Stock vs. Asset Sale

Assuming that the business being acquired is a corporation, there is a choice in how the deal is structured. The buyer can either acquire the stock or the assets of the firm. There is a clear advantage to the buyer in acquiring the assets of the firm instead of the stock – most liabilities do not follow the assets, and most small business acquisitions are structured as asset sales. In general, acquiring liabilities is not a problem; you just adjust the price to reflect the liabilities that you assume. However, by structuring the transaction as an asset sale you reduce the chances that you will be responsible for undisclosed or contingent liabilities. Be careful, because existing tax and tort liabilities can follow the assets. If real estate is acquired as part of the transaction, environmental liabilities can also be an issue.

Selling the assets of a corporation generally only requires a majority vote of the shareholders, so even if a minority shareholder objects to the sale and refuses to sell his shares, an asset sale can allow the business to be sold. An asset sale also allows for the sale of only part of the company, although in most cases all of the assets of the corporation are purchased, including the company name, customer lists, etc.

One advantage to a stock sale is that it is easier and less expensive than an assets sale. In an asset sale, the property must be re-titled in the name of the new business and the business name must be transferred. Some contracts and licenses, including leases and customer contracts, may not be transferable to another entity or may require written consent from the other parties to the contracts. In a stock sale, the owners of the company change, but the company itself does not change, so there is no contract transfer issue unless the contract has a clause triggered by a "change of control."

A purchase by corporate stock is often the vehicle of choice if there is to be a partial buyout. If you wanted, for example, to buy into a corporation at 25%, 50%, 60% or any other proportion, you would merely buy that percentage of stock in the corporation. Compared to the alternatives, a stock sale makes partial ownership transition relatively simple.

An asset sale also allows the new owners the flexibility to change accounting methods, including how inventory is valued, cash vs. accrual accounting methods, and depreciation methods. In a stock sale, assets retain their basis and the depreciation schedule is uninterrupted. However, a Section 338(h)(10) Election can be used in a stock sale to treat the sale as an asset sale from the perspective of the corporation and the buyer, even though a stock sale occurred. This allows assets to be stepped up by the purchaser to the price paid for the company plus liabilities assumed plus acquisition costs.

One big advantage from the seller's perspective of structuring the deal as a stock sale is that in a stock sale, the seller clearly leaves behind almost all contingent liabilities, including the threat of future lawsuits. Purchasers are not eager to assume liabilities, so most small business acquisitions are structured as assets sales. With strong representations and warrantees, however, stock sales do happen, especially in businesses where hidden liabilities are unlikely.

Bulk Sales Act and Asset Sales

All 50 states of the United States have agreed to a set of rules and regulations known as the "Uniform Commercial Code". In short, the UCC is a body of laws and regulations that govern commercial transactions.

One provision of the UCC, The Bulk Sales Act, used to be very relevant to the sale of businesses. The Bulk Sales Act essentially protects the creditors of a business from the possible sale of bulk of the assets of that business for the purpose of defrauding the creditors. That is, a business owner cannot sell off his business or major parts thereof without creditors being notified of his intention.

However, in many states, the bulk sales act has been repealed. In states where it has not been repealed, it has been narrowed in scope. For example, the bulk sales act generally does not apply to sales of assets less than $10,000,000 or greater than $25,000,000. While you should check with your attorney, it is unlikely that the Bulk Sales Act should be a problem when purchasing a business.

Nevertheless, you should make sure that all of the purchased company's creditors are paid. Even if you are not legally liable you do not want to have conflicts with suppliers, wholesalers, service providers, or others. You can require that money be escrowed to pay creditors.

Tax Consequences

When buying a company, careful consideration needs to be given to the tax consequences of the transactions. From a seller's perspective, there can be a significant impact on how much of the purchase price he can actually keep, based on whether he must pay ordinary income tax or capital gains taxes on the proceeds of the sale. As a buyer, you want to be able to either immediately expense, or quickly depreciate or amortize as much of the purchase price as possible. In our experience, both as intermediaries and principals, the best strategy is one in which both parties cooperate in legally minimizing the total tax burden and negotiate over how to divide the benefits of the taxes that were saved.

S Corporations

In a stock sale, the S Corporation does not pay taxes at the corporate level. The stockholders pay capital gains taxes on the transaction, not ordinary income taxes. Since individual capital gains rates are lower than ordinary income rates, it is clearly in the seller's interest to structure the deal as a stock sale.

In an asset sale, however, the tax treatment is less certain. The proceeds from an asset sale must be allocated: an amount for tangible assets, an amount for consulting and non-compete agreements, an amount for goodwill, etc. for tax purposes. The allocation must be reported on IRS form 8594. Both parties must file the form with the IRS and the two forms must match. The purchase price is allocated to the assets acquired. The IRS requires that you allocated the purchase price based on the fair market value of the assets being transferred. The buyer will want to allocate the purchase price to items that can be quickly depreciated after the sale. The amount allocated to these items forms the buyers basis in the items and the buyer can get a fresh start depreciating the assets. However, if more than the depreciated value of items on the seller's balance sheet is allocated to those items, the seller will pay ordinary income tax on the depreciation recapture.

Generally the purchase price is for more than the fair market value of the tangible assets. Once the value of the tangible assets has been determined, the remainder is allocated to intangible assets. When allocating the purchase price it is important to keep in mind that although intangibles, goodwill, and non-compete agreements can all be amortized over 15 years by the buyer, the seller pays only capital gains rate on goodwill but must pay ordinary income taxes on the non-compete agreement.

Intellectual Property, such as patents, trademarks, or copyrights, which have a legal life are treated as a capital gain for the seller. The buyer can then amortize the intellectual property over the remaining life of the assets. In some cases, a strategy of allocating purchase price to intellectual property may allow the seller to receive a capital gain and the buyer to rapidly expense the purchase price.

Consulting or employment agreements are far more favorable to the buyer. They are deductible as an ordinary expense when paid. However, the seller will pay ordinary income tax rates on the income and be subject to FICA.

Limited Liability Corporations (LLCs) can elect to be taxed as either an S Corporation or a C Corporation. They usually have used from 2553 to elect to be treated like S Corporations for tax purposes. Smaller LLCs file as partnerships and may even (if there is a single owner) just file a schedule C on an individual return. You need to determine the tax structure of the acquisition target to be certain how the transaction will be taxed, but it is reasonable to initially assume that the transaction will be taxed as if you were acquiring an S corporation.

C Corporations

Buying a C corporation via an asset sale is problematic. The C Corporation pays tax on the goodwill at regular corporate rates and then the proceeds are taxed again when they are distributed to shareholders. Total taxes can approach 50% of the proceeds. Converting the company from a C corporation to an S Corporation before the sale won't matter; there is a ten-year waiting period during which an asset sale is treated as if the company were still a C Corp.

If a C Corporation must be acquired as an asset sale, there are a few strategies that can reduce the tax rate. Allocating part of the purchase price to covenants not to compete, employment agreements, and personal goodwill can reduce the amount subject to this double taxation.

It is important to note that an asset sale typically includes both tangible and intangible assets of the selling entity. Intangible assets such as customer lists, business name, trademarks, and patents can be, and usually are, part of an asset sale.

Crafting an Offer

It is convenient to liken the process of buying a business to that of buying a house or an investment real estate property. While the analogy is easy to understand, it is also inaccurate in many ways.

There are a myriad of factors to consider in the mechanics of acquiring a company. There is, of course, the deal structure to consider: That is, what are you buying? Is it a stock sale in which you're buying the stock of a corporation? If so, are you buying 100% of the stock or some lesser percent? Or are you buying the assets? In either case, exactly which assets are included? See chapters VII and X for a discussion of a stock vs. an asset sale.

Then there is the price. How will that price be paid? Will it be all cash at closing, or will some be paid over time. Will some of the price be in the form of owner financing, and if so, on what terms? How much of the payment will be contingent on the future performance of the business? Will the existing owners continue as employees after the closing, and if so, on what terms?

Of course, there will be a period of verification (due diligence), so the buyer can be sure that he is buying what the seller represents that he is selling.

There are several other important details to consider in the somewhat complex process of buying a company. Having just said that, it may sound like a contradiction to say we like to keep the initial offer stage as simple as possible. We advise that buyers submit a non-binding proposal or "term sheet" designed more to establish whether a deal is likely. Such a proposal should outline the buyer's thinking in somewhat broad strokes, recognizing that there are many details that need to be worked out, but establishing the parameters of the negotiations. The seller's response to your non-binding proposal will at least establish whether he is serious about making a deal within the range that you consider reasonable.

Submitting this broad proposal, rather than specifying all issues at this early stage can potentially save a lot of time and money. For example, suppose you determine that a particular target is worth $1,000,000 to your company and you need the owner to remain on as manager of the company he now owns for at least a year under your ownership. You submit a proposal at say $900,000 (figuring you're open to going up on price to $1,000,000) with a stipulation that owner stays on for at least a year full time. Based on your attorney's advice, you specify an asset sale. The buyer, on the other hand, insists on a minimum of $1,600,000 and a stock sale (based on his accountant's advice) and a commitment to remain 6 months maximum. Well, you've spent a few hours putting together a proposal and learned that a deal is not going to happen. That's unfortunate, but it's a lot better than having spent many more hours and many dollars on accountant and lawyer fees working out all the details for a deal that isn't getting beyond the starting gate.

If, on the other hand, the seller responds with $1.1Million as the selling price, and saying he's open to an asset sale with as long as a few other conditions are met and that he'd be happy to stay for at least a year, then we're in the ballpark, and further discussions are merited.

A few tips regarding your initial proposal:

• Make sure it's non-binding. State clearly, "This document is for discussion purposes only and not binding on either party." It would be a good idea to run the document by your lawyer first to make absolutely sure you are not committing to anything you don't with to commit to. But don't let your lawyer talk you into a full-fledged detailed offer at this point.
• For now, assume that everything you have been told is true. You can prepare your non-binding proposal based on this assumption as long as you make it clear that your proposal is based on the information represented to you and that no deal will go forward until and unless you verify that what has been represented to you is true and accurate to your satisfaction. This verification process is called "due diligence". It will come after you have agreed on the major terms of the deal.
• Keep it simple and stay away form legalese. We've seen more than one deal get into trouble at this early stage simple because the seller didn't understand the buyer's proposal. Your proposal here is for discussions between prospective buyer and prospective seller. There is plenty of time to translate your plain language agreement into legalese and to address the myriad of details later.

When presenting the price we like to present the total potential price and then break it down based on terms. For example:

Proposed Purchase Price. MyCo will agree to buy, and the Sellers will agree to sell, 100% of the Stock of the Company for total consideration of $20,000,000 which will be paid as follows:
(i) $10,000,000 in cash at closing and;
(ii) $1,000,000 in equity representing 2.0% ownership in MyCo; and
(iii) A cash escrow of $1,000,000. The escrow will be held for any future claims. If there are no claims the escrow will be released eighteen (18) months following closing.
(iv) 2,000,000 in a note payable over 60 months with a 7% interest rate
(v) 1,000,000 in the form of assuming the mortgage on the property at 123 Main Street
(vi) A dollar for dollar earn-out up to $5,000,000 to the Sellers based upon NewCo generating from $9,000,000 to $14,000,000 of EBITDA in the first year after closing.


Potential terms are discussed in detail below in the LoI Section.

It is our longstanding belief that many, if not most sellers don't really know what they will or won't accept until a proposal is placed in front of them. Remember that selling one's business is often at least as much an emotional undertaking as it is a financial transaction. Unfortunately, it sometimes takes an actual proposal for the seller to realize he is not really a seller at all. Conversely, we have seen situations where a proposal has demonstrated to a prospective seller that selling at a favorable price is a reality and he gets more excited and more serious about the prospect of selling and moving on to the next life phase. We see the non-binding proposal as the gateway to discovering whether a deal is genuine possibility. If such a proposal is positively received, then serious discussions and negotiations can follow.