Selling a Business: Why Buyers and Sellers Often Want Different Deals—and How They Find Common Ground

When a business changes hands, agreeing on the price is only half the battle. How the sale is structured can make an enormous difference in taxes, risks, and how much money the seller actually takes home.

Imagine that you have spent 25 years building a successful business. You have loyal customers, good employees, a respected name, and a potential buyer offering $5 million.

Sounds straightforward, right? Not quite.

You want to sell your company and enjoy the proceeds of your hard work. The buyer wants to acquire a profitable business without inheriting unnecessary risks—and would also like to minimize future income taxes. You may agree that the business is worth $5 million, yet strongly disagree about what, exactly, is being sold.

Welcome to one of the most common negotiating challenges in buying and selling a business: the buyer usually wants to buy assets, while the seller usually wants to sell stock.

Understanding why—and how the two sides resolve their differences—can be worth a substantial amount of money.

Two ways to sell the same business

Most privately owned businesses can be sold in one of two basic ways.

An asset sale: The buyer purchases the things that make the business valuable. These might include equipment, inventory, customer relationships, contracts, trademarks, the company name, and goodwill. Goodwill is the value of a business's reputation, customer loyalty, and ability to keep generating profits. The seller generally retains ownership of the original legal entity, along with any assets and liabilities that were not transferred.

A stock sale: The buyer purchases the shares of the corporation and becomes its new owner. The company continues to own its assets, employ its people, and operate under the same legal entity. For businesses organized as limited liability companies (LLCs), the ownership being transferred may be membership interests rather than stock. The tax treatment can differ, but many of the same negotiating issues arise. 

To customers, the difference might barely be noticeable. To the buyer, seller, and their accountants, it can be enormous.

Why buyers usually prefer asset purchases

The buyer's preference generally comes down to two things: tax savings and protection from past liabilities.

The tax advantage

Suppose a business has equipment, customer relationships, and goodwill that are worth millions of dollars, but the seller originally paid much less for them—or has already deducted much of their cost for tax purposes.

If the buyer purchases the company's stock, the business generally keeps its old tax values for those assets. The buyer may have paid millions for the stock without receiving new tax deductions based on the full purchase price. By contrast, an asset purchase generally allows the buyer to establish new tax values based on the purchase price. That can create valuable deductions over time.

For example, the cost assigned to certain equipment may be deductible relatively quickly, while acquired goodwill generally is deducted over 15 years. These deductions reduce the buyer's future taxable income. Over several years, they can save a meaningful amount of money.

Accountants call this a step-up in tax basis. In plain English, it means the buyer may get to deduct costs based on what the buyer paid, rather than what the seller originally paid.

The liability advantage

Buyers also worry about what they might inherit. What if the company owes back taxes? What if a former employee files a lawsuit? What if there are warranty claims, environmental problems, or undisclosed debts?

In a stock purchase, the buyer generally acquires the corporation along with its history, including liabilities that may not yet have come to light. An asset purchase often allows the buyer to choose which liabilities to assume, although certain liabilities can still follow the business under applicable law.

For many buyers, the ability to obtain future tax deductions while limiting exposure to old problems makes an asset purchase particularly attractive.

Why sellers usually prefer stock sales

The seller is looking at the transaction from a different angle. The seller wants to receive the largest possible amount of money after taxes, with as little continuing responsibility as possible. In many circumstances, selling stock held for more than a year results in long-term capital gains, which generally receive more favorable federal income tax treatment than ordinary business income.

An asset sale can be less favorable. That's because the IRS doesn't necessarily treat the sale of an entire business as one transaction for income tax purposes. Instead, the sale price is divided among different assets, each potentially receiving different tax treatment.

For example, profits attributable to inventory, certain unpaid customer bills, or previously depreciated equipment may be taxed as ordinary income, potentially at higher rates. Other portions of the sale, such as qualifying goodwill, may receive more favorable treatment.

The distinction becomes especially important when the seller operates as a traditional C corporation. If a C corporation sells its assets, the corporation may pay income tax on the gain. If it then distributes the remaining proceeds to shareholders, those shareholders may owe a second layer of tax. The result can be substantially more expensive than selling the stock directly.

For S corporations and many LLCs, the problem is different because income generally passes through to the owners without the same corporate-level federal income tax. Even so, asset sales can still produce more ordinary income and less favorable tax results.

There is also a special tax benefit for certain qualifying small-business stock that can exclude some or even all eligible gains from federal income tax. A seller entitled to that benefit may have an especially strong reason to insist on a stock sale.

The important point is that two transactions with the same selling price can produce very different after-tax proceeds.

How the tax disagreement gets resolved

Does this mean buyers and sellers reach an impasse? 

Sometimes. But more often, the tax differences become another subject for negotiation. The buyer's future tax savings have economic value. If those savings are large enough, the buyer may be willing to pay more for an asset purchase.

Consider a simplified example. Suppose a buyer calculates that purchasing assets rather than stock will create future tax savings worth $400,000 in today's dollars. The seller's accountant determines that an asset sale would generate an additional $250,000 of taxes compared with a stock sale. There is potentially $150,000 of additional economic value available for the parties to share. The buyer might agree to increase the purchase price enough to compensate the seller for the added tax burden, while still benefiting from the additional deductions.

The calculations need to account for taxes on the additional purchase price itself, the timing of deductions, state taxes, and other expenses.

But the principle is simple: Instead of arguing over which structure is better, the parties compare what each structure is actually worth to them.

This is one reason sophisticated buyers and sellers prepare tax calculations before signing a binding purchase agreement.

A compromise: sell stock, but treat it like an asset sale for taxes

In certain transactions, particularly involving S corporations, the tax law offers another possibility. The buyer may legally purchase the corporation's stock while the parties make a special tax election causing the transaction to be treated much like an asset purchase for federal income tax purposes.

One such arrangement is known as a Section 338(h)(10) election.

There is no need for business owners to memorize the technical terminology. The important concept is that the legal form of a sale and its tax treatment can sometimes be different. The buyer gets the desired tax deductions, while the parties retain some of the practical advantages of a stock transfer.

There is a catch: the election may increase the seller's taxes, so additional compensation may be needed to make it worthwhile. These elections also have strict eligibility requirements and must be planned carefully.

They are useful negotiating tools, not magic solutions.

The purchase price isn't always paid at closing

Even after the parties agree on the structure and price, another question remains: How much money changes hands immediately?

A seller naturally wants all the money at closing. A buyer may want to pay some of it later, particularly if there is uncertainty about whether the business will remain successful under new ownership.

Several common arrangements help bridge this gap.

Earnouts: "If the business performs, we'll pay you more"

An earnout makes part of the purchase price dependent on the business's future performance.

For example, a buyer might agree to pay $4 million at closing, plus another $1 million if the business achieves an agreed revenue target over the following two years. The seller sees an opportunity to receive the desired price. The buyer avoids paying the full amount unless the business delivers the expected results.

Earnouts sound attractive, but they can become contentious. After closing, the buyer controls the business. What happens if the buyer changes prices, reduces advertising, moves customers into another division, or increases administrative expenses?

Those decisions may affect whether the earnout targets are met.

A well-negotiated earnout needs clear financial measurements, consistent accounting rules, access to relevant records, and safeguards against actions that unfairly reduce payments. It should also address what happens if the buyer sells the business again, combines it with another company, or changes its operations significantly.

There are tax complications as well. Earnout payments that genuinely represent additional purchase price may receive different tax treatment from payments that are really compensation for the seller's continued employment.

Simply calling a payment an "earnout" does not determine how the IRS will tax it.

Seller financing: The buyer pays over time

Sometimes the seller agrees to finance part of the purchase price.

For instance, the buyer pays $3 million at closing and promises to pay the remaining $2 million over several years, usually with interest.

This can make a transaction possible when bank financing is limited. It may also permit the seller to spread recognition of certain taxable gains over time under the installment-sale rules.

However, not every type of gain qualifies for deferral. Some taxes, including those arising from depreciation recapture, may be due in the year of the sale even though the seller has not collected all the money.

The seller also becomes a lender and faces the possibility that the buyer will fail to make future payments. Security, guarantees, payment priorities, and remedies for default therefore become important negotiating issues.

Escrows and holdbacks

A buyer may insist that part of the purchase price be held back temporarily to cover unexpected claims or purchase-price adjustments.

For example, $300,000 might be placed in escrow for 12 or 18 months. If a covered liability is discovered, the buyer may be able to recover the agreed amount from those funds. If there are no valid claims, the balance is released to the seller.

These arrangements reduce some of the buyer's risks, but they also mean the seller cannot immediately use all the expected proceeds.

What happens to employees?

Employees are often one of the most valuable parts of the business being sold—and one of the biggest practical concerns during a transaction. The buyer may be purchasing a successful business largely because of the people who know its customers, products, and operations. Losing those employees shortly after closing could seriously damage its value. 

In an asset transaction, employees may need to receive new employment offers from the buyer. In a stock transaction, they may remain employed by the same legal company, although ownership and management have changed. Either way, there are important questions to resolve.

Will employees retain their salaries and benefits? What happens to accrued vacation, unpaid bonuses, retirement plans, and outstanding stock options? Which employees are essential to keeping the business running?

Buyers frequently want key managers or technical personnel to stay for a period after closing. They may offer retention bonuses or new employment agreements. These payments have their own tax consequences. Compensation paid to employees is generally taxed as wages, potentially subject to payroll taxes, rather than as capital gains.

This is particularly important when the seller is also an employee. Suppose the founder agrees to remain as president for two years. Payments for those services should be distinguished from payments for ownership of the business.

Otherwise, the seller may discover that money expected to receive favorable capital-gains treatment is actually taxable as compensation.

Beyond the tax issues, thoughtful treatment of employees is simply good business. A transaction that alienates the people who keep the company operating can undermine the very value the buyer hoped to acquire.

What actually happens during negotiations?

In real life, business acquisitions rarely proceed in a perfectly straight line. 

The parties usually begin with a general understanding of the business's value and a preliminary document called a letter of intent. This document often outlines the proposed price, whether the deal will be an asset or stock purchase, financing arrangements, earnouts, and other major terms.

It is tempting for a seller to focus on the headline price. That can be a costly mistake. An offer of $5 million in a stock sale might be more attractive than $5.3 million in an asset sale if the seller will incur considerably more taxes and expenses in the second transaction.

Next comes due diligence, when the buyer examines the financial statements, tax returns, contracts, employee arrangements, customer relationships, and potential liabilities. This process often reveals issues neither side fully considered at the beginning. Perhaps a major customer can terminate its contract upon a change of ownership. Perhaps the company has unpaid sales taxes. Perhaps reported earnings include personal expenses of the owner that will disappear after the sale. Or perhaps the business depends heavily on one employee who has no intention of staying.

Each discovery may lead to further negotiations. The buyer might request a price reduction, an escrow, additional guarantees, or a longer transition period. The seller might resist those demands or offer a different concession.

The final agreement also commonly specifies the amount of cash, debt, and working capital the business must have at closing. Changes in those amounts can increase or decrease the final price.

This is why experienced deal advisers look beyond the initial valuation. A successful sale depends on the combined effect of the purchase price, taxes, financing, employee arrangements, legal obligations, and future risks.

Common pitfalls that can turn a good deal into a bad one

Several mistakes come up repeatedly in business sales:

• Waiting too long to consider taxes. Once the parties agree on a price and structure, changing them can be difficult. Tax planning should begin before the letter of intent is finalized.
• Ignoring the company's legal and tax structure. A C corporation, an S corporation, and an LLC can produce very different outcomes from an otherwise identical sale.
• Failing to agree on how the purchase price is allocated. In an asset sale, the amounts assigned to equipment, inventory, goodwill, and other assets affect taxes for both parties. The allocations must follow applicable tax rules, and both sides generally report them to the IRS.
• Agreeing to a vague earnout. If the buyer controls the business but the seller's payment depends on future results, the agreement must clearly address how those results will be measured and protected.
• Confusing the selling price with the cash actually received. Debt repayment, transaction expenses, working-capital adjustments, taxes, escrowed funds, and deferred payments can dramatically reduce the amount available at closing.
• Overlooking employees and business relationships. Losing a key employee, customer, supplier, or license can threaten a transaction. Required consents and transition arrangements need attention well before closing.
• Underestimating continuing obligations. Sellers may remain responsible for representations and warranties, indemnities, seller loans, transition services, or other commitments long after ownership has changed.

There is also a more fundamental pitfall: treating a business sale as if it were only a tax transaction. The tax savings from a particular structure may be significant, but they should not overshadow the buyer's ability to operate the business successfully or the seller's ability to collect the promised purchase price.

A slightly smaller amount of money paid securely at closing may be preferable to a higher theoretical price dependent on several years of uncertain payments.

The most important number: What you actually keep

Selling a business can be one of the largest financial transactions of an owner's lifetime. For a buyer, it can represent an equally significant investment and assumption of risk. Both parties naturally seek to protect their interests.

The buyer wants future tax deductions, protection against old liabilities, and confidence that the business will continue performing. The seller wants favorable tax treatment, the highest possible after-tax proceeds, dependable payment, and freedom from future problems. Those objectives are different, but they are not necessarily incompatible.

Sometimes the answer is a higher price for an asset sale. Sometimes it is a stock purchase with special tax treatment. Sometimes the compromise involves seller financing, an earnout, an escrow, or an agreement for the seller to remain involved temporarily.

The best solution usually comes from understanding the financial consequences of each alternative and then negotiating a reasonable sharing of the benefits and risks. An experienced tax adviser and transaction attorney can help both sides identify options that might otherwise be overlooked.

The bottom line? When selling a business, don't ask only, "How much is the buyer offering?" Ask, "How much will I actually keep after taxes, expenses, and liabilities—and when will I receive it?"

And if you're the buyer, ask not just what the business costs today, but how its tax treatment, inherited obligations, employees, and future performance will affect the total investment.

In the end, the best business sale is not necessarily the one with the highest announced price. It is the one where both sides understand what they are getting, what they are giving up, and what the transaction will really cost them.

This information is intended for educational purposes, and is not tax, legal, actuarial, or investment advice. It is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.