Stock vs Asset Purchase When Buying a Business
Stock vs Asset Purchase When Buying a Business
The first decision you have to make when preparing an LOI is how to structure the deal. In general, there are three ways to acquire a business. You can:
Purchase the assets of a business
Purchase the equity of a business
Undergo a merger.
In an asset deal, the buyer forms a company with which to purchase all or substantially all of the assets of the target company, leaving behind the things she doesn’t want. The buyer also gets to leave behind the target company’s liabilities, unless she explicitly assumes them.
An asset deal is like an open box of toys: You get to pick and choose what you want.
In an equity deal (be it stock or otherwise), the buyer purchases the equity of the target company. In doing so, the buyer owns the target company, including everything in it, the good (assets) and the bad (liabilities).
With an equity deal, you have to take the full toy box.
A merger is a transaction in which one company is absorbed by another, with the surviving company legally succeeding to all of the assets and liabilities of the absorbed company. Mergers take many forms (forward, reverse, and triangular).
Structuring the deal
For most, the right way to structure their SMB M&A deals is as an asset deal.
Why?
An asset deal is generally to the buyer’s advantage.
The buyer usually receives a stepped up basis in the acquired assets, potentially leading to significant tax savings.
As previously mentioned, the buyer only assumes the liabilities that she explicitly agrees to assume, which protects her from undisclosed liabilities.
It’s not all positives; asset deals are more time-consuming.
The assets have to be legally transferred to the new company, including intangible assets like contracts and intellectual property. Employees need to be fired and rehired. Local laws governing the sale of the assets of a business are sometimes burdensome.
But in general, these drawbacks are manageable in SMB deals (unlike large transactions, where asset deals are notably less common). As a result, buyers should almost always consider an asset deal first.
Why do buyers sometimes go for equity deals?
There are times when an asset deal just isn’t possible. For example:
Certain key contracts may be unassignable without the consent of the counterparty, and either the counterparty won’t consent or there are too many contracts to make seeking consent practical.
The business may need certain key licenses to operate, and either the licenses cannot be assigned, or assigning the licenses could lead to long delays, even the risk of losing those licenses.
The buyer intends to rely on SBA financing and the seller wants to retain a minority interest in the company post-close. Current SBA rules mandate structuring the transaction as an equity deal [Note: Since this post was published, the SBA has changed its rules on rollover equity. Read my subsequent post, Rollover Equity, for more details.]
It may also be that the seller is insisting on an equity deal.
Why?
An asset deal is disadvantageous to the seller for similar reasons as it is advantageous to the buyer:
The seller is left holding a box full of liabilities, and will likely have a worse tax outcome (the seller will be taxed on income rather than incurring capital gains, and may be liable for sales, use, and other transfer taxes).
If the target company is structured as a C-corporation, the seller may even suffer double taxation (once at the corporate level and once at the shareholder level).
But just remember, asset deals are market in SMB M&A. The seller will only be in a position to demand an equity deal if an asset deal is impractical, or the seller is selling into a hot market.
Don’t fear.
If you find yourself staring at an equity deal, there are steps you can take to protect yourself.
The buyer can request that the seller indemnifies the buyer for all pre-closing liabilities (this is standard practice anyway).
The buyer can request an election under Sections 338(h)(10) and 336(e) of the Inland Revenue Code, which allows the parties to treat the transaction as an asset purchase for tax purposes (or, alternatively, propose that the target company undergoes an F-reorganization).
More on these mitigating strategies in subsequent posts.
What if I don’t know what to do?
At the time of preparing the LOI, you may not have all the information you need to decide how to structure the transaction. If that is the case, go with an asset deal and explain that you are willing to discuss structuring the transaction as an equity deal on the condition that it allocates liabilities and results in tax outcomes as if it were an asset deal.
What about mergers, the M in M&A?
Mergers are rarely (if ever) used in SMB M&A. The advantage of a merger is that, like an equity deal, it is simple and will generally avoid the problems associated with an asset purchase. Moreover, unlike an equity deal, a merger does not require reaching an agreement with each individual stockholder, just some specified number of stockholders.
That can be huge if dealing with a large company. But most SMB deals involve one or two business owners at most, making mergers largely unnecessary other than as a structuring tool (more on this in future posts).
What kind of language should I include in my LOI?
For an asset deal:
1. Acquisition of Assets and Purchase Price.
(a) Subject to the conditions described in this Letter, at the closing of the Transaction, Buyer will acquire substantially all of the assets, and certain specified liabilities, of the Business (the “Assets”), free and clear of all encumbrances, at the purchase price stated in Section [__].
For an equity deal:
1. Acquisition of Shares and Purchase Price.
(a) Subject to the conditions described in this Letter, at the closing of the Transaction, Buyer will acquire all of the outstanding shares of capital stock of the Company (the "Shares"), free and clear of all encumbrances, at the purchase price stated in Section [__].
***
Adjust as necessary. For example, if the target is an LLC, the buyer will acquire membership interests, not shares of capital stock.