In the first blog in our series on Mergers and Acquisitions (“M&A”) in California we introduced the different types of structures for M&A transaction – asset purchases, stock purchases, and mergers. Understanding the basic mechanical differences is only part of the equation. The most important question is how does your company choose the right structure for your deal?
In this post, we focus on the strategic drivers behind that decision. From control and liability exposure to tax outcomes, the structure you choose directly shapes the value and risk profile of your transaction.
Align the Structure of the Transaction with Your Company’s Strategic Goals
When deciding on the type of M&A transaction to pursue, you should align the structure of the deal with your company’s strategic priorities. 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 transaction allows your company to avoid assets, divisions, employees or other legacy 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 normally 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, employees and real property. In most cases you also assume the liabilities that go along with them. This wholesale takeover of the target company is ideal when complete operational control and continuity is your company’s 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 of the target entity or flexibility in the acquisition of assets you need from the deal. If full integration and ownership of the entire company – including its brands, contracts, and workforce – is your goal, a stock purchase or merger may be appropriate. If instead your goal is to acquire only certain select assets – and 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, employment disputes 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 unforeseen 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 remain in place.
Tax Impacts
The tax effects of a particular transaction on your company and the target company can significantly influence the choice of deal structure selected by both of you. 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 greater 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 typically 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 the buyer may think it has lost some tax benefits.
The U.S. Internal Revenue Code (“IRC”) offers hybrid solutions when a proposed transaction meets certain requirements. An IRC Section 338(h)(10) election treats 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 can be made by 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. There are some limits, however, because if the target corporation is an S-corporation, all of its shareholders, including shareholders who do not sell target stock in the QSP, must make the election.
Ultimately, the tax effect of a particular transaction often 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.
Conclusion
Choosing the right M&A structure starts with aligning the transaction to your company’s priorities. Whether your focus is maximizing control, limiting liability exposure, or optimizing tax outcomes, each deal structure carries meaningful trade-offs that can materially affect the success of your transaction.
Careful evaluation of these significant deal factors lays the groundwork for a well-structured transaction. In the next post, we’ll build on this foundation by examining how timing, complexity, industry norms, and financing considerations further influence deal structure, and how these elements play out in real-world transactions.
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.
