbacks if they experience a high number of property owners not renewing their agreements. Or employees not staying on following the transition. Or vendors who don’t continue relationships.

Because relationships are so valuable to a property management company’s performance, clawbacks are sought by savvy buyers who understand the purchase risks.

Most sellers resist clawbacks whenever possible. The idea of giving back money is not attractive. However, clawbacks can become a useful instrument, like an earnout, in achieving a higher sale price. If the seller is able to get a number that would otherwise be out of reach, the possibility of repayment becomes a more manageable seller risk.

Earnouts and clawbacks can both become valuable assets to a property management seller who’s open to their benefits and who fully understands their risks. 

 

This post intended for informational purposes only. It is not intended to constitute legal, tax or investment advice. There is no guarantee that any claims made are accurate or will come to pass. ManageVisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.

 

Top Tax Considerations in PM Business Sales

Top Tax Considerations in PM Business Sales

Biggest Tax Issues When Selling Your PM Company

Don’t Let Uncle Sam Step On Your Plans for the Future

 

Long before you try selling your property management company, you need to understand what costs are involved. I’ve seen over many years in business brokerage that some sellers have not taken the time to understand the tax implications of a sale.

Like any transaction that makes you money, the sale of a business is considered income and you are required by law to pay taxes on it. This income is usually a capital gain and it applies whether you’re selling the assets of a company or shares of company stock. (See accompanying post “Advantages & Disadvantages of Stock vs. Asset Sales”)

The tax consequences depend greatly on the deal structure. There are substantially different implications for an asset sale versus a stock sale versus a merger. So you need to know, going into any negotiation process with a prospective buyer, how the dollars in the deal will play out.

At ManageVisors we take a great deal of time and energy to help you understand the tax landscape you’re entering. Still, I can’t stress enough the importance of consulting your accountant or other tax advisor long before your business hits the market. I’ve had many entrepreneurs stop the sale process cold once they fully understood the tax implications.

Jason, a Ventura County property manager, told me back in 2018 “I just can’t afford to sell right now. It wouldn’t be worth it.”

 

C Corp. vs. S Corp vs. LLC vs Partnership

Any PM company operating as a C Corporation will be taxed two times on the sale. The first tax you’ll have to pay is the corporate tax which coincides with your commercial income tax return. Since corporations are considered separate entities from their owners, the IRS requires each entity to pay their share of taxes from it.

The corporation will pay whatever the current corporate tax rate is on longterm capital gains. Then, each shareholder of the company will be subjected to a capital gains tax on their personal income tax return. They won’t have to pay taxes on the full amount of the capital gains, though. The profits of capital assets get distributed equally among the shareholders of the company. Therefore, the amount that was distributed to each shareholder will get multiplied by the capital gains tax rate. The result is the amount that each shareholder must pay in personal taxes.

S corporations and partnerships have a similar tax structure in the sense that there is no double taxation like you have with C corporations. When you sell assets through an S corporation or partnership, the individual owners or shareholders are each responsible for paying the taxes on their personal income tax returns. The upside is they don’t have to pay another set of taxes on the commercial income tax return of the company.

This makes S corporations perfect for property managers who want to sell shares of their company while still maintaining a single tax rate for the profits. BE WARNED. C corporations are not allowed to change their corporate status to an S corporation, for the purposes of avoiding the double taxation. The IRS loves cracking down on this. The government requires C corporations to change their status many years before the sale of any assets takes place. This is their way of deterring owners from committing tax evasion.

Limited liability companies, LLC’s, are a bit dicier. In California, real estate law prohibits real estate brokerages and property management companies from being owned by an LLC. Current legislation is winding its way through the state Legislature to loosen this restriction but existing law has not changed. However, there are work-arounds to separate the licensed sponsoring broker from the majority owner selling the business.

The IRS usually considers LLC’s and sole proprietorships to be disregarded entities, treated as pass-throughs. This means that these companies won’t get taxed separately and you won’t have to file a commercial income tax return. Instead, any profits made from these capital assets will only have to be paid on the owner’s personal income tax form. Of course, you have the option of making your limited liability company a separate entity if you want to, but most people don’t because the tax benefits are so much better when keeping it as a disregarded entity.

 

Stock Sale vs Asset Sale

When a small business owner sells stock in their company, they are really selling the entity of the company to the buyer. Remember that selling a stock is like selling a portion of the ownership to your company. The more stock that is purchased, the bigger percentage of the company that your buyer owns. Of course, the buyer will assume the debts and liabilities that are attached to their ownership of the company as well.

That is why most buyers prefer an Asset Sale. They buy the assets of a company without incurring the debts and liabilities of your corporation. It is quite common for a business to be sold in an Asset Sale while the seller’s corporate entity continues on, long after the business has changed hands.

Sellers, on the other hand, generally prefer a Stock Sale because they will get taxed at a much lower rate than they would if they sold their capital assets. Buyers might not always like this idea, so sellers will typically lower their purchase price in order to make the offer more appealing to the buyer.

Anytime the seller makes a profit on the sale of their stock, they must pay a longterm capital gains tax, unless the business is less than a year old, which is rare. The difference is that stocks are usually held for a lot longer than capital assets, which means the seller will get a more generous tax break for selling stock that they’ve held for longer than one year.

 

Dealing wih Capital Assets

Property management businesses are typically sold with very little in the way of capital assets. The vast majority of a service company’s enterprise value is in goodwill, defined as all value after tangible assets. The common tangible assets in PM transactions include office equipment, software and hardware, furniture, tenant improvements, maintenance equipment and vehicles.

Capital assets are thrown into three categories by the IRS – real property, depreciable property, and inventory property. Some PM owners sell real estate along with their business. The real estate gets taxed as a separate capital asset unless the buyer was purchasing the entire entity of the company in a Stock Sale. If the buyer purchases the entity, it would allow the buyer to just take over all the real estate holdings of the company because those properties are under the company’s name. The only time this wouldn’t apply is if the original owner’s name was on the property. Then, the owner would have to actually sell the property through a real estate transaction to the buyer and pay a capital gain tax on the profit.

Depreciable property is the furniture, computers, vehicles and such whish gets treated as a gain or loss, based on the current value. This value is almost always lower than what the seller originally purchased it for. If you held the depreciable property for longer than one year before you sold it, then your tax rate will be considerably less than if you held the property for under a year. The current value versus the purchase price will be what decides the tax rate in this situation. Depreciation recapture is the term used to describe the amount of profit you made from selling the depreciable property.

Inventory sales is not relevant to property management companies and most service businesses.

 

One Way To Close a Deal Tax-Free

Property management sellers want to pay as little tax as possible. Is it possible to avoid paying taxes altogether?  Yes and no. If you put cash in your pocket upon the sale of the company, you’re going to get taxed. But there are a few ways to close your deal on a tax-free basis.

One way is with stock exchanges. If a buyer has his own corporation and offers his company stock in exchange for stock in your company, it could qualify. As long as certain IRS provisions are met which pertain to a reorganization, you can conduct a stock exchange like this and not have to pay any taxes at closing.

The IRS states that the seller must receive 50%-100% of the buyer’s stock in order for it to be tax-free. As for asset transfers, you can make these tax-free as well if you receive 100% of the buyer’s stock. The only time you will be taxed is if the buyer gave you actual cash for your stock or assets. Otherwise, you can get away with a tax-free transaction by simply keeping it as an exchange of non-cash assets.

 

The benefit of seller financing

Business sellers love all-cash offers. Because property management is a highly-desirable category in business sales, all-cash deals are very achievable. But more often than not, buyers are not willing to pony up 100% cash to close the transaction.

Seller financing allows an owner to achieve a higher price by deferring payments from the buyer. The buyer makes monthly payments for 3, 5 or 7 years typically, with an interest rate added onto the monthly premiums. SBA lenders and local banks usually require some amount of seller financing in order to underwrite their loan. A seller carry note is usually the best way to bridge the gap in price expectations between a seller and buyer. It’s also seen as a way for the outgoing owner to still have skin in the game and actively assist the new owner in a successful transition.

Many sellers struggle with incurring this risk. What if the new guy makes a mess of things? Loses many of my clients or employees? If the business goes south and the buyer defaults, there is a chance you could lose your business and the money still owed on the note.

On the favorable side, the nature of PM’s recurring revenues and contracted fees makes this, thankfully, pretty uncommon. In a worst case of a default or BK, the seller can defer all taxes on the monthly payments until they’ve landed. You only pay taxes on the money the buyer has already paid you. Not only that, you get to retain ownership of your company while keeping the money the buyer already paid you.

This outcome can be great as long as the company has not lost a lot of its income potential. These are serious considerations you need to make before you offer seller financing to a buyer. But if you are just selling some of your assets through seller financing while retaining stock ownership of the company, then it may be a less risky transaction for you.

 

This post intended for informational purposes only. It is not intended to constitute legal, tax or investment advice. There is no guarantee that any claims made are accurate or will come to pass. ManageVisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.