While no two deals are ever quite the same, the purchase and sale of a business will usually fall in to one of three categories:
- an asset purchase;
- a stock purchase; or
- a merger.
There are numerous pros and cons for each type of transaction.
Probably, the easiest way to buy a business is to purchase a seller’s assets, free and clear of any and all liabilities. With this type of transaction, the purchaser is not actually buying the business entity itself. In realty, an asset purchase is like buying the seller’s merchandise without buying the store.
As a general rule, a buyer should, whenever possible, purchase the assets of a business instead of a stock purchase or merger. Some of the best reasons are as follows:
- The buyer can purchase the sellers assets, without assuming the seller’s liabilities. The buyer can also pick and choose which assets to acquire from the seller. Conversely, the seller can also choose which assets to retain from the buyer.
- The buyer may get a stepped-up tax basis on the assets acquired in the purchase.
- The buyer has the option to hire the seller’s employees.
- The buyer can also determine which contracts to assume.
In this type of transaction, the seller may only be required to sell the company’s shares of stock certificate(s) in exchange for a check from the buyer. In an asset purchase, the buyer is actually taking over the seller’s store, and not just purchasing the seller’s inventory or merchandise. In a stock purchase, the buyer is essentially stepping into the shoes of the seller.
With all things being equal, a seller should choose a pure stock purchase transaction because the tax consequences are favorable. The seller may be able to realize certain capital gains on the sale of the stock. In essence, this avoids double taxation which may occur with an asset purchase. In an asset purchase, the business entity is [first] taxed on the sales proceeds, then the shareholders are taxed again on distributions that they may be received.
For a stock purchase, the result can be a seamless change of ownership. The store may look like it is under new management. However, title to corporate assets may remain the same. Thus, there is a very good chance that the status quo will be preserved. Employees can remain in place and it may not be necessary to change the title to certain assets or assign existing contracts to a different business entity. Good will and other intangible assets will remain with the seller’s business.
It should be noted that many buyers are leery of a stock purchase, because they usually end up assuming the liabilities of a seller. Therefore, a seller must anticipate that a buyer will expect concessions. The buyer may, for example, insist on very strong indemnification language from the seller and the purchase price may also be adjusted accordingly.
A merger is a marriage of two businesses [and cultures]. In some respects, a merger has a lot of the same characteristics as an asset purchase, as well as a stock purchase. In most cases, the surviving corporation will issue new shares of stock to the shareholders of the disappearing corporation, in exchange for their stock in the disappearing corporation. In a merger, the surviving corporation takes title to all of the assets of the disappearing corporation and the disappearing corporation subsequently ceases to exist. A merger is a time-tested vehicle for combining the strength of two or more business entities, and merging them in to one company.
In today’s economy, it may make economic sense for two corporations [or businesses] to merge. While a merger may create duplicate positions for some employees, and cause some employees to be laid off, the intent of a merger is to improve the corporate bottom line by cutting overhead expenses and increasing efficiencies as well as revenue.
In a merger, tax consequences can be neutralized or even deferred. If done properly, stock swapping will not result in any taxable gain to the shareholders of either organization.
Depending on the size and complexity of the deal, it may be difficult to pigeonhole a transaction as an asset purchase, stock purchase or a merger. For the most part, deal progresses in the following manner:
- Preliminary Discussions
- Negotiating a letter of intent
- Signing a confidentiality agreement
- Drafting and finalizing a formal agreement
- Undertaking due diligence
- Seeking approval from governmental authorities and consents from third parties
- Post-closing adjustments
Negotiating the Deal
Depending on the nature and complexity of the transaction, bringing a deal to closure could take anywhere from two months to a year. From the beginning and before the transaction takes on a life of its own, you should always consult with an attorney and tax advisor.
Once the parties shake hands and slap each other on the back, the next step is to issue a letter of intent. A letter of intent will secure a level of commitment from the parties to show that they are serious about closing the transaction. Without a letter of intent, the parties never discuss the finer points of the deal, which some how always show up in the formal agreement. Generally, a letter of intent is non-binding . Once the parties secure a letter of intent, the buyer will immediately want access to the seller’s books in order to verify certain financial information. As a general rule, a seller should never allow a buyer to inspect their books without a confidentiality agreement. A confidentiality agreement will protect the seller’s interest, just in case the buyer has some unscrupulous motive.
As the transaction progresses, the parties should always enter in to a formal agreement. Sometimes the parties may sign the final document at the time of closing. Invariably, the parties will negotiate the terms of a formal agreement, which is the point of the transaction where you absolutely need legal counsel. Once the parties reach an agreement, the due diligence stage commences, which is where a business will come under a great deal of scrutiny.
One thing to keep in mind is that in some cases, the government approval process can be rigorous. One example is tax clearance certificates and certificates of good standing for your business entity. Sometimes, you may even need to get a governmental entity to approve a transaction before it goes forward. In certain franchise transactions, you will also need to get the consent of a third party in order to proceed with the transaction.
Finally, some form of post-closing adjustments may be involved. In some cases, a buyer and seller may agree that the business will perform at a certain volume for a certain period of time, after closing has taken place. Depending on the agreement, the purchase price may be adjusted up or down after the closing has already taken place.
There are many hidden pitfalls to any type of asset purchase, stock purchase, or merger. It is essential to get good legal and financial advice before entering in to any type of transaction.
Recommended Books on the Purchase and Sale of a Business:
- The Complete Guide to Buying a Business
- Buy a Business (For Very Little Cash)
- How to Buy and Sell a Business: How You Can Win in the Business Quadrant (Rich Dad’s Advisors)
- The Complete Guide to Selling a Business
- 11 Things You Absolutely Need To Know About Selling Your Business
Stuart J. Oberman (Law Office of Stuart J. Oberman), an attorney in Loganville, Georgia, works with clients on a wide variety of transactional issues, including commercial, corporate and real estate law. For questions or comments regarding this article please call (770) 554-1400.
- Benefits of Asset Management for a Small Business
- 10 Do’s and Don’ts in Buying a Business
- Understanding “Owned and Controlled” Licenses
- 12-Step Template to Write an Effective Sales Letter
- What is Incorporation?