In the first blog in our series on Mergers and Acquisitions (“M&A”) in California we introduced the different types of M&A transaction structures – asset purchases, stock purchases and mergers – and the basic characteristics of each. In this second blog we focus on the business rationale behind choosing one type of transaction over another. This blog explores how your company’s strategic goals – like control of the acquired entity, insulation from liability, maximizing the tax impacts of the deal, and the speed with which the transaction can close – drive the structure of the deal. We examine industry-specific preferences when structuring certain types of business transactions. We illustrate real-world reasons why buyers and sellers favor certain types of deals. And we discuss how the structure of the transaction must align with financing conditions, market timing, and your company’s business objectives. The aim is to understand not just what the transaction structures are, but why a particular transaction makes sense for your company in a given scenario.
Align the Structure of the Transaction with Your Company’s Strategic Goals
When deciding on the type of M&A transaction, you must align the form of the transaction with your company’s strategic priorities for that transaction. You should consider several key factors when making this decision:
Control & Selectivity
Different transactions offer different amounts of control over the business entity or assets you wish to acquire. An asset sale allows your company to pick and choose specific assets and liabilities, tailoring the deal to include only desired parts of the target company you wish to purchase. The selectivity of an asset transactions allows your company to avoid assets, divisions or obligations you don’t want and focus on the high-value assets you do want. It can also be useful if your company only wants a purchase part of a target company – like carving-out a business unit – rather than the entire company.
In contrast, a stock purchase or merger transaction gives the buyer control of the entire target company as a going concern. Your company steps into the shoes of the seller and takes ownership of all assets, contracts, equipment and real property and typically the liabilities that go along with them. This wholesale takeover of the target company is ideal when fully operational control and continuity is your goal. But it means your company, as the buyer, cannot cherry-pick assets. Many stock transactions, and certainly all mergers, are a package deal.
When you’re contemplating a transaction, your company should consider how much control or flexibility you need from the deal. If full integration and ownership of the entire company – including its brand, contracts, and workforce – is your goal, a stock purchase or merger may be appropriate. If instead the goal is to acquire only certain select assets – and to leave unwanted liabilities behind – an asset purchase transaction will provide your company with the flexibility and control you desire.
Insulation from Liability
A major reason a buyer leans toward an asset purchase transaction is to avoid assuming the target company’s liabilities. In an asset purchase transaction, the buyer typically assumes, if any, only specific liabilities that it explicitly agrees to take on, while any legacy or latent liabilities remain with the seller, unless for some reason they are explicitly transferred to the buyer. This type of transaction insulates the buyer from the target’s past debts and other legal liabilities, which can be a critical consideration if the target company has known or unknown issues like pending lawsuits, environmental cleanup obligations, intellectual property theft or other liabilities.
With a stock purchase transaction, however, the buyer assumes all of the seller’s liabilities – whether disclosed or undisclosed – along with the assets, since all or a controlling interest in the corporate entity is typically acquired in this type of transaction. That means any skeletons in the closet – like lawsuits, faulty products, regulatory fines, tax liabilities — now become the buyer’s problem. To mitigate these risks, buyers doing stock purchase transactions rely on thorough due diligence, extensive representations and warranties from the seller, weighty claw back provisions, and comprehensive indemnification to manage the risks. Even with these protections you cannot eliminate all risk so with a stock purchase transaction you will inevitably buy something you may wish you hadn’t.
If minimizing downside risk is a top priority in a transaction your company is contemplating – like in industries with high liability exposures or acquiring troubled companies – an asset purchase is more favorable so you can identify and exclude those liabilities you’re not willing to assume. On the other hand, if the target company is relatively clean or the need for continuity outweighs your concerns about existing and latent liabilities, a stock purchase transaction or merger might be acceptable so long as necessary contractual protections are in place.
Tax Impacts
The tax effects of a particular transaction can significantly influence the choice of deal structure selected by both buyer and seller. In general, asset sales tend to be tax-advantageous for buyers, but potentially costly for sellers. Stock purchase transactions tend to favor the sellers from a tax perspective.
When a buyer purchases assets, it can step up the tax basis of the acquired assets to their purchase price, yielding future tax benefits through higher depreciation and amortization deductions. This step-up in basis can increase the present value of the transaction for the buyer.
Selling assets, on the other hand, can impose significant tax consequences on a corporate seller – particularly a C-corporation – because it may trigger double taxation; tax at the corporate level on any gains from the sale and tax on the shareholders when the proceeds are distributed. Corporate sellers often shy away from asset transactions due to the excessive tax impact.
By contrast, a stock purchase transaction usually results in the selling company paying a single capital gains tax on the proceeds of the sale of stock, which is more tax-efficient and straightforward in part because capital gains tax rates are lower than the ordinary corporate income tax rate. The buyer in a stock transaction, however, does not get a step-up in basis in the underlying assets because they are sold for a particular purchase price, and thus may think it loses some tax benefits.
The Federal Internal Revenue Code offers hybrid solutions when a proposed transaction meets certain requirements. An IRC Section 338(h)(10) election treat a stock purchase of a selling corporation generally as an asset purchase for federal income tax purposes. A buyer may want to make this election if it would receive a step-up in basis in the selling corporation’s assets, like where the buyer’s cost basis in the seller’s assets would exceed the carryover basis the buyer would otherwise take in a stock purchase deal.
A section 338(h)(10) election may be made for a selling corporation if the buying corporation has made a qualified stock purchase (QSP) from the selling corporation from a (1) selling consolidated group, (2) selling affiliate, or (3) S-Corporation shareholders.
A QSP is the purchase of at least 80 percent of the total voting power and value of the stock of a corporation by another corporation in a transaction or series of transactions during a 12-month period. A Section 338(h)(10) election is jointly made by the buyer and the common parent of the selling consolidated group or selling affiliate or S-corporation shareholders. If the seller is an S-corp., all of the target’s shareholders, including shareholders who do not sell target stock in the QSP must make the election.
Ultimately, the tax effect of a particular transaction plays a pivotal role in the deal. Neither buyer nor seller wants to pay more tax than absolutely necessary. If maximizing the buyer’s future tax deductions is important, and the buyer is willing to pay a higher price for it, an asset purchase transaction may be the way to go. But if minimizing the seller’s tax liability is key to closing the deal, a stock purchase transaction may be more attractive.
Tax advisors often model both scenarios early on, since a small change in the structure of the transaction can have large after-tax impacts for one or both sides.
Speed & Complexity
The schedule and complexity of closing an M&A transaction depends on many factors, including the final structure of the transaction. Asset purchase transactions can be more complex and slower to close in some cases because they require identifying, evaluating and transferring each asset individually, and sometimes obtaining third-party consents for the assignment of certain contracts, permits, leases, and other legal entitlements
For example, customer contracts, supplier agreements and commercial real estate leases often contain assignment clauses that require the other party’s approval before the contract can be assigned to the buyer of the selling company. Regulatory permits or licenses may need to be transferred or even re-applied for in the buyer’s name. All of these complexities to transferring assets add time and paperwork to a transaction.
By contrast, a stock acquisition may be simpler and faster, especially for a privately held company with a modest number of shareholders because ownership is held by a small group and transferring the shares from sellers to buyer in a single transaction is common and, and the selling company remains intact as a going concern. Contracts remain with the same business entity, which usually avoids the need for individual assignments or consents, except for those contracts that have change-of-control provisions triggered by a new owner, which sometimes is less common than conditional assignment clauses in asset sales.
In short, a stock transaction can mean one larger comprehensive transfer rather than hundreds of smaller transfers, allowing for a quicker, cleaner closing process, which could be crucial if the transaction is subject to a competitive bidding process or a narrow market window that may close for market or governmental reasons.
There are absolutes. Your company must evaluate each transaction based on its own facts, market conditions and government regulations that exist at the time of the transaction. Sometimes a stock deal might face regulatory approvals – like antitrust or foreign business entity limitations – or shareholder approvals – like different approvals by common and preferred shareholders – that take time. Whereas a small asset purchase transaction could potentially be done very quickly. As a general rule, asset transactions can involve more upfront complexity, while stock transactions offer more continuity and fewer transactional hoops to jump through.
Your company should consult an experienced M&A attorney to help you weigh the need for a fast closing against the other factors that weigh on the deal when determining the optimal structure for the particular acquisition or sale you are considering.
Industry Trends and Real-World Examples
Certain industries frequently favor one form or transaction over another due to a variety of factors, including federal and state regulatory requirements, business models of the buyer and seller and commonly accepted market norms for companies in particular industries.
In the healthcare sector, for instance, regulatory licenses and patient contracts may be difficult to transfer, making stock sales or mergers more common to preserve the selling company’s operational continuity. Similarly, technology companies that own and continually develop important intellectual property and frequently have complex employment agreements may favor stock transactions to avoid transferring and possibly disrupting sensitive assets and personnel.
Conversely, buyers of manufacturing or logistics companies often prefer asset acquisitions to isolate environmental liabilities or legacy labor obligations. In retail transactions, inventory-heavy sales may lend themselves to asset purchase transactions because of the ease of allocating value and managing stepped-up tax bases of tangible assets.
A private equity firm might favor an asset purchase transaction to control risk and maximize the tax bases in the acquired equipment and goodwill. Meanwhile, a strategic acquirer might pursue a merger to streamline integration and preserve the seller’s valuable brands, workforce, and licensing relationships.
Structure the Transaction to Accomplish the Buyer’s Business Objectives
Finally, the choice of business transaction should support the broader strategies of the buyer and seller. If the buyer is seeking to enter a new market, and values immediate scale of sales and acquisition of the seller’s reputation for the goods or services, a merger or stock purchase may be the best fit. If, however, the buyer’s goal is to integrate selected assets into its own existing platform while avoiding risk and maintaining a cleaner balance sheet, an asset purchase acquisition may be a smarter and more strategic play.
The terms of financing the transaction also matters; a lot. A lender may prefer an asset acquisition, where the collateral securing the loan can be clearly identified and separated. In contrast, a buyer relying on equity financing may find a stock purchase more attractive, particularly if the company’s valuation is driven by EBITDA or recurring revenue streams.
Conclusion
The manner in which your company decides to structure an M&A transaction is a complex strategic decision that should reflect your business goals, your risk tolerance, tax planning, industry norms, and timing needs to close the deal. The different legal transaction structures discussed in this blog are suitable or any transaction, but your choice of structure must suit your company’s particular needs for that particular transaction.
Each deal is unique. Careful evaluation of the various commercial considerations discussed above will help guide your company toward the most advantageous transaction for you. In the next blog in our M&A series, we’ll turn from strategy to execution and walk through the asset acquisition process from start to finish, mapping the key phases and decision points that shape a successful asset purchase transaction.
How Our M&A Lawyers Can Help
Whether you are a California corporation planning to sell all or a portion of your company or a prospective buyer evaluating a new opportunity to purchase a business line or entire corporation, Finkel Law Group’s Mergers & Acquisitions attorneys have decades of experience helping clients strategically structure their deals. We can help you weigh the liability, tax, governance and all other applicable factors to choose the best transaction for your company and negotiate terms that protect your company’s business interests.
About Finkel Law Group
Finkel Law Group, with offices in San Francisco, Oakland and Washington D.C., has 30 years of experience counseling buyers and sellers in navigating the complexities of M&A transactions. When you need intelligent, insightful, conscientious, and cost-effective legal counsel to assist you with the sale or acquisition of a company, please contact us at (415) 252-9600, (510) 344-6601, (771) 202-8801 or info@finkellawgroup.com to discuss your transaction with one of our attorneys.