Transaction Structures – Part 1: Sales
The Anatomy of a Deal Newsletter June 28, 2019
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
We’ve touched on deal structures in previous installments of this series, but because it matters so much, we’re dedicating two pieces entirely to this topic.
Executive summary: Deal structure matters!
While M+A transactions come in a number of different forms and there are many hybrids and different permutations of each, there are basically three common structures:
- Asset Sale
- Equity Sale
Now let’s talk generally about each of these structures and why they may be beneficial for a Buyer or Seller.
Before we do that, the obligatory caveats, disclaimers, and legalese: The below summaries and discussions are generalizations only. The actual impact may differ depending on the specific facts and circumstances. As such, you still need to get specialized advice before committing to a particular structure.
Also, because of length, this installment will focus on Asset and Equity Sales, and we’ll save Mergers for next time.
With that out of the way, let’s dive in.
As the name implies, the Seller in an asset sale sells some (or all) of its assets to the Buyer. The Buyer, as the new owner of those assets, simply picks up operations of the Seller’s former business under the Buyer’s umbrella. The Seller continues to exist as a legal entity and will retain any assets and liabilities that weren’t acquired by the Buyer. This will help illustrate:
When the asset sale is completed, it looks like this:
Buyers generally love asset sales because they can pick and choose the specific assets they are acquiring, as well as the specific liabilities they are choosing to assume (which usually means that the Buyer assumes very few – if any – liabilities of the Seller). Everything else stays with the Seller. And Buyers get even more bang for their buck because, in an asset sale, the Buyer generally gets the ability to allocate purchase price specifically to the assets it is acquiring for tax purposes, which allows the Buyer to take tax depreciation and amortization deductions. This effectively allows the Buyer to write-off the purchase price, though generally over a period of years.
Asset sales also can be accomplished without approval of all of the target company’s owners. In most states, the vote of somewhere between a majority and 2/3 of the owners is required to approve the transaction.
On the other side of the coin, Sellers may prefer to avoid an asset sale for many of the same reasons. First, because the Buyer gets to pick-and-choose the assets and liabilities it is acquiring, the Buyer will naturally take the best assets and leave the Seller with less desirable assets and most of the liabilities relating to the business – some of which may be truly ordinary operating liabilities. Also, because the Buyer is allocating the purchase price directly to the assets it is acquiring, the Seller may find itself paying income taxes at the higher “ordinary income” rates as depreciation recapture. That result might have been avoided in an equity sale, as described below.
Furthermore, the nature of the asset sale oftentimes leads to headaches for both Buyers and Sellers. For example, the acquired assets and liabilities will actually have to be transferred to the Buyer. So, if there are titled or recorded assets (e.g., real estate, vehicles, intellectual property etc.), the title to those assets will need to be physically transferred. A mistake may leave the Buyer without all of the assets it needs. In addition, many contracts contain “anti-assignment” provisions that prohibit the transfer of the contract without the other party’s consent. These may lead to uncomfortable conversations with customers, suppliers, and third parties where the Seller must ask that party to consent to the deal. At best, this takes time and expense to complete this process while your deal hangs in the balance; at worst, these third parties may determine that your transaction provides the leverage to re-negotiate their deal with you, or outright deny their consent to the deal.
Asset sales also pose issues with employees. All employees of the Seller who are going with the Buyer technically are terminated by the Seller. If the Buyer doesn’t hire all of them immediately at closing on the same or better terms, you could run into issues if those employees seek out a lawyer to claim that their discharge was unlawful. In addition, the change in employment status may cause issues when transitioning off of the Seller’s benefit plans and into the Buyer’s benefit plans. This transition requires great care and expert advice to complete.
Finally, it’s worth pointing out that Buyers in asset sales don’t get a free pass on the unassumed liabilities of the Seller. While that may be the case under the agreement between the parties to the transaction, there are certain legal rules that may impose “successor liability” on the Buyer. While this can arise in many different circumstances, the risk of successor liability is greater when talking about things like taxes, environmental liabilities, and employer/employee benefits liabilities. In addition, successor liability may sometimes come into play – or the deal may be unwound – where the Seller is left with liabilities that exceed its ability to pay them. And, even if successor liability doesn’t apply in a given case, in many cases disgruntled creditors of the Seller will take shots at the Buyer in an effort to collect. Even if they’re unsuccessful, these collection efforts require time and expense to resolve. Moreover, if these debts are owed to a supplier with which the Buyer will continue to work after the closing, the Buyer may nonetheless be forced to pay for the sins of the Seller as a price of doing business with that supplier.
For the above reasons, we generally say that asset sales favor Buyers, but note that even Buyers need to be careful in an asset sale if there are significant titled assets to transfer, third parties holding consent rights, or significant undischarged liabilities that remain in place post-closing.
Equity sales go by a number of different names, depending on the type of company that’s being acquired. If it’s a corporation, it’s a stock sale or share sale. If it’s an LLC, it’s a membership interest (or unit) sale. If we don’t want to waste time thinking about what to call it, we’ll just call it an equity sale or sale of securities.
The basics of an equity sale are pretty simple: the Buyer simply acquires the equity (e.g., stock, LLC interests, etc.) of the target company directly from the owner(s) of the equity. After the transaction, the Buyer is left owning the target company and the Seller is left with nothing except cash (or whatever other consideration it received in the deal). The deal looks like this:
So the result is this:
The target company is mostly unaffected by the transaction. All of its assets, liabilities, contracts, employees, and relationships remain in the same place. The taxpayer identification number (usually) remains. The Buyer simply steps into the shoes of the selling equity owners and picks up the business with minimal interruption.
For that very reason, however, Buyers often are more wary of equity sales. Whereas in the asset sale, the Buyer gets to pick-and-choose the assets and liabilities it wants to acquire, it doesn’t have much choice in the equity purchase; the Buyer is getting everything…the good, the bad, and the ugly. We attempt to reallocate monetary responsibility for the undesired liabilities in the equity purchase agreement, but that’s not nearly as effective as never taking on those liabilities in the first place.
To make matters worse for Buyers in an equity sale, the purchase price is paid to the selling equity owners for the actual equity of the business rather than to the target company for the assets. That means that the Buyer doesn’t get to increase its tax basis in the target company’s assets and therefore doesn’t get to write-off the purchase price by virtue of increased depreciation and amortization deductions. Fortunately, there are workarounds in many cases that may get to the same tax result as an asset sale (which are beyond the scope of this piece), but there are always issues to be addressed before getting comfortable that these workarounds will be available in a given case.
For their part, Sellers are usually big fans of the equity sale. Sellers get to offload everything to the Buyer and don’t have retained assets and liabilities to deal with. While Sellers still have meaningful contractual obligations under the purchase agreement that keep this from being a total walk-away for Sellers, their risks are largely compartmentalized to that agreement, which is heavily negotiated and often limited. Moreover, due to the nature of the equity sale, the tax result to the Sellers is pretty clear, and the entire purchase price for most (but not all) Sellers should be treated as capital gains; if they’ve held the equity for at least a year, the Sellers will qualify for favorable long-term capital gains rates and avoid the dreaded “ordinary income” rates entirely.
In addition, because equity sales don’t involve any actual “transfer” of assets or liabilities, the transaction is usually easier to accomplish – with one very important exception noted below. The Buyer generally is less concerned about the risk of failing to acquire all of the assets it needs, though it still needs to ascertain if any property used in the business is owned by a third party. Because the contracts of the target company aren’t being transferred, the dreaded “anti-assignment” clauses won’t be triggered. Some contracts will still treat a “change of control” over the target company as a prohibited assignment, but those contracts are generally much less common. Employees and their benefits also stay put (unless otherwise agreed), which may ease the transition.
While the nature of the equity sale generally makes it easier for both sides to complete the deal, there is one major deal risk that exists when the target has multiple equity owners: each of the equity owners of the target company has effective veto power over the entire deal. Unlike the asset sale, which can be accomplished without unanimous approval of the equity owners, every equity owner must effectively go along with the equity deal to make it work.
Next Month: Transaction Structures – Part 2: Mergers
Read last month’s piece: Material Adverse Effect After the Akorn Decision