By Michael T. O'Neil, Esq.
Always buy assets and always sell stock. This is the mantra that has been drilled into the heads of entrepreneurs by their accountants, lawyers, and tax advisors since their first business venture. The mantra itself certainly has merit, however, if every potential acquirer and every seller of a business were to follow the same mantra, no deal would ever get done due to the seller's insistence that the sale be in the form of stock while the buyer insists that the sale be in the form of assets and although my own law school professors and mentors have instilled the same philosophy on me, I have learned that each transaction needs to be viewed on a case by case basis and the simple truth is that the purchase of a business through a stock deal isn't always a bad proposition and in fact sometimes can be the preferred method.
Assets vs. Stock: Although an entire treatises can be written on the differences between the two forms of deals, all of the major differences can be summarized into two (2) major categories: Taxes and Liability Exposure.
The key difference in tax treatment between a stock deal and an asset deal is the buyer's deductibility of the purchase price. In an asset deal, the buyer gets to deduct the purchase price in the form of depreciation and amortization, however, in a stock deal the buyer gets no deduction for the purchase price. For example, if seller has equipment with a fair market value of $100 but a book value of $0 (because the equipment has been fully depreciated by seller) and buyer purchases the equipment for the fair market value of $100 in an asset sale transaction, then buyer will be able to depreciate the equipment over the term of its useful life thereby getting a valuable tax deduction every year until the equipment is depreciated down to zero. If buyer purchases the equipment pursuant to a stock deal, then buyer will spend the same $100 without affecting the book value of the equipment thereby getting no tax deduction. However, if the buyer purchases a business with an eye toward reselling in the near future, then a stock deal may be advantageous because it will give buyer a higher basis in the stock and will therefore reduce his tax liability when he flips his business.
The other and more straight forward reason why buyers often prefer asset deals to stock deals is liability exposure. If a buyer purchases the assets of seller and only the assets of seller, then all liabilities of the business remain with seller after the closing. For example, in an asset deal seller remains responsible for all bank loans, potential and existing litigation, and all other customer and creditor claims whether they actually existed at the time of closing or arose after the closing. In the same transaction, if buyer purchased all of the stock of seller then buyer would essentially be in the shoes of seller and would be responsible for all liabilities of the seller whether they arose prior to or subsequent to the closing.
As was mentioned in the introduction, doing a stock deal isn't always all that bad. Here are 5 reasons why doing a stock deal might be beneficial for any particular transaction.
1. Lower Purchase Price. Isn't this what every deal hinges on? Seller asks $1 million for the stock of his company, but will not take the same $1 million for the sale of the assets of his company, plain and simple. The reason is that the seller is receiving a tax benefit by selling his shares as opposed to the assets of the company. For example, seller wants to sell his shares for $1 million and has a basis of $100k. This results in a gain of $900k that will typically be taxed at long term capital gains rates of approximately 20% which will result in an after tax profit of $920k. A sale of assets will result in a much different net result for the seller. If seller sells his assets for $1 million and has a basis in those assets of $100k (assume no type of recapture, shareholder loan repayment or return of capital) then the company will have a net gain of $900k which will be taxed at corporate rates of approximately 35% resulting in a net gain to the corporation of $685k. The $685k will then be distributed out to the shareholder and be taxed at approximately 20% resulting in a net gain to the shareholder of $548,000. As you can see this is quite different than the $920k result we saw with the stock sale. This means that a buyer can usually get a much better deal on the purchase price if he agrees to purchase the stock of the company as opposed to the assets. Sometimes the parties may agree that the buyer will purchase the stock of the business but for tax and accounting purposes the transaction will be treated as an asset sale. This is what is referred to as a Section 338 election so named for the I.R.S. Code section that allows parties to elect such tax treatment. An entire article may be written about Section 338 elections and therefore this article will only mention the topic.
2. Ease of Transition. Buying the shares of a company is simply easier than buying each of the company's assets. By buying the shares of the company, you are stepping into the shoes of the previous owner. Legally, it is as if nothing has changed and therefore there is no need to transfer the legal title of each piece of equipment owned by the company, no need to get assignment of leases, consents to transfer contracts, consents to transfer licenses, consents to transfer financing, no need to create bills of sale for each piece of equipment, etc. In other words, a lot less paperwork needs to be generated by the lawyers and accountants which lowers the buyer's transaction costs. Additionally, no existing debt needs to be paid off and security interests terminated like in an asset transaction, no mortgages need to be paid off, no new leases need to be renegotiated with landlords, no new companies need to be formed to hold the assets and no names need to be changed. As a result, stock deals can often get done much quicker than asset deals.
3. Appearance. From a marketing standpoint, customers of the businesses being sold prefer stock deals to asset deals. Often times in asset deals buyers will change the name of the company and often times new customer agreements need to be negotiated and entered into. It is a universal truth that customers prefer stability and are averse to change. A buyer can project a perception of stability by disrupting as few customer relationships as possible and therefore for this purpose often times a stock deal is preferred.
4. Retain Non-Transferable Rights. Often times, particularly in technology-based companies, there are rights such as licensing rights that are not transferable. In these cases a stock deal may be the only way to get the deal done.
5. Escrow Holdbacks. In a stock deal a buyer has a much better argument to ask for various representations and warranties of the seller. These representations and warranties made by seller create a snapshot of all of the liabilities of seller on the date of closing. If the buyer later learns that the snapshot was inaccurate, then he should be entitled to a refund of a portion of the purchase price that he paid. Hand-in-hand with the representations and warranties of seller is the right of indemnification which is the mechanism by which buyer obtains his refund. Seeking indemnification from a seller that has retired and moved to the Bahamas, however, may be an academic exercise and therefore the best way to satisfy any breach of the seller's representations and warranties is to hold back a portion of the purchase price. In a stock deal a buyer has a much better chance to hold back a larger portion of the purchase price in case the snapshot of liabilities was inaccurate. These inaccuracies may be liabilities that seller may have chosen not to disclose and other ones that seller may have just forgotten to disclose.
In general, the rule of thumb that sellers should sell stock and buyers should buy assets is a good one, however, all rules have exceptions and therefore it is important for the business decision maker to sit down with his advisors prior to making any decision to acquire or sell a business to see how the basic structure of the transaction will effect his bottom line.