M&A Basics | Asset vs. Stock Sale
When it comes to buying or selling a business, you’ll typically encounter two primary transaction structures: asset sales and stock sales. These two options may seem distinct, but in essence, they share more similarities than differences.
In an asset sale, the entity (e.g., a corporation or LLC) sells off its individual assets, such as furniture, fixtures, equipment, and customer lists, to the buyer, who typically operates through their own entity.
On the other hand, a stock sale involves the seller (e.g., an individual like John Smith) transferring ownership of their entity (Corporation, LLC, etc.) to the buyer. This is akin to owning a share of a company like Ford Motor Company and selling that stock to another individual.
For businesses valued at less than $50 million, asset sales tend to be the preferred choice. From the buyer’s perspective, asset sales often present tax advantages and mitigate potential legal risks associated with the seller’s entity. Meanwhile, from the seller’s viewpoint, asset sales may be less favorable, primarily due to the possibility of higher ordinary income tax rates on hard assets.
Now, let’s delve into a more comprehensive exploration of each scenario.
Why Most Transactions are Asset Sales
The primary reasons behind structuring the majority of small transactions as asset sales are twofold:
- Tax Efficiency: When buyers acquire your entity (be it a corporation, LLC, etc.), they inherit your tax basis. Conversely, purchasing your assets allows them to commence depreciating those assets anew, leading to more favorable tax benefits. Asset sales are prevalent in smaller business transactions because they enable buyers to adjust the asset value upwards and realize depreciation-related cost advantages. In contrast, in a stock sale, the buyer typically inherits the seller’s tax basis (with some minor exceptions), resulting in fewer tax benefits.
- Risk Mitigation: Acquiring your entity implies inheriting any undisclosed legal risks linked to it, commonly referred to as “contingent liabilities.” For this reason, buyers often opt to establish a new entity devoid of any unanticipated risks.
There is, however, one notable exception that might prompt a buyer to consider purchasing your entity, and it revolves around the continuity of contracts or licenses.
If your business holds valuable contracts or licenses that could be disrupted by a change in ownership, it may necessitate structuring the sale as an asset sale. It’s essential to exercise caution, as many contracts incorporate a “change of ownership” clause stipulating that a significant change in ownership of company stock constitutes an effective change of ownership, requiring explicit consent.
In summary, for businesses valued at less than $50 million, it’s reasonable to assume that the transaction will likely be structured as an asset sale.
Definition of Buyer and Seller: In legal contexts, such as references within agreements, “Buyer” or “Seller” pertains to the individual or entity participating in the transaction.
– If the Seller is an entity, such as a corporation or LLC (e.g., Acme Seller Incorporated), the reference is to the entity itself, not the individual (e.g., John Smith).
– Similarly, when the Buyer is an entity (e.g., Acme Buyer Corporation), the reference is to the entity, not an individual.
– If the Buyer is an individual (e.g., John D. Buyer), the reference is to that individual.
Understanding this distinction is crucial when discerning the key disparities between an asset and a stock sale.
Asset Sale — Asset Purchase Agreement (APA)
In an asset sale, the Buyer, represented by an individual like John Smith or their entity (Corporation, LLC, etc.), acquires the individual assets of the business from the Seller. It’s important to note that the Seller maintains ownership of the entity even after the transaction is finalized.
The legal document governing an asset sale is typically known as an Asset Purchase Agreement (APA), which is essentially synonymous with a “Definitive Purchase Agreement.” The key distinction lies in the fact that the former explicitly outlines that the purchase is structured as an asset sale.
In this type of transaction, specific assets and liabilities are transferred from the Seller to the Buyer. The Buyer typically establishes a new entity, and this entity then procures the individual assets of the Seller (technically speaking, the assets of the Seller’s entity, be it a Corporation, LLC, etc.). The identification of which assets and liabilities are part of this transfer is a collaborative decision made by both parties.
Typically, the assets included in the sale encompass all tangible assets necessary for the business’s operation, including supplies and inventory. On the other hand, the Seller usually retains ownership of accounts receivable, cash, and working capital. It’s worth noting that working capital may be included if the Buyer is a private equity group or a highly sophisticated corporate buyer.
Stock Sale — Stock Purchase Agreement (SPA)
In a stock sale, the Buyer acquires the Seller’s entire entity, whether it’s a Corporation, LLC, or similar structure. This acquisition effectively grants the Buyer ownership of all the assets held within the entity.
The legal document governing a stock sale is commonly known as a Stock Purchase Agreement (SPA), which is essentially synonymous with a “Definitive Purchase Agreement.” The use of the term “Stock Purchase Agreement” clearly indicates that the transaction falls under the category of a stock sale. In a stock sale, the Buyer typically assumes ownership of everything held by the Seller’s entity, including any undisclosed liabilities.
It’s worth noting that stock sales are relatively rare in small business transactions. They come into play when there’s a need to transfer assets held by the Seller’s entity that can’t be transferred independently.
For instance, certain contracts are bound to the entity and can’t be transferred without explicit permission from the other party. In such cases, structuring the transaction as a stock sale ensures that these contracts are effectively transferred to the Buyer, unless, of course, the contract includes a “change in control provision” necessitating consent for assignment upon a change of control.
In practice, most small business sales are not structured as stock sales due to several factors. One major consideration is the potential for the Buyer to inherit “contingent liabilities” – liabilities that are unknown and hence unpredictable. When you acquire the stock of a company, you potentially take on various undisclosed liabilities, which could pose significant challenges.
Note: While shares in an LLC are technically referred to as “membership interests,” the term “stock sale” is often used for simplicity and clarity in most cases.