The Dynamic Duo of Working Capital and IRS Forms 8594/8883

In this episode we cover an important and often overlooked topic of Working Capital and how it relates to the important IRS filing of forms 8594 (regular Asset Sale) or 8883 (with a Section 338(h)10 election).  We may be "geeking out" a bit here as we delve into these two important aspects of every transaction over $1.5 M, but these are things that you are going to want to know...your advisors may not even know about them.

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Transcript

Transcript

Hello, and welcome to "M&A Murders and Accusations: The Good, the Bad, and the Ugly of Selling Your Business." We delve into what you need to know and how not to kill the sale of your business. Now here's our host, Rick J. Krebs, Mergers and Acquisitions Adviser.

Hello, everyone. This is Rick J. Krebs, coming to you from the mountains of Heber City, UT. I tackle all things related to mergers and acquisitions. Today, we're going to talk about something that has killed a lot of deals. This is something that I can send death certificates for to those who don't know what they're doing and haven't dealt with it. The concept is called working capital. It may be something you haven't heard of or know about, but it's crucial when you're looking to sell a business.

If you have a business worth less than one and a half million, it's not particularly applicable. It doesn't come into play because your selling price generally includes the base price and then any inventory, receivables, or cash in addition to the negotiated price. So, if it's under one and a half million, you don't have to worry about it. But for transactions over one and a half million, buyers will negotiate to get some working capital included.

Let me tell you about working capital, starting with a story. Years ago, I was selling a pet store. The price was around 800,000, and it included inventory. As we closed the transaction and began counting the inventory, we found a large quantity of outdated dog food. The buyer didn't want to purchase it, saying it was outdated. We had to figure out what to do with this expired dog food. Additionally, the seller had sold a lot of inventory off the shelves without replenishing it.

Working capital is crucial. At the letter of intent stage, you must define how you'll calculate it or agree on an exact number. Failing to do so can harm your deal. If this isn't addressed, it can result in failed deals. I can tell you from experience that not handling this properly can lead to deals falling through. At times, buyers come to me after things have blown up and want me to close them.

Working capital knowledge is essential. It might not even be in your financials, but you should examine it to determine your accrued liability. Another issue that catches people is deferred revenue, which is a liability. There are also factors like Billings in excess of costs and costs in excess of Billings, which engineering firms often have.

Both on the asset and liability sides, it's crucial to understand what's involved, negotiate it upfront, and ensure it doesn't jeopardize your deal. For example, if you get close to closing and, like in the case of the pet store, issues arise, such as what to do with outdated inventory, it can complicate things. Generally, if your business is valued over a million and a half, buyers won't want to inject additional cash into the business to run it.

You need to define the working capital target, and at closing, if you have less working capital than agreed, the selling price decreases dollar for dollar. If you have more, it's added to the selling price. We always aim for the latter - a little sweetener at the end rather than a deduction.

Working capital's accounting definition is the current assets minus current liability. This includes cash, receivables, inventory, prepaids, deposits, accounts payable, revenue, and accrued expenses. Short-term debts and liabilities are considered current, while long-term debts are the responsibility of the buyer.

Why is this important? If you're on a cash basis reporting system and the buyer wants you to switch to an accrual system, you need to know your accruals. Transactions have seen sizable amounts at stake, with several hundreds of thousands. Failure to understand and manage this can negatively affect your closing.

Working capital is vital, and it should be specified in the letter of intent. Numeric examples and clear expectations are beneficial.

Now, I want to discuss another important but often overlooked aspect - IRS Form 8594. It's used after the sale of a business when tax returns are filed for both the buyer and seller. This form indicates how the assets' allocation was agreed upon.

The allocation of assets is crucial, and certain assets have zero gain, like cash. On the other hand, the gain on receivables can be substantial, depending on whether you're a cash or accrual basis taxpayer. You must ensure that the allocation is correct, as it can impact the buyer's tax liability. If not handled properly, it can become a point of contention later in the transaction.

Consider the asset allocation as part of your overall deal strategy, and consult with your CPA and advisor. IRS Form 8594 is often overlooked but plays a significant role in the transaction.

Thank you for tuning in, and remember, working capital and asset allocation are vital when you're negotiating and selling a business. Have a great day, and thanks for joining our podcast. Until next time, this is Rick J. Krebs, your M&A cowboy, coming to you from the mountains of Utah.

Thank you for attending our podcast. We invite you to join us for future episodes of "M&A Murders and Accusations: The Good, the Bad, and the Ugly of Selling Your Business." You can also visit us at www.bsalesgroup.com or email Rick directly at Rick@bsalesgroup.com.