Winding Up (Going Out of Business)
Winding up of business affairs is a phrase commonly found in agreements for partnerships and limited liability companies. However, it is an overall business principle for all forms of business entities and it refers to a process of closing a company’s business, i.e. going out of business. The process is comprised of three steps: terminating operations, completing all financial affairs and finally distributing the remaining cash balance to all owners.
Winding up comes into play when the owners of a business operation decide to no longer cooperate with each other or have decided to pursue other opportunities and can not or will not sell their respective rights to a third party. Often, winding up has to occur due to internal strife among owners. It is in the best interest of all parties to terminate the company in an organized manner. The following sections cover the basic steps to an organized closure of an entity.
Winding Up – Terminate Physical Operations
The first step to winding up a business operation is to create a plan on how to cease physical operations of the company. In most cases, the owners select a final date to stop operations; inform staff, customers and vendors of this final date and implement a plan for an organized termination. A plan is created to carry out this step including proper timing of staff adjustments, notification to vendors as to the last day to provide product and a logical timing with the sale of products or servicing contracts for customers.
Included in this step is the liquidation of tangible assets such as inventory, fixed assets and other assets. Of these, inventory is usually the easiest to liquidate (turn into cash). Everything from conducting product sales including liquidation sales to requesting your competition purchase the remaining inventory are options available during the terminating step to dispose of inventory.
As for fixed assets, this often takes longer and requires a lot more effort. If real estate is involved, it often takes upward of a year to complete a deal. Other types of fixed assets can be sold for pennies on the dollar depending on how long management/owners want to take in terminating the physical operations. Transportation equipment often can be sold quickly as there is a large market for trucks and cars. Office equipment is a whole different story. In this case, it is best to engage a used office furniture/equipment company to make an offer on all the respective items as a package deal.
The most difficult fixed asset to sell is a specialized piece of equipment; the more customized the equipment, the less likely you will be able to find a buyer. Sometimes the only value it is worth is as scrap metal. As an owner, you must be realistic in how long it will take to sell off the fixed assets.
Other assets are a bit different. Most other assets are intangible in nature and include patents, copyrights and goodwill. There is little to no market for copyrights and patents. To acquire cash for these assets, an owner must be aggressive and typically the best course of action is to approach your competition and have them purchase these rights. Goodwill is whole different story; it generally has no value as it is tied to the ongoing operations and when a company ceases operations, it also terminates or states that the goodwill no longer exists.
Naturally, as an owner or manager there is a process of accounting to close out these assets.
Winding Up – Financial Closing
The second step is typically performed while the first step is ongoing and continues after physical operations are complete. This step is the paperwork part and it is most important function is paying off the financial commitments made. This includes all forms of liabilities. All long-term debt is paid, customarily the proceeds of the sale of the asset used as collateral are used to extinguish that corresponding debt. Often the company has to pay the difference between the actual amount collected for the sale of the respective items and the remaining principal left on the respected note.
In addition, the company must pay off all short term liabilities including credit card balances, vendor balances and of course taxes. Unlike many liabilities, owners are legal trustees for taxes and are personally liable for tax obligations owed by the company.
As a part of this process, those assets sold (other than inventory) have a different form of accounting done for federal and state income tax compliance. Gains and losses must be calculated including depreciation/amortization taken to date. This is generally a tad more sophisticated than traditional bookkeeping; so keep this in mind when recording this information.
On the other side of this equation, there exists accounts receivable and these require collection of amounts due to the company. Better operations have very little bad debt or have tools that are enforced to collect monies from customers. If your company doesn’t have an active accounts receivable management program, then you must be realistic in how much you are actually going to collect from your customers. There are options with slow or non paying customers:
A) You can sell the receivables to a third party receivables agency; most will pay upwards of 20 cents on the dollar depending on the nature of your business.
B) You can engage a collection agency to pursue these customers, but they have limitations on how far they will go in collecting money.
C) Utilize your legal process to collect monies owed.
The goal of the financial closing step is to pay off all liabilities and document the conversion of assets into cash. This step is completed once the balance sheet has only one asset remaining and that’s cash in the bank account. Now it is time to distribute or pay the owners their respective share of what is left.
Winding Up – Distribute Cash to the Owners
The third step in winding up a company (closing the business) is the distribution of cash to the owners. If the above two steps are done properly, this third step creates a wonderful feeling of accomplishment. Any remaining cash is distributed to the owners based on their respective pro-rate share of ownership. But it doesn’t always end up this easily. Actually, nine times out of ten, it gets really ugly. The emotions and the value issues kick into gear during this step and that is when the proverbial insinuations start. Almost every single time, the actual remaining cash to distribute is far less than what was expected. This almost always relates to the value received for the fixed and other assets sold in step two above. Since liquidation forces the sale at an accelerated rate, the actual sales price of the respective asset is a lot less than fair market value thus the difference is felt upon final distribution to the owners.
Other liquidation issues include the inability to collect 100% of the value for accounts receivable; the losses absorbed due to the sale of intangibles or the writing down of the respective value for these intangibles; and reserving some cash to address contingent liabilities.
Contingent liabilities exist at the termination of business due to several sources. The most common source is the tax obligation. Often the tax obligation is an unknown until the tax return(s) is prepared for that respective year. Other contingent liabilities include the cost of professional services to close operations. The legal team will charge fees to complete all necessary documentation, CPA’s are utilized to prepare tax returns and outside consultants (auctioneers, agents, brokers etc.) must be paid when they render their respective services. To successfully comply with these future needs, management will set aside funds to pay them; think of it as trust funds. Thus not all the cash is actually paid out to the owners. The initial payout is commonly referred to as a ‘Safe Distribution’, an amount that leaves enough money in the bank account of the business to pay for future bills known and estimated.
Another common problem with final distributions relates to value that many owners believe they bring to the table and are entitled to compensation at termination. This is very common with your idea guy who may have founded the business. He/She firmly believes they are entitled to a greater share of the final distribution. Well, the simply truth is that if it isn’t in writing, the law or the internally generated documented arrangements override this founder’s belief.
I state it often in many of my articles, DOCUMENT, DOCUMENT, DOCUMENT the understanding between all parties. There is no substitute for good legal counsel, well drafted and appropriate legal agreements among the owners. Feelings are going to get hurt, it is the nature of business especially when a company terminates its operations and winds up its affairs. ACT ON KNOWLEDGE.
Value Investing
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