Are you selling your Business? What should you do with the Debts?

This blog will discuss what occurs to a business's obligation when the company is sold. We'll also deliver examples of how specific procedures permit debts to be shared or transferred between buyers and sellers. We also touch on misunderstandings about how debt is managed in a business sale. 

What is Debt?

Debt can include short-term and long-term liabilities. 

Short-term debt, also called current liabilities, is a firm's financial obligations expected to be paid off within a year.

Long-term liabilities, also called long-term debts, are debts a company owes third-party creditors that are payable beyond 12 months. 

This article states that debt means long-term debt.

Does the decision of who will pay the debt affect the company's value?

One critical issue that is often not considered is whether deciding who will pay the debt - the buyer or the seller - affects the firm's value.

The answer is positive.

When the seller of the company wants to understand the company's value, he will call for a valuation of the company with the existing loan structure, that is, with the current financial leverage of the company. On the other hand, the seller who will take over the company without loans will see lower financial leverage. The result is that the valuation presented by the buyer and the valuation offered by the seller will be different because the seller's valuation is based on higher financial leverage. For this reason - most likely, the value of the company presented by the seller will be higher.

Who Pays Off the Business's Debt? 

As written above, the seller usually pays off the long-term liabilities at closing in small-midsize business sales. This long-term debt would contain any obligations to acquire equipment, vehicle, real estate, or other bank loans taken by the business.  

Usually, banks will not give loans to small businesses without the business owners providing a personal guarantee against the loans. Therefore, when the company is sold, the shareholder who gave the personal assurance to the bank has an interest in paying off the obligations. For this reason, the shareholder will repay the loans when the company is sold.

Another reason you should pay off the loans with the sale of the company's shares is that sometimes the interest rate in the economy changes. This means that it would be worthwhile for the company to take new loans at a lower interest rate, and therefore it would be advantageous for it to pay off the existing loans.

In most cases, these long-term liabilities are paid off from the proceeds of the sale. Therefore, when examining the terms of the purchased transaction, one must determine whether the seller will pay the principal's balance. As a result, one must understand what amount will be left in his hands after the debt is paid off and, of course, the tax he will have to pay.

Can Debt Be Transferred to the Buyer? 

While sellers often pay off their business's debts at the closing of the deal, there are some cases in which the obligations can be shared or transmitted between a seller and buyer.  

For instance, a business that just purchased a new piece of equipment when the business 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 buying the equipment because the new owner would need it to grow the business, and the seller would need it if the business sale wasn't ended successfully.  

In this case, the deal did go through, and the buyer chose to take on the loan payment because they knew it was something they ought to grow the business.   

Another example is the case of costly equipment that would soon need to be replaced. Moving the useless equipment to the buyer would yield a worthless company. The buyer and the seller might agree that it is better off to finance the new equipment with debt to be refunded by the company's buyer.

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 widespread.  

Conclusion

In this article, we discussed the question - what should you do with debts when selling the business? Wonder how you can evaluate your company with and without debts? In that case, you can try our intuitive ai based business valuation software or our business valuation calculator, or you can contact us for free advice or schedule a demo.