Asset vs. Equity Deals: Weighing the Benefits and Risks
When you decide to buy or sell a business, you have two choices: an asset sale or an equity sale.
Each has its own legal, tax, and accounting implications that impact both the buyer and the seller. Here are some definitions and key considerations stakeholders should understand to help maximize their benefits and minimize their risks.
What is an Asset Sale?
An asset sale occurs when the seller remains the legal owner of a company, but sells all or some of the business’ individual assets. The buyer gains control of the company by owning the assets that created the seller’s equity worth. Buyers typically prefer this option.
What are the Benefits of an Asset Sale for the Buyer?
- Tax Treatment of the Transaction: In an asset sale, the buyer doesn’t have a “taxable event”—a transaction that results in tax being owed—at the time of purchase. So, the buyer isn’t subject to a tax liability until they sell the business themselves.
- Basis Step-Up: The buyer receives a step-up in the tax basis of the acquired assets. In other words, the assets’ cost basis is reset to align with the property’s fair market value. This may decrease their future tax liability through increased depreciation and amortization deductions.
- Goodwill Creation: This occurs when the buyer pays more for the company than the value of its assets due to value placed on “goodwill”—namely intangible assets such as customer lists, brand name, and reputation. It can result in significant tax deductions for the buyer over a 15-year period due to increased amortization.
- Choice of Assets and Liabilities: Buyers have the flexibility to hand-pick the assets and liabilities they want to acquire, so they can avoid potential liabilities, such as product liability or employee lawsuits. This can mean less need for due diligence, saving the buyer time and money.
What are the Drawbacks of an Asset Sale for the Buyer?
- Rights to Assets: Retitling and obtaining consents for certain assets, like client contracts, employment agreements, and intellectual property, can get complicated— slowing down or even jeopardizing the transaction.
- Renegotiation: The potential renegotiation or reassigning of contracts with customers, suppliers, and key employees can be challenging, particularly for businesses that depend heavily on a few major suppliers or customers. This may lead to higher legal costs for the buyer.
What are the Implications for the Seller during an Asset Sale?
For sellers, asset sales offer the major advantage of retaining ownership of the legal entity. However, sellers should consider:
- Tax Treatment of the Transaction: In an asset sale, the seller pays taxes on the gain from the sale. Different tax rates apply to intangible assets, such as goodwill, and to tangible assets. Also, if the entity sold is a C corporation, the gain may be subject to double taxation—both at the entity level and the shareholder level when proceeds are distributed.
- Higher Purchase Price: Sellers may insist on a higher purchase price to compensate for the tax liability incurred by an asset sale.
- Retention Assets and Liabilities: The seller typically carries all the cash and debt of the business. So, they may need to liquidate the assets that were not purchased and take care of any outstanding liabilities.
What is an Equity Sale?
The buyer acquires the entire legal entity during an equity sale, including all assets and liabilities, unless otherwise negotiated.
Sellers tend to favor stock sales because they’re typically more simplistic from both a legal and tax perspective, which decreases their responsibility.
What are the Implications for the Buyer during an Equity Sale?
- Simplicity: Equity sales can save buyers time and money because they don’t have to worry about revaluation or retitling assets.
- No Basis Step-Up or Goodwill: Since all the assets and liabilities are transferred at the tax basis as of the time of sale, the buyer doesn't receive a step-up in basis. This can result in a higher taxable income for the buyer since they may be losing out on the additional depreciation and/or amortization deductions.
- Assumption of Risk: Buyers in equity sales assume all existing liabilities, both known and unknown, unless specific agreements are made that state otherwise. This can increase due diligence requirements, which will cost the buyer more time and money.
What are the Implications for the Seller during an Equity Sale?
- Tax Treatment of the Transaction: The gain from the sale isn't taxed at the entity level. It will only be taxed at the individual level and at the lower capital gains rate.
- Less Responsibility: Sellers are typically less responsible for future liabilities because they transfer all their assets and liabilities.
- Shareholder Complications: If some shareholders—even minority shareholders—don’t want to sell their stock, it could compromise the sale. This could lead to additional legal and accounting costs, or jeopardize the transaction altogether.
What are the Diligence Considerations Associated with these Deals?
Both asset and equity deals require careful diligence and consideration. It’s important to take account of which assets and liabilities are being purchased, how to best structure the pro forma financial statements, and how to craft net working capital versus indebtedness.
The seller must provide the Net Working Capital Purchase Estimate Guide (PEG) to the acquirer and the target to review as the deal approaches the closing date in order to minimize the working capital adjustment as much as possible.
Also, if the deal is structured as "Cash-Free, Debt-Free," meaning the buyer won’t receive any of the cash or take on any of the debt on the seller’s balance sheet, the seller and target need to decide which debt-like instruments to eliminate before the acquisition. This helps establish the pro forma financial statements.
Asset sales offer tax advantages and selective asset acquisition, but can be complex and require additional time and costs. Equity sales provide simplicity and continuity, but require the buyer to assume all liabilities. Both types of transactions involve important accounting considerations and post-close diligence. To maximize the acquisition’s value, both parties should reflect on their specific circumstances and objectives.
If you have questions about asset and equity deals, please reach out.