Purchasing an existing business is a monumental decision. It requires intensive review, significant investment, and monetary commitment. When purchasing a business, the transaction will either be an asset purchase or a stock purchase. This article will give an overview of those transaction types and pros and cons associated with each. There are several key factors that purchasers must take into account when choosing which option they will implement, including commercial, legal, third-party consents, and time requirements.
A Note on Corporate Structure Implications
Before getting too far into the ins and outs of the different purchase types, please note that if you are contemplating acquiring a sole proprietorship, partnership, or a limited liability company (LLC), then, by definition, a stock sale is not an option as none of those corporate structures has stock which can be sold.
There is no entity to purchase in a sole proprietorship; these will always be asset purchases.
When purchasing a partnership, it will nearly always be an asset purchase. A general partnership is dissolved when the partners exit the business, and a partnership cannot exist with a sole owner. There are complex ways to enter a partnership, convert it to another form of entity and then carry forward, but those are beyond the scope of this article. Further, those types of complex machinations are typically not required.
When purchasing a limited liability company, a buyer is acquiring the membership units in the target, as opposed to stock. For the limited purposes of this article, we will consider those purchases analogous to a stock purchase.
In corporate asset purchase transactions, the selling party retains legal ownership over the entity, and the acquiring party buys individual assets of the corporation such as equipment, licenses, client lists and inventory. Asset purchases do not involve buying the target company’s capital (i.e., cash accounts, accounts receivable, investments), and the selling entity remains obligated to fulfill any outstanding debts. Acquiring companies may opt for asset purchases over stock purchases because they offer a greater degree of flexibility. Asset purchases allow the buyer to retain the ability to cherry-pick the individual assets and liabilities it feels align with its financial and business objectives.
Benefits of Asset Purchases
Asset purchases offer a potentially significant tax advantage in that the acquiring company can “step up” the basis of assets over present tax valuations, and take advantage of tax deductions for either depreciation or amortization, or both in some instances. Additionally, any goodwill associated with the transaction, which is the amount paid for the target business over and above the market value of its tangible assets, can be amortized on a straight-line basis over 15 years for tax considerations—as opposed to a stock purchase where the buyer cannot deduct goodwill on taxes until the stock is resold.
The asset purchase route also enables the buyer to control if it will assume any existing liabilities associated with the target entity. This mitigates potential risk to the buyer in the form of unforeseen obligations either not revealed by or known to the seller. This has the correlated bonus of minimizing the time and money expense required for conducting due diligence prior to the acquisition. The acquiring company can dictate which assets it will not buy. For example, if the purchasing company decides that the seller has numerous accounts receivable it will not be able to collect on, then it can opt not to purchase the target’s accounts receivable.
Last, but certainly not least, minority shareholders who are reluctant to sell their shares can be essentially sidelined with an asset purchase (provided the governing documents permit the sale of assets at a threshold above the minority stake). In a stock purchase, adversarial minority shareholders can stall the acquisition process and make it more expensive in the long run.
A stock purchase is more simplistic conceptually compared to an asset purchase transaction. The acquiring company purchases the stock of the target entity and assumes the target company as it finds it with respect to both its preexisting assets and liabilities. Generally, the contracts the target company has, including leases and any applicable permits, automatically transfer to the buying party. This makes it a more efficient and streamlined—albeit riskier from the purchaser’s perspective—process than an asset purchase.
Stock purchases are generally ideal for a purchaser seeking to acquire a business that is operating without the threat of liquidation in the immediate future. When there is economic instability, purchasers may prefer stock purchases as their basis in the purchased assets will not exceed the fair market value of the purchased assets. This means that if a purchaser is acquiring assets from a seller whose asset valuations have decreased, the asset purchase would result in a “step-down” basis of the acquired assets.
Stock Purchase Pros and Cons
The upsides of a stock purchase include the fact that the buyer does not have to conduct expensive re-valuations and retitles of each individual asset of the target company. Additionally, buyers can usually assume non-assignable licenses and permits without having to first acquire specific consent from the issuer. When it comes to taxes, purchasing companies can potentially avoid certain transfer fees as well.
There are some drawbacks, however, when it comes to conducting stock purchases. The key disadvantages are that the buyer is unable to receive the aforementioned “step-up” tax break as well as the fact that they are unable to unilaterally elect which assets and liabilities they will assume from the target entity. There are also certain securities regulations that can make stock purchases complex and non-consenting shareholders may be unwilling to sell their stocks which can increase the transactional cost for the acquiring party.
And, of course, the major drawback is purchaser buys not only the assets of the business, but any preexisting liabilities as well, known or unknown, disclosed or undisclosed.
The Importance of Due Diligence
Regardless of whether the acquiring company chooses a stock or asset purchase, it must conduct due diligence. This refers to the process of aggregating and analyzing all the pertinent information of the target company to determine any factors that may significantly impact the transaction and/or its valuation. Typical due diligence concerns related to asset purchases include the nature and ownership of the assets and liabilities the buyer will ultimately elect to take on. For stock purchases, due diligence includes researching the target company’s stock, contractual obligations and existing liabilities. Generally speaking, the buyer will need to conduct a lengthier due diligence process with a stock purchase due to the inherently higher degree of risk associated with assuming potentially unanticipated liabilities.
For more on Due Diligence, see our article here.
Francine E. Love is the Founder & Managing Attorney at LOVE LAW FIRM, PLLC which dedicates its practice to serving entrepreneurs, start-ups and small businesses. The opinions expressed are those of the author. This article is for general information purposes and is not intended to be and should not be taken as legal advice.