Why buy a business?

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Estimated read time: 6 minutes 03 seconds

1. Why buy a business?

2. How to buy a business

3. Getting your a** waxed

Good morning and happy Monday - let's get smarter

Why buy a business?

Whether you are an average Joe looking to buy a business or you are a big corporation, there are multiple reasons why buying a business is > starting a business

For the average guy/gal like you and me. The main reason for buying over building is to increase your chance of a successful venture

Here are some reason's individuals should buy rather than build:

Average Joe

1. If it ain’t broke don’t fix it - Lindy’s law: The longer a business has been around, the higher likelihood it is to continue to stay around

   1. Startups come and go, but that local flooring company that has been around for 20 years, will probably be around for another 20

2. Reduced chance of failure - Approximately 20% of new businesses fail during the first two years of being open, 45% during the first five years, and 65% during the first 10 years (per BLS). Buying a business drastically reduces the chance of failure

3. Reduced time, effort, and risk - A startup requires funding, proof of concept, product market fit, acquiring customers, scaling the business and operations - all which takes time and money

   1. Buying a business with customers, proof of concept, operations, cuts out the time and stress of proof of concept, acquiring customers, and building out a team

4. Using other people’s money

   1. We have discussed in our newsletter “How to buy a business” the power of using debt to finance an acquisition. Buying a business that already generates cash flows allows you to take on debt for the acquisition, and use the businesses cash to pay the debt down

      1. For startups, they typically don’t have positive cash flows to pay down debt, so the debt options are limited. This is why you have venture capital firms that write startups big equity checks for 30% of their company. Now, if you do sell down the line, the VC firm rather than getting a fixed debt payment, gets a large equity check. Not great for you, great for them and their investors

For corporations, there are various strategic reasons for M&A. A lot of them also come down to the buy vs build dilemma

Buy vs build dilemma - how much time and money will it cost me to build what that company has/does and how effective will it be vs just buying them and their solution

Corporations

1. Move into a new market - Amazon purchases One Medical getting into the healthcare market

2. Move into an adjacent market - Facebook acquired Oculus VR to get into the virtual reality hardware landscape. Facebook most likely analyzed the costs to build out these capabilities themselves, the % chance of being as successful, and determined they had the funds and preferred to acquire Oculus.

3. Eliminate competition - Disney acquired Lucasfilm (Star Wars) and Pixar (Toy Story) who were competing in the film production space

4. Vertical integration - Apple acquires chip maker Dialog. This acquisition is to help reduce costs or supply chain/vendor pressures. If your chippmaker has pricing power and keeps raising the costs, you can buy a chipmaker and bring the operations in house to make it either 1. More cost effective and/or 2. More efficient

This is why M&A happens. When markets are in turmoil, you typically see M&A to help boost earnings aka buying revenue and profit

However, it gets harder when interest rates are higher as this makes debt more expensive

So now that you know why, here's how you can structure a deal

How to buy a business?

Two things you probably didn’t know about me - I am a CPA (no I will not do your tax return I don’t even do my own) and my first job out of college was in M&A tax

So while I am not an expert in structuring acquisitions, I know enough to be dangerous

At a high level, there are 2 main ways to structure a transaction: asset deal or stock deal

Asset deals - In an asset deal, the buyer picks the assets of the business they are acquiring and only gets those assets and corresponding liabilities

Pro’s

1. You get to choose the assets they want and the corresponding liabilities and nothing more or less. If there are certain liabilities, or bad contracts, or items you don’t like about the biz, you don’t buy them

2. Stepped-up tax basis: To avoid going into jargon, this just means you get increased depreciation/amortization deductions to use which lower your tax liability going forward because it drives down your profit

   1. It doesn’t drive down your CASH, only your PROFIT, because depreciation and amortization are non-cash expenses

Con’s

1. When you purchase the stock of a business, you get everything. The things you know about and the things you don’t know about

2. No step up in basis / increased deductions

3. Typically cost more in legal fees to transfer all of the assets, contracts, etc

4. Depending on the type of business, can take awhile to get approval to change the owner of the contracts from vendors, get issued new licenses, etc.

5. In an asset sale, the seller typically has to pay more in taxes. In a stock deal, all of the sale proceeds get capital gains tax treatment, rather than certain assets getting higher (ordinary tax rates) in asset sales

   1. As such, the seller generally needs to be “grossed-up” aka paid more to compensate for the additional tax

Stock Deals

In a stock deal, the buyer is buying the legal entity. For example, instead of a buyer only buying Amazon’s AWS division in an asset purchase, the  the company would be buying the entire Amazon legal entity, Amazon.com, Inc.

Pro’s

1. The buyer acquires the whole entity, which typically reduces legal expenses

2. The seller pays capital gains tax on sale proceeds (20% rather than 30-40%)

Con’s 

1. The buyer doesn’t get the “stepped-up basis” aka increased deductions to reduce tax

2. The buyer now assumes all the hair that comes along the company/legal entity instead of specific assets and liabilities, they are getting them all

338(h)(10) - the best of both worlds

338(h)(10) is a section of the tax code. When a buyer makes this election, the purchase is treated as a stock purchase from a legal perspective, but an asset purchase for tax purposes

So why is that good?

You avoid the complexities of contract transferring and all of the additional legal work that go into an asset purchase from a legal perspective, BUT, you get the stepped-up basis aka increased deductions to lower your tax from a tax perspective

So if you get the best of both worlds why the hell doesn’t everyone do this?

Good question

Answer: There are only specific situations where you are allowed to make this election. One of them being when the target company/seller is an S corporation

If you are interested in learning more about these, just do some googling. There are a ton of free blogs and posts about transaction structuring

Markets Get Their Ass Waxed

Last week was a BRUTAL week in the public markets. The Nasdaq got obliterated

What happened?

CPI (measures inflation) came in higher than expected

Why did that make stocks go down?

The main reason it drastically impacted stocks is because it means that The Fed (US Central Bank) who is trying to raise interest rates to slow inflation, hasn’t raised enough

Meaning The Fed will likely now increase the number of rate hikes (amount they will raise interest rates), which slows borrowing because interest is higher -> which slows spending -> which slows GDP aka the US economy is slowing -> which slows consumer spending -> decreases businesses profits

Nothing is that simple, but at high level, that’s the flow

So is now the time to buy the dip? It’s not. GDP is expected to keep slowing, profits will continue to slow, companies will report worse earnings, and markets CAN KEEP GOING DOWN

Don’t be this guy

What we do like on the long side 

$UUP - The US Dollar continues to outperform and should be your biggest position

$XLU - Utilities

$PINK - Healthcare

$LANC - Lancaster Colony Corp (Food and Beverage)

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.