Co-Authored by Thomas Cockriel, Trenam Law and Shelby Faubion, Vector Advisory Services, LLC
Introduction
Before the sale of a business can occur, buyers and sellers have to, among many other things, agree on the type of transaction they wish to enter into. Generally speaking, the two most common ways to structure the purchase of a business are either a stock /equity purchase or an asset purchase.¹ There may be circumstances that result in a hybrid between these two structures or other structures such as a merger. The structure of the deal is critically important to both the buyer and the seller as there are tax, legal, regulatory, administrative, and post-close integration considerations for each structure type. Accordingly, companies planning an acquisition would do well to seek advice from skilled legal and financial advisory professionals to help ensure the most advantageous approach is selected and to chart a path for a successful business combination no matter the decision.
Given the myriad of published information regarding the relative advantages and disadvantages of stock purchases vs. asset purchase for both the buyer and seller, this article briefly reviews the fundamentals of each but focuses heavily on considerations for each through a Merger and Acquisition (“M&A”) Integration lens. Vector Advisory Services, LLC (“Vector”) has created an integration assessment and planning tool (available for free download on our website)² which helps business owners and sponsors consider each functional area of an acquisition target in terms of its relevance and complexity to integrate, including:
- Human Capital, Leadership & Culture
- Growth (Sales & Marketing)
- Operations
- Technology & Systems
- Finance & Administrative
This article examines the key impacts to the buyer and seller of the purchase agreement structure in terms of each of the functional areas described above. We will also dive into how advisors can add value in both asset and stock sale situations.
Keep reading to learn:
- What is a stock purchase and what are some of the advantages and disadvantages for buyers and sellers?
- What is an asset purchase and what are some of the advantages and disadvantages for buyers and sellers?
- If the newly-purchased organization or assets will be integrated with another entity, what considerations should buyers and sellers be aware of?
- How can advisors add value in either type of transaction?
What is a stock purchase?
In a stock or equity purchase, generally facilitated through a Stock Purchase Agreement or “SPA”, the purchaser acquires all of the target company’s equity from the target company’s shareholders. Once the transaction closes, the buyer becomes the owner of all of the assets and all of the liabilities (both known and unknown) of the target company. Unknown liabilities may include taxes, indebtedness, and pending litigation.
Stock purchases are generally advantageous for the seller because of favorable tax treatment for the seller, as well as reduced exposure to the company’s unknown liabilities that could have resulted from the company’s business prior to the sale. Sellers also often prefer a stock purchase since the seller would not need to wind down the business after the transaction, or deal with any assets or liabilities that could be left behind with the seller in an asset purchase. In a stock purchase, the proceeds to the seller have the opportunity to be taxed at a lower capital gains rate and, in C-Corporations, the corporate level taxes that would be a consideration in an asset purchase are bypassed.³ The target company’s business and assets, including certain attributes such as the federal employer identification number (“FEIN”), business registrations, etc., remain in place with the target company but are now controlled by the purchaser. In addition, stock purchases are often considered simpler transactions because only the equity is changing owners, and the direct ownership of each asset does not have to be transferred from the target company to the purchaser at the closing of the purchase. Buyers on the other hand may be hesitant to do a stock purchase for fear of unknown liabilities that may arise associated with the target business, such as employment practices and/or inaccurate tax reporting under the prior ownership. These liabilities would remain with the target company and become the responsibility of the buyer, however, we note that the buyer might try to obtain indemnity protection for these items from the seller in the stock purchase agreement.
If a buyer is acquiring a company that provides a service or product that is different from their own business, a stock purchase may be more advantageous from a business perspective as many of the considerations highlighted below under an asset purchase would not be immediately required. In a stock purchase, the acquired company can continue to drive revenue while any systems, processes, and people can be evaluated over time.
What is an asset purchase?
In an asset purchase, generally facilitated through an Asset Purchase Agreement or “APA”, the seller retains ownership of the target company’s legal entity and the target company transfers the agreed-upon assets, and generally the operational liabilities (e.g., trade payables) to the purchaser’s entity. Assets can be physical, like equipment, real estate, and inventory, or intangible assets including customer lists, contracts, goodwill, intellectual property, and licenses, just to name a few. As the name implies, buyers typically only purchase certain assets, however, buyers often agree to assume a certain set of liabilities such as obligations under assigned contracts.
In general, buyers tend to prefer asset purchases as compared to stock purchases.
In an asset purchase, all purchased assets change legal ownership at close. In an asset purchase, the seller’s FEIN and business registrations are not transferred to the buyer. Typical actions that are then required include transferring employees to the buyer’s or a new FEIN for payroll, registering in jurisdictions of operation (if an acquisition entity is utilized in the transaction), establishing new bank accounts for the acquired business under a new FEIN, etc. Additionally, one consideration in asset purchases is that some contracts such as leases, on their terms, require consent or notice in connection with an assignment to the buyer and an APA often requires additional consents for leases, suppliers, and customers.
Asset purchases often come with tax advantages for the buyer and disadvantages for the seller. Buyers can gain significant tax advantages by allocating a higher value for assets that depreciate quickly (e.g., equipment) and a lower value for assets that depreciate slowly (e.g., goodwill). Buyers also get a step up in basis in the purchased assets that can have favorable tax implications to the buyer. Sellers, on the other hand, can face higher taxation during an asset purchase because “hard” assets are subject to higher ordinary income tax rates than intangible assets which are typically taxed at lower tax rates. In addition, the shareholders of C-Corporations are subject to double taxation in connection with asset purchases – the corporation is first taxed upon selling the assets to the buyer, then the corporation’s shareholders are taxed again when the purchase proceeds are distributed from the corporation to the shareholders. Finally, the selling entity could be left with the unwanted assets and liabilities of the company after the transaction is completed, which would need to be liquidated or addressed after the transaction closes. The seller would remain responsible for dissolving the company and dealing with any remaining assets and liabilities after the transaction, which creates additional complexity for the seller.
In addition to tax advantages, if the acquisition is primarily focused on expanding existing services an asset purchase may be an ideal approach as it would allow for duplicative systems and processes to be quickly evaluated and consolidated where possible, saving on costs and freeing up cash.
Considerations for M&A
If the purchased entity or assets will be integrated with another entity, it’s important to consider the following when determining the optimal sale structure:
Human Capital, Leadership & Culture
Upon closing, one of the most critically important tasks are to ensure that employee payroll is not interrupted. The deal structure will drive how employees are paid. In an asset purchase, the federal employee identification number or “FEIN” of the target company is not acquired. The FEIN defines the payer and therefore, an acquisition via an asset purchase may necessitate a transition services agreement or “TSA” to allow the seller to continue to process payroll on behalf of the buyer. Otherwise, entity registrations, payroll account establishment and other preparatory activities should be done in advance of close or immediately thereafter to ensure employees are paid as expected.
Other key considerations include:
- In an asset purchase, each employee needs to be rehired by the new entity upon execution of the asset purchase agreement. This could lead to compliance issues if the seller was not diligent in their hiring and compliance practices. It can also be a time-consuming process if employees choose to renegotiate their employment contracts.
- If the target company has employees on an H1-B visa status, there may be additional complications and costs to cover the employee’s sponsorship application, if it is even permissible.
NOTE: Similar human capital, leadership, and culture considerations are true for a stock purchase; however, these issues can be addressed both before and after the close and may be less complex given, if no contrary actions are taken by the buyer, the employees remain employed with the target company on the same terms as before the closing.
Growth (Sales & Marketing)
One of the areas that most buyers are very cognizant of is to ensure that cash flow cycles are not interrupted as a result of the acquisition. In a stock purchase, the buyer can usually leave existing processes in place as there is no need to change the “pay to” entity and receiving bank accounts for ACH payments from the company’s customers. In some cases, no communications to customers may be required with respect to the transaction. However, even in a stock purchase, a buyer may be required to notify certain customers, vendors, or other counterparties that have a change in control or change in ownership clause within their agreements. Additionally, some buyers may have a strategic advantage to recontract with its clients under a new entity (due to tax advantages for example).
Typically in an asset purchase, a buyer will need to immediately communicate to customers that a transaction has been completed, notifying them of any changes to the “pay to” entity and/or bank accounts, and providing all customers with the new entity’s W9.
Other key considerations include:
- All contracts must be reviewed to determine if assignment is authorized or if additional steps such as consent or notice will be required. Further, assignments and/or change of control transactions could trigger various rights to the contract counterparty. Organizations with many customers and clients may find the review and renegotiation process time consuming.
- There is a possibility of lost revenue if previous clients or customers do not wish to work with the new entity.
Operations
A stock purchase is preferred for the continuity of business operations. As ownership of the company remains intact and the management team and employees remain in place, this helps retain key contracts and relationships that may impact operations. With contracts, licenses, and other agreements with third parties, such as suppliers and customers, remaining in place, this can help ensure continuity of operations and relationships and prevent disruptions to the overall business.
In contrast, the buyer may view the continuity of ownership, management, and employees as a deterrent, as this may limit their control over existing operations of the acquired company (e.g., limit the buyer’s ability to make changes to existing operations or culture and otherwise implement contemplated synergies).
Companies in higher regulated industries, requiring numerous licenses and certifications are often acquired via a stock purchase or merger to help minimize business disruptions.
Other key considerations include:
- Buyers may prefer an asset purchase, as it may allow for more flexibility to pick and choose the assets it wants to acquire, allowing for a more targeted integration of operations.
- An asset purchase provides an opportunity to streamline operations and focus on core assets and capabilities, which can help increase efficiency and profitability.
Technology & Systems
As noted previously, contracts that contain certain provisions may need to be renegotiated during an asset purchase. This includes contracts with technology vendors and service providers. These negotiations can add additional time, expense, and complexity to an asset purchase transaction.
Intellectual property rights are especially important to understand in the case of a company that sells or otherwise delivers clients solutions with software and other technologies that are critical to the ongoing success of the business.
In either situation (asset or stock purchase), there may be disparate systems that cover the same services resulting in process and system inefficiencies.
Other key considerations include:
- A buyer acquiring a like-kind organization should make it a priority to review those systems to avoid inefficiencies and potential overspend.
- A buyer expanding its services or product offering might need or want those services to exist independently until such time as an analysis of those systems can be completed.
Finance & Administrative
The finance and accounting functional integration is substantially impacted by the structure of the deal. In a stock purchase, most day-to-day finance and accounting activities can continue with little to no change. Typically, the buyer will take over accounting tasks in the same accounting system, transact banking transactions with the same bank account, etc. However, in an asset purchase, unless a TSA is established, the buyer will need to take over activities immediately after closing, often in a new accounting system, using new bank accounts (under a new FEIN), and ensuring registrations and other filing compliance under the new FEIN is completed.
Other key considerations (if structured as an asset purchase) include:
- The new acquiring entity may lack a credit history needed to re-establish credit accounts with vendors and setting up direct deposits with payroll providers.
- The new acquisition entity must be registered in states where the business is conducted. Having multiple LLCs registered in multiple states requires careful oversight for compliance and planning.
- Vendor agreements may need to be established with the new acquisition entity.
- All suppliers wishing to do business with the new entity will need to update their invoicing processes. This can lead to additional complexity when customers pay through third parties (e.g., insurance).
- In either approach, accounting systems and processes will need to be evaluated to minimize duplicative efforts, ensure transactions are accurately recorded, and consolidated financials are available as/when needed.
- Consolidation of vendor services, office leases, and other services may need to be completed depending on geographic location to minimize unnecessary spend.
NOTE: Some of these considerations are relevant in a stock purchase; however, many of these issues can be resolved post-close.
How do Trenam and Vector Advisory support clients through a transaction?
Transactions, whether an asset purchase or a stock purchase – are complicated and nuanced. Companies benefit from the experience of professional service providers. Attorneys can work with buyers and sellers to shape the various documents from indication of interests (“IOI”) and letters of intent (“LOI”) through the purchase agreement and disclosure schedules in a manner that works best for their client. At the end of the day, both the buyer and seller must be on the same page with respect to the deal structure or an agreement will not be reached. Implications for the buyer and seller must be well understood so that the impact can be measured carefully before agreement is reached.
Advisory firms like Vector Advisory Services can support buyers and sellers by sharing experiences and bringing organization, structure, and leadership to the M&A process from pre-signing through signing and closing, and beyond. Vector Advisory offers:
- Pre-close deal management, data room management, and integration planning
- Post-close integration planning, management, leadership, and execution support
- Post-close accounting deliverables, including the recording of the opening balance sheet, working capital calculations, closing statement preparation, lender compliant reporting, etc.
- Specific, tailored integration planning tailored to the needs of each unique transaction
Summary
Both asset and stock purchases are complicated transactions for both the buyer and the seller. Understanding the key considerations across the entirety of an organization will help improve the likelihood of a successful transaction regardless of the type of sale. This article focused on the key considerations of each type of transaction for various functional areas of the organization, including HR, Operations, Technology, Sales/Marketing and Finance. Vector Advisory is an experienced M&A integration advisory firm and has helped many clients navigate complex transactions with favorable outcomes.
About Shelby Faubion
Shelby Faubion is the founder and Managing Partner with Vector Advisory. Shelby has a diverse background with over 25 years in corporate finance and accounting, “Big 4” (KPMG and PwC), boutique consultancies, start-ups, and global industry leaders. He specializes in delivering comprehensive and cost-effective M&A advisory services, including merger and acquisition integration, financial due diligence as well as post close accounting and finance services. Shelby also delivers a variety of CFO Advisory services, including interim financial leadership and other solutions that optimize the office of the CFO.
About Vector Advisory
Vector Advisory is the go-to partner for private equity firms, family offices, and their portfolio companies. We provide cross-functional leadership to drive successful merger and acquisition integration and portfolio company on-boarding. We also deliver best practice solutions across the office of the CFO, providing interim management and financial transformation services to optimize accounting transaction processing and financial reporting. If you’re looking for a trusted partner to facilitate a successful transaction, contact us to learn how Vector Advisory provides this expertise at a great value.
About Thomas Cockriel
Tom Cockriel is a shareholder in Trenam’s Business Transactions practice group. Tom’s practice focuses on corporate and business transactions, including mergers, acquisitions, and sale transactions, capital raising transactions, intellectual property and technology agreements, trademark and copyright protection, commercial contracts, and other general business legal matters. His clients include private equity and venture capital investors, entrepreneurs and business owners, startups and local and regional businesses. Tom also provides strategic and commercial advice to companies on all aspects of technology transactions, including intellectual property portfolios, IP licensing, software and data issues, strategic sourcing, cloud computing, IT infrastructure, data protection, and cybersecurity. His experience in numerous industries, including emerging technology, financial services, software, digital platforms, and medical devices, provides clients a broad-based perspective on critical issues.
About Trenam Law
Trenam Law’s corporate attorneys represent numerous public and private enterprises, financial institutions, private equity and investment funds, and portfolio companies in connection with all phases of mergers and acquisitions, from initial structuring through closing. We represent both sellers and purchasers, and our work spans mergers, stock and asset purchases and dispositions, as well as other transactions that transfer business interests, including joint ventures of all types. Because we are a full-service law firm, we are able to draw upon the experience of our attorneys in other practice areas as well in all phases of the transaction, including employment, real estate, litigation, intellectual property due diligence, tax structuring, and other necessary areas to support our clients and the particular transaction.