I have been handling sales and purchases of businesses for over three decades, and the first question I always have is whether the owners are selling their interests in the company (i.e. stock) or whether the company is selling its assets. The distinction here is CRITICAL and will impact how the deal is structured, how it is financed, how employees and third parties are impacted, and the tax consequences to the seller (and later, the buyer). Understanding the difference between a stock sale and an asset sale is an important first step for anyone wishing to buy or sell a business. Read on as we take an in-depth look at the company sale.
While it’s best to leave the ultimate structure of the transaction you have in mind to your professionals, it is common practice for a buyer and a seller to agree on price and remain flexible on how the deal is organized until initial due diligence is conducted. Ideally a structure will be found that benefits both parties. For purposes of this discussion, let’s focus on a business operated by a corporation and the shareholders who own the stock in the corporation (the analysis would be roughly the same for a limited liability company).
EXAMPLE: Tent Corporation is a business in the camping industry. It owns tent making materials, an inventory of tents, trademarks relating to the tent business, tent designs, and manufacturing equipment. It has 10 employees to whom it offers benefits, a bank loan secured by its assets, a lease on a building, and contracts with various stores to supply tents. Ellen and Nick each own 50% of the shares in Tent Corporation. John would like to buy the tent business. How should this be done? Should he buy the stock in Tent Corporation from Nick and Ellen? Or should he set up a separate entity that would buy the assets and the contracts and hire the employees from Tent Corporation?
Explaining the difference between these structures to those who have not been involved in business sales is sometimes a challenge. Introducing the box analogy. Think of it this way: When you file Articles of Incorporation, you are creating a corporation that is a separate entity from its owners. You have created an empty entity, much like a cardboard box with the name you have chosen on the front. In this case, Ellen and Nick are holding a cardboard box between them labeled “Tent Corporation.” In that box are the assets of the corporation – the designs for tents, the inventory and materials, the contracts with stores that want to buy the tents, and other property used in the tent business. Also in the box are the obligations of Tent Corporation – the loan to the bank, obligations to employees under employment, employee benefit plans, obligations to the landlord, and other debts. Every Tent Corporation asset or debt, contingent or not, is in that box. Some of those items are obvious (tents) and some are not (obligations to pay employee bonuses, for instance).
An asset sale is somewhat like picking specific items out of that box. John may decide that he only wants one line of tents, which would be a straightforward sale by Tent Corporation to John of the line he is interested in buying. Tent Corp. would still stay in business and still be owned by Ellen and Nick but would simply have sold one of its tent lines. If John wants the entire business, though, should he buy the assets (and assume debt perhaps) or should he just buy stock? To do an asset sale, John needs to specifically identify every asset and have them transferred to him via Bill of Sale (or other conveyancing document). If he wants the employees to work for him, he will have to hire them. If he wants to benefit from the contracts that Tent Corporation has with stores and suppliers, those third parties will likely need to be contacted and will have to specifically consent to the transfer of the contracts to John. If he wants to run his new tent business from the same location, the landlord will have to consent to transfer the lease to John or enter into a new lease with John. Each item must be specifically picked out of the “box” by John. At the conclusion of the transaction, Ellen and Nick still own the box but it may not have much left in it. They could use if for another business, or decide to dissolve the corporate (hence, the box).
So, what does a stock sale look like using our box analogy? Ellen and Nick simply hand over the entire box to John. This seems like a simple matter and is an attractive option in many cases. Generally speaking, it will be more attractive for the sellers from a tax perspective. But there is increased risk for a buyer in picking up that entire box. What might be in it of which the buyer is not aware? Remember that if John simply takes the entire box, he is assuming all the risks and liabilities of that company. Imagine a pending lawsuit hidden under one of those flaps in the bottom of the box. If John simply takes over the box, he is assuming the risks of debts of which he may be unaware. Undertaking extensive due diligence (i.e. review of Tent Corporations’ business) will reduce the risk to John, and the purchase agreement would likely contain a provision indemnifying him for debts which aren’t disclosed prior to closing. The benefit to John in a stock sale is that he may not have to notify and get consent from all those stores and vendors and suppliers, since the contracts aren’t changing at all. John is just holding the box instead of Ellen and Nick, but the box itself and what it holds has not changed. In many cases, the decision to do a stock or asset sale is based primarily on the company’s contracts, and whether or not they can be easily assigned.
The above analogy is a general one and provided simply for educational purposes. As noted, most transactions include legal counsel early on, so the structure of the transaction will be the subject of analysis by the various professionals. The experts at Barna, Guzy & Steffen will work with you and your accounting teams on the best structure for your particular transaction, taking into account many factors that are not noted above. Contact us today.