Legal Deal Structure

A question in every M&A deal is whether the transaction should be structured as an asset or stock sale. In this section, I’ll define these terms and then go over some of the key differences between these two transaction structures. 

Asset Sale

Most buyers prefer an asset deal due to the lower level of perceived risk inherent in such a structure. In a stock sale, the buyer inherits all your liabilities, which include any unknown liabilities, which are commonly called contingent liabilities. In an asset sale, the buyer only inherits those liabilities the buyer explicitly agrees to assume in the purchase agreement, along with successor liabilities, which the buyer assumes via statutory law and the parties therefore can’t avoid regardless of the form of the transaction. As a result of the reduced potential for risk, the reps and warranties can be more narrow in scope in an asset sale than in a stock sale.

In an asset sale, the buyer purchases the individual assets of the business from you, and you will retain ownership of your entity after closing. 

The Purchase Agreement used in an asset sale is normally called an Asset Purchase Agreement (APA) and is often used synonymously with a Definitive Purchase Agreement. The only difference is that the former includes an indication that the purchase is structured as an asset sale.

Also, in an asset sale, your assets and liabilities are transferred to the buyer individually. The buyer forms an entity, and that entity purchases the individual assets of your company. The parties then jointly decide which assets and liabilities are included in that transfer. The sale usually covers all hard assets necessary to operate the business and long-term liabilities are seldom assumed by the buyer.

If the value of a business is less than $100 million, chances are the deal will be structured as an asset sale. From the buyer’s viewpoint, an asset sale is more desirable due to certain tax advantages and the avoidance of any unknown legal risks (i.e., contingent liabilities) associated with your entity. From your viewpoint, asset sales are usually less desirable because the taxes due on a sale structured as an asset sale can be significantly higher than if the sale were structured as a stock sale.

If the value of a business is less than $100 million, chances are the deal will be structured as an asset sale.

Stock Sale

If a buyer acquires the stock in your entity, they will inherit all your liabilities, whether known or unknown (i.e., contingent). As a result, reps and warranties in stock deals are broader in scope than in asset deals due to the greater level of risk present. If your transaction is structured as a stock deal, the purchase agreement will customarily include representations regarding the capitalization and liabilities the buyer will be inheriting. 

In a stock sale, the buyer purchases your entity, such as your corporation or LLC. By purchasing your entity, the buyer then owns the assets owned by your entity. 

The Purchase Agreement used in a stock sale is normally called a Stock Purchase Agreement (SPA) and is also synonymous with a Definitive Purchase Agreement. The name “Stock Purchase Agreement” indicates the transaction is a stock sale. Generally, in a stock sale, the Buyer acquires everything owned by your entity – including unknown liabilities.

Few transactions in the lower middle market are structured as stock sales. Buyers prefer to structure a transaction as a stock sale if they want to transfer something your entity owns that can’t be independently transferred. For example, some contracts are owned by an entity and can’t be transferred without the explicit permission of the counterparty. 

In those cases, structuring the transaction as a stock sale ensures these contracts are passed to the buyer, assuming the contract doesn’t state that a change in control requires the consent to an assignment of the contract, known as a “change in control provision.”

Most transactions aren’t structured as stock sales due to the potential for the buyer to assume contingent liabilities and because the buyer inherits the tax basis of your entity, with the exception of a 338(h)(10) election, which recharacterizes a stock purchase as an asset purchase for federal tax purposes. 

A contingent liability is a liability the buyer doesn’t know exists, so they don’t know what they’re inheriting. When they purchase the stock of a company, a number of unknown liabilities could exist, and they’ll assume liability for those issues when purchasing the entity. 

Note: Shares in an LLC are technically called “membership interests.” However, for the sake of simplicity, most parties refer to the transaction as a “stock” sale.

Reps and warranties in stock deals are more comprehensive than in asset deals. 

Successor Liability

Regardless of the transaction structure, there’s a possibility of successor liability. Successor liability is a state law doctrine that allows a creditor to seek recovery from the purchaser for liabilities that weren’t assumed as part of the acquisition. Product liability, environmental clean-up, and employment law are areas where the doctrine of successor liability is most commonly applied.

Successor liability can be mitigated to a certain extent through reps and warranties, a holdback, and other protective measures. But for certain matters, successor liability can never be eliminated, such as for tax or environmental issues. 

In other matters, such as employee issues, successor liability can be mitigated by reducing the possibility of being labeled a “continuation” if the sale is an asset sale. The business is considered a successor, or continuation, if the product lines, employees, and other aspects of the business are substantially similar both before and after the closing. In other words, if the business is essentially the same, the courts may characterize the business as a “mere continuation” and impose successor liability. This happens in most M&A transactions, meaning that successor liability exists in most M&A transactions. As a result, many of the reps and warranties are designed to address these potential areas of liability.

Here are some of the tools the buyer usually proposes to reduce successor liability:

  • In an asset deal, the buyer may explicitly list any liabilities they are assuming and any liabilities you are retaining.
  • The buyer may also propose stringent reps and warranties regarding potential issues that may be susceptible to successor liability, such as environmental issues.
  • Indemnification with reduced baskets for issues relating to successor liability may be included in the purchase agreement.
  • A buyer may also attempt to reduce the appearance of “business continuity” to minimize the possibility a court may label the business as a mere continuation and therefore impose successor liability.
  • A buyer may also require you to keep your entity open and liability insurance in place as long as possible. In certain cases, such as environmental or tax issues, liability may be indefinite, so the time the entity remains open should be carefully weighed against the potential for and the size of the risk. 
  • A buyer may also propose a triangular acquisition structure to isolate liabilities in the subsidiary entity. In a triangular structure, the buyer entity forms a subsidiary entity, and the subsidiary entity either acquires or merges into the target. This structure isolates the liabilities within the subsidiary entity.

Why Most Transactions Are Asset Sales

Most transactions are structured as asset sales for two primary reasons:

  1. Tax Purposes: If a buyer purchases your entity, they inherit your tax basis, with the exception of a 338(h)(10) election. But if they purchase your assets, they can often begin depreciating those assets again and experience more advantageous tax benefits. Asset sales dominate business sales because the buyer can write up the value of the assets and depreciate the cost based on the stepped-up value of the assets. On the other hand, in a stock sale, the buyer inherits your tax basis, with minor exceptions, and receives fewer tax benefits. 
  2. Risk: If buyers purchase your entity, they inherit any unknown legal risks associated with it. These are known as “contingent liabilities.” For this reason, buyers prefer to form a new entity that doesn’t have any unknown risks.

One of the few reasons a buyer may want to purchase your entity has to do with the continuation of contracts or licenses. If your business has valuable contracts or licensing that may be interrupted by a transfer of ownership, the sale is sometimes structured as a stock sale. Be careful, though, as many contracts have a “change of ownership” clause that states that a substantial change of ownership in the company is treated as an effective change of ownership and explicit consent is therefore required.

The bottom line is that you can assume your transaction will most likely be structured as an asset sale if the value of your business is less than $100 million.

Definition of Buyer and Seller

When I refer to “Buyer” or “Seller” in a legal context, such as a reference to a party to an agreement, I’m referring to the individual or entity participating in the transaction. If the seller is an entity, such as a corporation or LLC, that’s what I’m referring to, not the individual. The same applies to a buyer. If the buyer is an individual, as in John D. Buyer, the buyer is John D. Buyer. 

The same rule applies to the buyer if the buyer is an entity, such as Acme Buyer Corporation. This distinction is important in the context of understanding the key differences between an asset and a stock sale.