You’ve worked for years in building the value of your company, looking towards an exponential return upon sale. With a little wind at your back and a favorable economic outlook, you’re beginning to field some inbound interest. Maybe it’s the long-standing competitor looking to grow market share, the private equity firm looking to add value-added services to their portfolio, or the financial buyer looking for asset diversification and solid returns. Prospects are beginning to flow!
It’s exciting to have someone take interest in your “baby”. You’ve poured your blood, sweat, and tears into the business and you’ve finally “arrived”, gaining the attention of some key players. It’s energizing to share your passion, story, growth trajectory, and key accomplishments and the initial conversations are overwhelmingly positive!
You entertain a couple additional prospective buyer meetings and get some high level terms on your table napkin. Wow, they said they’d offer $10M for my company! Who knows what 2019 will bring and I’m not sure I want to weather another downturn… This sounds almost too good to be true and they made the process sound pretty simple!
And the hook is set…
For the purposes of this post, we’ll not address how much cash you may actually receive, the due diligence process, the performance caveats, or the non-competition agreements you’ll encounter. We’ll cover the deal structure (what is actually being bought and sold): asset vs. stock sale?
Once you’ve arrived at some key high-level terms, it is important to address the structure of the deal. Is it the ownership interest in the business (Stock sale) or are only selected assets being transferred without an actual transfer of the business entity (Asset sale)? Identifying the structure early on helps to avoid major pitfalls and unintended tax consequences.
An asset sale is the purchase of individual assets and liabilities, whereas a stock sale is the purchase of the owner's shares of the corporation. Approximately 35% of the deals we see are structured as asset sales. Tax implications and potential liabilities are the primary drivers in negotiating the type of transaction.
In an asset sale, the seller retains possession of the legal entity and the buyer purchases selected individual assets of the company (equipment, fixtures, licenses, goodwill, customer lists, trade names, IP, and inventory. Asset sales generally do not include cash and the seller typically holds onto long-term debt obligations. Accounts receivable, prepaid expenses, accounts payable, etc. are typically included in the sale.
The buyer has the opportunity to select those assets which it desires while not absorbing specified liabilities. An asset sale also allows buyers to "step-up" the company's depreciation. The buyer can gain tax advantages by allocating portions of the purchase price to certain asset classes to maximize annual depreciation, stabilizing cash flow in the first few critical years of the acquisition. Buyers also prefer asset sales because they avoid absorbing potential liabilities (current and future), especially contingent liabilities in the form of product liability, contract disputes, warranty issues, or employee lawsuits.
An asset sale isn’t a “clean exit” and typically involves the owner winding down the legal entity, paying off long term notes, and remaining entangled in affairs longer than they’d like. An asset sale also generates a higher tax burden, lessening the actual net amount shareholders receive from sale proceeds. Intangible assets (goodwill) are taxed at capital gains rates (Federal rates are currently 20% - with no state tax in Florida). "Hard" assets can be subject to higher ordinary income tax rates. Ordinary income tax rates depend on the seller's tax bracket (could be 40% depending upon your personal bracket).
The legal structure of your company also plays a role in determining the tax treatment. If the entity sold is a C-corporation, the seller faces double taxation. The corporation is first taxed upon selling the assets to the buyer. The corporation's shareholders are then taxed again when the proceeds transfer outside the corporation.
Through a stock sale, the buyer purchases the selling shareholders' stock directly obtaining ownership in the seller's legal entity. Assets and liabilities not desired by the buyer will typically be distributed or paid off prior to the sale. Unlike an asset sale, stock sales do not require numerous separate conveyances of each individual asset because the ownership of each asset resides within the legal entity.
Buyers lose the ability to gain a stepped up basis in the assets and must utilize the book value of the asset for depreciation. This lower depreciation expense can result in a short-term reduction in cash flow and potentially higher future taxes. Buyers also accept more risk by purchasing the company's stock outright. Future lawsuits, employee suits, and other liabilities become the responsibility of the new owner.
Although the buyer typically prefers an asset sale, unassignable contracts, leases, permits, contracts, etc. held by the company may necessitate the buyer executing a stock sale. A stock sale may be a better option because the corporation, not the owner, retains ownership of the key contracts and poses little to no business interruption.
Sellers typically favor stock sales because all the proceeds are taxed at a lower capital gains rate (maximizing the net cash proceeds to the owner on sale). Sellers also see the stock sale as a “clean break” due to their decreased responsibility/risk for future liabilities.
Every deal is unique and is often more complex than initially expected. Deal structure evaluation is critical to address the various implications to net proceeds, future responsibilities, and risk management. It’s important to have the right team in your corner to deliberately address the critical aspects of your exit to increase the probability of achieving “success” on YOUR terms.