Introduction:
When purchasing an ongoing business, the structural method of the purchase can be one of the key negotiating points. Put simply, sellers often want the buyer to purchase the outstanding shares or membership interests of the company while the buyers normally want to purchase selected assets and leave certain of the corporate or limited liability entity assets (and liabilities) with the sellers who continue to own the entity.
This article shall discuss the rationale for the different approaches to buying a business and explore key areas of concern.
Asset Purchase vs. Stock Purchase: The Basic Difference.
Most business entities are limited liability entities, either limited liability companies or corporations. Both types have owners who control the entity and it is the entity that enters into contracts, hires employees, pays taxes, engages in business, pays vendors, collects sums due and owns the various assets of the company. It is also the entity that normally owes the debts and taxes of the business though at times vendors may require personal guaranties from the owners of the entity. Corporations normally also pay corporate tax, while limited liability companies are pass- through entities in which the members normally are liable for their prorata share of the taxes, much like partnerships.
Whether a corporation or limited liability company, the entity, itself, is the owner of the assets while the owners of the entity own either shares of stock or membership interests of the entity.
A buyer can either buy the stock or membership interests and thus ownership of the entity itself, gaining control of those assets owned by the entity or, alternatively, a buyer can purchase selected assets directly from the entity, leaving unwanted assets with the entity.
If the entity is purchased, the buyer buys all the assets but also buys all the liabilities of the entity, including potential tax liability and current tax status of inventory and depreciable equipment must be factored in. If the assets are purchased, that successor liability can usually be avoided by various procedures, such as a statutory Bulk Sales Notice which gives published notice to the world of the purchase and if a creditor does not put in a claim within a specified time period, the successor liability is usually extinguished. If a bulk sales notice procedure is utilized, buyers normally only agree to proceed with the purchase if the potential creditors are paid out of escrow from the sales price, thus eliminating the potential liability entirely.
Keep in mind that absent the bulk sales notice process, described in other articles, the liability of the buyers for unknown liabilities may still exist. The buyers may have a claim against the seller for failure to disclose such debts, but often the sellers no longer have assets to obtain in litigation and the third parties will not be stopped in seeking relief against the buyer because a buyer relied on representations of a now missing or asset poor seller.
Indeed, it is quite possible for an entity to sell the bulk of its assets but remain in business in another field or restricted to only one type of product or market. Thus, I could buy all your assets you need for your construction business, but you could remain in business consulting on construction in earthquake zones or the like…if the asset purchase agreement so allowed.
Buyers Normally Want to Buy Assets.
Most buyers do not want to have to deal with the myriad obligations that may exist on the part of the entity. They may wish to buy equipment and inventory, good will and customer lists, perhaps the name and logo, but the entity itself, with possible unknown tax and vendor liabilities and/or disputes between the owners, is something that buyers wish to avoid.
By properly publishing the Bulk Assets sales notice, the buyer can be free of unknown claims regardless of whether the seller remains solvent after the sale and if creditors suddenly appear in response to the notice, the buyer can either walk away from the deal or negotiate down the price unless the seller pays the creditor. Disputes involving the entity ownership or rights that may exist are not something a buyer need worry about once the entity executes the sales agreement and the tax treatment may be more favorable to the buyer if the buyer need not include in its analysis the tax planning…or lack of planning…that the seller engaged in while controlling the entity.
Determining the value of an ongoing business is made easier if the various nontangible assets that are not being purchased are not included. And various claims from employees, governmental entities, third party vendors and even competitors of the entity remain with the entity. As one buyer we represented commented during negotiations in an e mail to the seller, “Let’s keep it simple. I don’t want to know what you did ten years ago or what tax ploys you may have explored. I want some assets and your contacts and that is what I will buy. You keep the shell and all that baggage that may exist…”
There are other benefits. Such issues as pension plans, 401K plans, bonus plans, stock options, ESOPs and the like are left to the Seller to handle and the buyer avoids having to master the often-arcane world of employee benefits and options or potential employee related claims that may exist involving the entity. The cost for expert pension plan advice and CPA involvement can be avoided and any employment agreements between the entity and an employee do not bind the buyer of assets.
Bookkeeping can be made far easier. Ancient inventory which must somehow be evaluated can simply be left with the entity and the buyer selects what will be of most value to the buyer.
However, buying assets is not a silver bullet. Some third-party creditors may still try for successor liability, claiming defects in the bulk sales notice and the tax ramifications of purchasing certain assets must still be carefully considered. Additionally, such third parties as suppliers, lessors, equipment lessors and financing companies may have claims on the assets wanted by the buyer and negotiations will still be required for these whether an asset purchase or entity purchase.
Sellers Normally Want Entity Purchase.
One reason for the seller wanting an entity purchase is the same reason buyers seldom want it: the entity with all of its issues, problems, tax status and employee rights is simply transferred to the buyer and with the right indemnity provisions, the sellers walk away with whatever profit they gained from the sale and no further liabilities assuming they made full and fair disclosure of existing liabilities, both actual and contingent. As one seller told the writer, “I sell the business, I sell the risk. If I’m going to keep the risk, I might as well keep the upside as well.”
Most sellers feel buyers seek to cherry pick the best assets and would leave the questionable assets and potential liabilities with the sellers in a shell without significant assets left. Further, getting the money out of the entity to the actual owners may have problems with creditors claiming such transfers should allow successor liability against the owners and may also have tax ramifications that make the sale far more tax expensive for the sellers. The process of dissolution of the entity often occurs after the sale of most of its assets and that process requires as much notice to creditors as any bulk sale and costs money for attorneys and accountants. If the entity is not dissolved, monies transferred out to the owners may be treated as dividends and taxable.
Employee rights can also still be an issue for the entity left with few assets. Pension plans, ESOP, employment contracts and obligation remain with the entity and can lead to personal liability if Federal law as to pensions is not complied with closely.
Some owners of the entity may not want an asset sale since they want the stock or interests sold and the money in their pocket. While that can happen if the entity is dissolved, some owners may not want to dissolve it for tax or future business reasons. Remember that the bulk sale of assets has the money going to the entity and that does not automatically put the money in the hands of the owners. This potential dispute is entirely avoided if all the stock is sold.
Of course, in a stock sale, each shareholder is selling his or her own stock. An owner could refuse to sell the stock and interfere with the entire sale. This seldom happens since the other owners apply pressure and make it clear that if one owner nixes the sale, they will not continue working to make the company operate well and that the objecting shareholder has only one chance to successfully liquidate the shares and it is this sale. Nevertheless, some companies with toxic relationships between the owners are incapable of being sold since no buyer wants to get involved in that dispute. Again, an asset sale can avoid that very issue for the buyer.
Lastly, there is often an advantage to certain owners who are offered generous salaries if the company is sold and they are hired as employees or consultants to the new company. That may not be possible if they remain officers or employees of the old company since they could end up in a conflict of interest or face objections from other shareholders who claim that they are getting “extra” value for their stock via the compensation and that is a violation of their duty to get the same stock price for each owner. An asset purchase puts the money in the corporate coffers and must be approved by the board and, usually, shareholders. In discussing the vote, the other owners can also determine other compensation going to certain shareholders and determine if they want to support the sale, either asset or stock.
In short, there is typically a conflict of interest between the buyer wanting an asset sale and the sellers wanting a stock or interest sale.
Solutions Via the Purchase Agreement.
Many of the problems can be avoided by careful drafting of the sales agreement. Buyers concerned about undisclosed liabilities can insist upon full indemnity if such liabilities arise, with personal guaranties and an escrow account set up to pay such liabilities if they emerge in X time. Different tax costs can be analyzed and factored into the actual purchase price with tax liability resulting in reduction in sales price for the entity. Sellers can be required to obtain unanimous consent of all owners and approval of all employees who have rights under pension plans, ESOP, etc.
In short, an intelligent buyer can go along with a stock purchase if the buyer integrates into the sales arrangement the protections and liabilities that may exist in the purchase of the entity. The sellers can then elect to go along or not, but the exercise may simply have the use of demonstrating to both buyer and seller the true value and cost of the sale.
Expert tax advice is as critical as good legal advice in determining how to structure the sale and the terms of the sales agreement. This may also include considerations of any employment or consulting agreements that may be entered into; the value of any noncompete clauses that the sellers may have to execute; and the tax effect of contingent liabilities arising down the road.
The solutions should be considered prior to making any offer or accepting any offer. The very act of making an offer can often cement parties into positions that are difficult to change. Employees, shareholders or officers may have been told the outline of a deal, made plans on it, and will resist inventive solutions to the underlying problems. There is no reason not to consider both an asset purchase and a stock purchase if you are a buyer, having a list of requirements you would want in the latter. As for the seller, it is likely that other buyers will have the same issues to confront so the wise seller examines methods to avoid the typical deadlock that can occur.
Conclusion:
It is vital to understand that negotiations, while often vigorous, need not be combative. The best negotiator known to this writer would play act the other party’s position prior to making any offer so that the full panoply of options become very clear as well as likely motivations. He would force himself to challenge his own assumptions, consider whether the deal made sense for both sides, even question his own motives as a buyer (or seller) and seek ways to safeguard the assets or deal as if he was the other side. By the time the negotiations progressed to deal points there were no surprises for him and he was not prone to emotional reaction.
He commented to the writer that he often came up with better deals for the other side than they would have thought of since he had already considered their position in such detail. He prided himself on making fair deals that were often true “win-win” deals. He wrote me the following e mail: “Any predator can force a weak opponent to give way and take a lousy deal if the situation is desperate enough for them. That does not show much skill in my book. Making a fair deal even when you don’t have to works for me.”
It must have. He died a multi-millionaire in a time when that was still a lot of money. Using that method can perhaps save a transaction which faces the conflicts described in this article.