When buying or selling a business, the parties involved have two options: an asset sale or a stock sale. These two types of transactions entail very different implications in the transfer of assets and liabilities. To complicate matters, such transactions involve a good amount of technical accounting, finance, and legal terminology. The goal here is to clarify this terminology and delineate what the potential outcomes are in either type of transaction for buyer and seller.
Background and Definitions
It is helpful to start with the basics, so let us look at assets, liabilities, and shareholders’ equity. A good primer on this subject is the balance sheet – one of the three core financial statements used to evaluate a business, the others being an income statement and a cash flows statement. Balance sheets provide a momentary snapshot, representing the state of a company’s finances at the date of publication.
Balance sheets show what a company owns, its assets; what a company owes, its liabilities; and, the money attributable to a business’ owners, its shareholders. By definition a balance sheet must balance. Therefore,
- Assets = Liabilities + Shareholders’ Equity
For example, assume a company has no shareholders, assets, or liabilities. If this company takes out a loan for $5,000, it now has an asset of $5,000. The loan must be paid back, however, so the company has also assumed a liability of $5,000. According to our equation above, $5,000 = $5,000, and the balance sheet balances.
Turning to what constitutes the components of a balance sheet:
1. Assets
- Cash and cash equivalents - equivalents include highly liquid assets such as Treasury bonds or short-term certificates of deposit that are easily converted to cash
- Marketable securities - stocks and bonds owned
- Accounts receivable - what customers owe
- Inventory
- Prepaid expenses - what a company has prepaid examples often include rent or insurance
- Long-term investments - securities that cannot or will not be liquidated in the next year
- Fixed assets - such as buildings, vehicles, machinery, equipment, and other durable assets
- Intangible assets - such as intellectual property and goodwill (i.e. the value associated with trademarks, patents, proprietary technology, etc.)
2. Liabilities
- Current portion of long-term debt
- Bank indebtedness
- Interest payable
- Wages payable
- Customers prepayments
- Dividends payable
- Earned and unearned premiums
- Accounts payable
- Long-term debt - principal and interest on bonds
- Pension fund liability - money a company must pay into employee retirement funds
- Deferred tax liability - taxes that have been accrued but will not be paid for another year
3. Shareholders’ Equity
For the sake of simplicity, we will consider shareholders’ equity to reflect the money attributable to a business’ owners. This element of the balance sheet is also known as “net assets” because it is equivalent to a company’s total assets minus its liabilities. Holding stock in a company means that one is a shareholder of that company, and, therefore one of the business’ owners.
Asset Purchases and Sales Versus Stock Purchases and Sales
Buyers and sellers are often at odds in their preference for asset sales versus stock sales. In general, buyers prefer asset sales while sellers prefer stock sales. The pros and cons to each structure are as follows:
Asset Sales
In asset sales, the seller remains the owner of the legal entity (i.e. the business), and the buyer acquires assets of the company such as inventory, equipment, licenses, telephone numbers, and goodwill. Some asset sales do not include purchasing the seller’s cash, and the seller retains its long-term debt obligations. These acquisitions are known as cash-free, debt-free transactions.
Generally normalized net working capital is included in a sale. Net working capital typically includes inventory, prepaid expenses, accounts receivable, and accounts payable.
- Pros:
- A buyer can “step up” the depreciable basis in its assets. What “stepping up” means is that the buyer can allocate a higher value to assets that depreciate quickly – such as machinery and vehicles; and, they can allocate a lower the amount to assets that amortize slowly – such as goodwill. By doing so, the buyer may obtain tax deductions for depreciation and/or amortization.
- Taking advantage of tax deductions enables buyers to improve their cash flows more rapidly.
- Buyers are able to select which assets and liabilities they are willing to assume in the acquisition.
- Buyers can more easily avoid inheriting liabilities such as product warranty lawsuits, product liability, employee lawsuits, and contract disputes.
- Since the buyer’s exposure to liabilities is limited, fewer resources (time, money, etc.) are needed to conduct due diligence.
- Buyers may choose which employees they wish to retain or let go without affecting the unemployment rates they must pay to the government.
- Cons:
- The tax cost to asset sellers is usually higher. Though intangible assets are taxed at capital gains rates, other assets generally carry higher income tax rates.
- Assets may need to be retitled.
- Buyers may need to renegotiate employment agreements, customer contracts, and supplier contracts.
- Sellers potentially have to pay any liabilities not assumed, liquidate any assets not purchased, and terminate leases.
Stock Sales
Stock sales are markedly different from asset sales. With stock sales, a buyer purchases stock directly from an existing shareholder, gaining ownership in the seller’s legal entity. There is no transfer of individual assets to the buyer because the title of each asset lies within the legal entity.
- Pros:
- Stock sales tend to be less complex transactions in part because the seller’s contracts transfer automatically to the buyer.
- Sellers’ proceeds are taxed at a lower capital gains rate.
- Buyers may potentially be able to avoid transfer taxes.
- Re-valuations and retitles of individual assets are not necessary.
- Since the legal entity maintains ownership of any assets that are difficult to assign – such as government or corporate contracts – a stock sale is preferable to an asset sale. It is more likely that the company in question will not lose those contracts with large customers or vendors.
- Buyers can usually assume licenses and permits without having to obtain specific consent.
- Sellers may benefit from reduced responsibility for future liabilities such as employee lawsuits or product liability claims. However, the specific terms in a purchase agreement could shift liabilities back to the seller.
- Cons:
- Buyers cannot “step up” the basis of their purchase and re-depreciate certain assets, losing the tax benefits of an asset purchase.
- Goodwill is not tax-deductible when it exists as part of a share price premium.
- Buyers are unable to pick and choose the assets and liabilities involved in the purchase. Unwanted assets and liabilities must be distributed or paid off prior to the transaction.
- Assets transfer at carrying value. Carrying value is a measure calculated by subtracting accumulated depreciation from an asset’s original cost. Carrying value is almost always lower than market value.
- Buyers assume additional risk with a stock purchase, including those liabilities that are unknown or undisclosed. These liabilities may be reduced in the purchase agreement via representations, warranties, and indemnifications.
- A representation is an assertion that a fact is true on the date the representation is made. It is meant to convince another person to enter into a contract.
- A warranty is a promise of indemnity if the assertion is not true.
- An indemnification is security against legal liability.
- Applicable securities laws, pertaining to the purchase and sale of stocks, must be managed and may complicate the process, particularly when the entity has many shareholders.
- Transactions may become more difficult when some shareholders do not wish to sell their stocks, increasing the time and money costs of the acquisition.
There are many factors to consider when undertaking a transaction. Black Iron Advisers (BIA) exists to bring together buyers and sellers and help them decide the optimal way to structure their deal. BIA exclusively represents our clients, and our preeminent concern is assisting you in realizing your future business goals.