Buying or selling a business is an exciting yet onerous time for both buyer and seller. The deal process will be filled with important decisions such as: How much risk should we assume? Is the target company in an industry I want to enter? What is the best method to value the target company? And the list goes on.
One of the very first decisions that will need to be agreed upon by both parties deals with how the transaction will be structured. Will the buyer be purchasing the stock or equity of the target company, or will it purchase only its assets? The decision involves time and attention as both the buyer and seller will have various reasons to prefer one transaction structure over another. Below are differences between an asset and equity deal and some of the benefits and drawbacks to each.
Pros and cons of a stock or equity deal
A stock or equity deal refers to the acquisition of the stock or ownership interests in the target company (i.e., a partnership, limited liability company, S corporation, C corporation, etc.). Equity purchases result in the transfer of the ownership of the target company, but the target continues to own its historical assets and liabilities after the deal closes. Several advantages and disadvantages exist in an equity acquisition structure:
Complexity. Equity deals are relatively straightforward as the assets and contracts of the target (e.g. leases, permits, vendor agreements, purchase orders, etc.) remain with the target company without additional need for renegotiation. It is, however, important to ensure that all securities laws have been properly considered and dealt with before selecting this method of acquisition.
Cost. An equity deal is generally less expensive to execute as the buyer does not have to revalue or retitle individual assets. The need for negotiating with third parties on contracts is also less likely unless the document includes a provision prohibiting a change in control of the target.
Taxes. Usually, an equity deal is not as advantageous for a buyer from a tax perspective. A buyer will not receive the benefit of a tax basis step-up nor will goodwill (in the form of a share price premium) be tax deductible. However, in most states a buyer can avoid paying transfer taxes on assets assumed in an equity deal. Depending on the value of the real estate and other assets involved, this could be a significant savings.
Risk. A buyer often assumes more risk in an equity transaction because the buyer is assuming the historical liabilities of the target company. A buyer in essence steps into the shoes of the seller and takes ownership of the target company “warts and all.” It is important to ensure that a buyer performs proper due diligence during the deal process and appropriate protections are negotiated into the purchase agreement such as strong representations and warranties and corresponding indemnification language to protect the buyer from the liability for claims based on the operations of the target company’s business prior to closing.
Pros and cons of an asset deal
In an asset deal, a buyer has the ability to pick and choose specific assets of the target company and exclude taking on the liabilities of the target unless specifically assumed. In the current economic climate, asset deals tend to be more common; however, pros and cons still exist in an asset deal as well:
Complexity. Asset purchases are typically more complex than an equity deal as most contracts, especially those with employees, customers, and vendors, will require the consent of the other party to the contract to assign them to the buyer or in some cases the contracts will have to be renegotiated in their entirety. Certain assets of the target (e.g., automobiles, airplanes, real property, etc.) will also have to be retitled in the name of the buyer.
Cost. Due to the additional complexities inherent in an asset deal, asset deals are generally more costly from both the buyer’s and the seller’s perspective. Additionally, a seller may need to sell off any assets not purchased and will have to settle any outstanding liabilities not explicitly assumed in the deal. However, due to the tax implications discussed below, sellers may be able to command a higher purchase price in an asset deal to offset higher tax costs.
Taxes. Buyers generally prefer an asset deal as the buyer can “step up” the basis of the acquired assets to fair market value. This results in additional depreciation/amortization deductions over time. Furthermore, a buyer can amortize goodwill over 15 years for tax purposes. Sellers commonly bear higher tax costs in asset deals, as assets can be subject to higher ordinary income tax rates. In some cases, if the target is a C corporation, a seller may even face double taxation.
Risk. Because a buyer may pick and choose the assets and liabilities it wishes to acquire, an asset deal is generally less risky from a buyer’s perspective. Nevertheless, it is still important to ensure adequate diligence is performed on the target’s business.
The transaction structure of any deal can have major tax, legal, and business implications for both parties. It is important for both a buyer and a seller to consider the benefits and consequences of each type of transaction. One of the easiest decisions you can make during the transaction process is which legal advisor to use. The team at Brouse McDowell is experienced in all aspects of a transaction and can help you decide whether an equity or stock deal is more advantageous for your particular situation.