Legal Transaction Structure – Asset vs. Stock Sale

When buying or selling a business, an M&A transaction can generally take one of two forms: It can be structured as an asset sale or a stock sale. Fundamentally, there are few differences between the two transaction structures. 

In an asset sale, the entity, such as a corporation or LLC, sells the individual assets it owns, such as furniture, fixtures, equipment, customer list, etc., to the buyer.

In a stock sale, the seller – say, John Smith, as an individual, sells the actual ownership of their entity – Corporation, LLC, or another type of entity – to the buyer. This would be similar to owning a share of Ford Motor Company and selling this share of stock to another individual.

If the value of a business is less than $10 million, chances are the deal will be structured as an asset sale. Most buyers prefer an asset deal due to certain tax advantages and the lower level of risk. In a stock sale, the buyer is inheriting all of the seller’s liabilities, also called contingent or unknown liabilities. In an asset sale, by contrast, the buyer is only inheriting those liabilities the buyer is explicitly agreeing to assume in the purchase agreement, along with successor liabilities, which the parties can’t avoid regardless of the form of the transaction. For the seller, asset sales are usually less desirable because gains on hard assets are subject to higher ordinary income tax rates.

Why Most Transactions Are Asset Sales

The majority of small transactions are structured as an asset sale for two primary reasons:

1. Tax Purposes: If a buyer purchases your entity, they inherit your tax basis. But, if they purchase your assets, they can often begin depreciating those assets again and experience more advantageous tax benefits. Asset sales dominate smaller business sales because the buyer can write up the value of the assets and depreciate the costs. On the other hand, in a stock sale, the buyer inherits your tax basis, with a few minor exceptions, and receives fewer tax benefits. 
2. Risk: If a buyer purchases your entity, they are inheriting unknown legal risks associated with your entity. 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 an asset sale. Be careful, though, as many contracts have a “change of ownership” clause that states if there is a substantial change of ownership of the stock in the company, this is treated as an effective change of ownership, and explicit consent is 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 $10 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 am referring to the individual or entity participating in the transaction. 

If the seller is an entity such as a corporation or LLC, the Seller is the entity – for example, Acme Seller Incorporated. If the buyer is an individual, the Buyer is, for example, John Smith. This distinction is important in the context of understanding the key differences between an asset and a stock sale.

Asset Sale – Asset Purchase Agreement (APA)

In an asset sale, the buyer as an individual, or the buyer’s entity, purchases the individual assets of the business from you, the seller. You retain ownership of the entity after closing. 

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

In an asset sale, there is a transfer of specific assets and liabilities from the seller to the buyer. The buyer forms an entity, and that entity purchases the individual assets of the seller – technically, the seller’s entity. The parties jointly decide which assets and liabilities are included in that transfer.

The sale typically includes all hard assets necessary to operate the business, such as supplies and inventory. You usually retain ownership of the accounts receivable, cash, and working capital. But, working capital is often included if the buyer is a private equity group or sophisticated corporate buyer.

Stock Sale – Stock Purchase Agreement (SPA)

In a stock sale, the buyer purchases the seller’s entity. By purchasing the seller’s entity, the buyer then owns the assets owned by the entity. Shares in an LLC are technically called “membership interests.” But, for the sake of simplicity, most parties refer to the transaction as a “stock sale.”

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 purchases everything owned by the Seller’s entity – including unknown liabilities.

Few small business transactions are structured as a stock sale. Buyers typically structure 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, also known as a “change in control provision.”

Most small business sales are not structured as stock sales due to the potential for the buyer to assume “contingent liabilities” and because the buyer inherits the tax basis of the seller’s entity. 

A contingent liability is a liability you don’t know exists, so you don’t know what you’re inheriting. If you purchase the company’s stock, a number of unknown liabilities could exist, and you will assume liability for those issues when purchasing the entity.