Note: The “Tale of Two Deals” series explores different aspects of two deals that we closed recently in the same week.
There are two basic types of acquisition structures: the asset sale and the stock sale. With the two deals I completed recently, one was an asset sale where specific operating assets were sold to the buyer and other was a stock sale where the stock of the corporation (and therefore the entire company) was sold to the buyer. This blog entry describes the asset sale.
Most buyers prefer an asset sale, and some will even go so far as to refuse to anything but an asset sale. This is why:
Undisclosed Liabilities are Not Assumed
With an asset sale, only specific assets (or liabilities) identified in the purchase agreement are acquired. This means undisclosed and unknown liabilities are not acquired or assumed. In plain english, this means if the seller was dumping toxic waste out the back door, or a lawsuit against the company was about to erupt, the buyer is well protected since those liabilities stay with the seller. The importance of this is obvious in our current legal environment.
In this case, the seller was obviously a very clean company with low risk of a nasty surprise, but buyers and especially professional buyers like a private equity group will automatically go for the asset sale. Why take the risk?
By the way, even in a stock sale the seller would be liable for undisclosed liabilities that originated before the sale – every stock purchase agreement will contain language to that affect. But the process is different because a lawsuit for something that happened before the acquisition will probably name the new company, which the buyer now owns. The buyer then can use the purchase agreement to sue the seller.
Flexible Newco Structure
If a buyer buys stock, they are stuck with the structure of the original company, in our case an S-Corporation. In an asset sale, the buyer sets up a new company of their choosing (usually referred to as Newco during a transaction). Our buyer uses LLCs for all their acquisitions because LLCs can be set up in very flexible ways by careful crafting of the LLC operating agreement. For example, one big difference is that an LLC can be set up so that profit flows per the operating agreement, whereas with an S Corp the profit flows to the corporate owners. They simply did not want to be stuck with an S-Corp.
If the seller happens to be a C-Corporation then the problem is even worse, because no one wants to be stuck with a C-Corp and the double taxation problem.
This was not a factor in our deal because there were so few hard assets, but typically a buyer wants to do an asset sale which allows them to pay fair market value for the hard assets, and then depreciate them again. This hurts the seller because the government doesn’t allow assets to be depreciated multiple times, so the IRS will charge the seller ordinary income tax rates (vs. capital gains rates) on the gain on the assets. (This is called depreciation recapture.)
So our deal was structured as an asset sale at the request of the buyer, although it became very complicated for tax reasons related to the equity rollover of the seller’s ownership (a topic for another article).
The main issue we ran into is that in an asset sale the customer contracts (well, any contract but usually the most concern is with customer contracts) are between the customer and the original corporation, which isn’t being sold. So the seller must get the contracts assigned to Newco in the days before close. Just the mechanics of getting this done can be daunting if there are a large number of contracts.
In our case there were thousands of contracts and the buyer knew that would be an impossible task, so they requested that only the top customer contracts be assigned. Well, it turns out the top customer was an international customer that had his own timetable on when things get done. It just wasn’t a priority for the customer like it was for us, and of course you can only push your top customer so much before you stop pushing them.
Our deal was delayed, day by day, waiting for the contract to be assigned. We were a little nervous, for delays are never a good thing. The sellers were more than nervous and were getting anxious, for we had been fast approaching the end of a long and winding road, yet now we were stalled. The buyer even had the wire transfer instructions ready to deliver to the bank to initiate a wire transfer of quite a few millions of dollars, and we waited still longer. Fortunately the buyer understood that we couldn’t push the top customer any further and that they were causing some degree of angst at the company, so they agreed to go ahead without the contract assignment. We closed. Done deal. The contract assignment came in the next morning.