If you’re a business owner, there’s a good chance your business has at least some amount of debt.
Now that you’re thinking about selling, you’re probably curious about what will happen to that debt when someone buys your business.
When a business with debt is sold, more often than not it’s the seller who must pay off that debt upon closing.
This allows your business’s assets to be transferred to the new owner “free and clear.”
In this blog, we’ll discuss what happens to a business’s debt when the business is sold. We’ll also provide a couple examples on how certain scenarios allow for debts to be shared or transferred between buyers and sellers, and touch on some misconceptions about the way debt is handled in a business sale.
NOTE
It's important for you to know that the debt discussed in this blog refers to long-term liabilities and doesn't include short-term debts related to working capital, such as accounts payable.
For more information on working capital in mergers and acquisitions (M&A), read our guide to working capital here.
Let’s jump in!
Who is Responsible for the Business’s Debt?
As mentioned above, in most small-midsize business sales, the seller pays off the long-term liabilities at closing. This would include any loans to acquire real estate, vehicle loans, equipment loans, or other bank loans taken out through the business.
In most cases, these long-term liabilities are paid off from the proceeds of the sale.
This means your seller net after the deal will be affected by your loan repayment, which is important to consider when setting your expectations for how much money you’ll actually walk away with once the deal is done.
Why Do Sellers Pay Off Their Business’s Debt?
Now that you know it's likely you’ll have to pay off your business’s debts at closing, you may be wondering why that’s the case.
After all, your buyer is going to benefit from the real estate, vehicles, and equipment you're being required to pay off, so why aren’t they taking over the loan payments?
That may seem fair at first glance, but let’s consider the way your business is valued.
In your business valuation, there will be several “add-backs” adjusted into your business’s earnings to show buyers the true financial benefit of owning your business.
One of these “add-backs” is the interest associated with any outstanding loans the business has. Your loans’ interest is added back during your valuation because of the assumption that you’ll be paying off those loans at closing.
By adding back the loans’ interest payments, your business’s earnings will increase.
Adding back the interest associated with your loans is necessary to value your business because of the comparable sales your business broker uses to determine the multiple to apply to your earnings.
The valuations in the comparable sales report add back interest on loan payments, so in order to get an accurate valuation, your loan interest payments must be added back as well.
In other words, business valuations are done assuming that the assets of the business will transfer free and clear of any loans. If those loans were transferred to the buyer, their values would simply be deducted from the purchase price.
Can Debt Be Transferred to the Buyer?
While sellers often pay off their business’s debts at closing, there are some cases in which business debt can be shared or transferred between a seller and buyer.
For example, we worked with a business that had just purchased a new piece of equipment around the time it was listed for sale. When drafting the purchase agreement, the seller hadn’t yet taken delivery of the equipment and had purchased it with a loan.
The seller didn’t want to forego purchasing the equipment because the buyer would need it to grow the business, and the seller would need it if the business sale wasn’t completed successfully.
In this situation, the deal did go through, and the buyer agreed to take on the loan payment because they knew it was something they needed to grow the business.
In a separate deal, one of our clients had some expensive equipment that would soon need to be repaired or replaced. He didn’t want to shortchange the buyer by transferring an inoperable asset, and the buyer understood that the seller wouldn't benefit from purchasing new equipment for the business before selling.
In this case, the buyer and seller came to an agreement and split the cost of a replacement piece of equipment upon closing.
So, even though it’s common for the seller to pay off all business debts, there are cases in which a buyer can share or split debt payments with the seller.
This can happen when there is a shared benefit in splitting or transferring loan payments, but it isn’t very common.
When Debt Cannot Transfer
Even though it's possible to negotiate the transfer of debt to the buyer in certain instances like those mentioned above, there are cases in which debt cannot be transferred.
Some loans come with "anti-assignment" clauses, which can disallow the transfer of the loan to any third party.
Loans can also come with negative covenants that restrict the business from going through any major changes, like a change in ownership, unless approved by the lender, or unless the loan is paid off.
In both cases, either the lender would have to approve the transfer of debt, or the seller would have to pay it off at closing.
Stock Sale Misconception
The examples and instances explained above are all related to asset sales, but what about stock sales? Since a stock sale transfers the entire business’s entity, that must include its debts, right?
Not quite.
While this could be true for larger deals surpassing $50 million, in most smaller business stock sales, the seller will still pay off the long-term debt at closing.
What to Expect When Closing with Debt
Now that you know a little more about how debt is handled in a business sale, you should have a better idea of what to expect when it comes time to close.
Knowing you will likely be responsible for paying off your debts gives you a more realistic expectation for your seller net, or the amount that you’ll actually take home after a sale.
This can help you avoid falling victim to surprises or misconceptions when a deal is all but done.
To learn more about how your business is valued, check out our blogs “What is a Business Valuation?” and “Valuing a Small to Midsize Business.” These are both great resources to help you learn what to expect when assigning value to your business before selling it.
If you’d like to learn more about how debt is handled in a business sale, or you're just curious about selling your business, contact us today. We’d be glad to help you get started.
