What is a merger, reverse-merger, acquisition, stock purchase or asset sale? Picking the right transaction structure can make or break your return.
There will always be a variety of reasons driving if and when to sell your business. On the one hand, things may not be going as well as you thought, and it’s time to consider options. On the flip side, there are inflection points when things are going exceptionally well, and opportunities to achieve liquidity present themselves. It is a great position to be in, but it’s also when founders are most hopeful for the future and least interested in selling. Perhaps something happened outside of the company that makes selling an attractive option, or you’ve taken the company as far as you can, and you’ve concluded that it is time. Usually, the decision is based on a combination of these reasons.
Just as you needed a plan to start your business, you’ll need a plan to get out of it. Selling requires forethought, strategizing, and careful implementation.
When you are ready to take steps to get your company sold, ensuring a transaction is structured in a tax-efficient manner is critical for maximizing a seller’s return. Evaluating the various structuring alternatives before undertaking a formal sale process allows the seller to choose a preferred structure and set expectations with prospective buyers regarding deal structure at the outset. Involve your legal and financial advisors early on and be proactive.
Ready to Sell?
Here are some structures for you to consider and some advantages and disadvantages of each in analyzing what optimizes outcomes for you.
A merger of equals is when two companies who are essentially equal combine into one. Typically, after the merger, only one CEO runs both companies, and the staff is combined (which may result in some staff being redundant). A merger is rarely equal…
In a merger, two companies that are distinct legal entities are consolidated into a single legal entity that holds the original companies’ combined assets and liabilities.
In a “reverse triangular merger,” which is the most common type of merger, a buyer creates a wholly-owned subsidiary company where at the closing, your company’s equity holders’ interests are canceled in exchange for “merger consideration,” most commonly in the form of cash or stock issued by the buyer. The buyer merges its subsidiary with and your company, with your company “surviving” the merger as a wholly-owned subsidiary of the buyer.
Reverse-mergers, or RTO’s
In 2020, the market saw an unprecedented spike in reverse mergers where operating companies obtained an exit in the public markets by combining with a special purpose acquisition corporation, or SPAC. More on SPACs here.
An acquisition is different than a merger insofar as that that one company is clearly the buyer. This may also be structured as a “reverse triangular merger.” The other company comes under them, and the company acquired often loses its name and is absorbed into the buyer. Separate branding disappears, and the seller’s operations are typically fully integrated into the buyer’s operations.
This is often actually the case with mergers as well. One company is usually less equal, meaning that it is an acquisition, not an actual merger at the end of the day. The buyer CEO often stays in her position, and the other company name eventually disappears. If your company is being acquired, you need to understand this. If you are acquiring another company or merging, you need to establish what it looks like early on.
The advantage of a reverse triangular merger, and why it is the most common form of M&A transaction, is because it accomplishes two fundamental goals:
- Minimal disruption to seller’s commercial activities, as the seller’s legal status is uninterrupted, and therefore contracts, licenses, leases and other operations are not terminated or disrupted by statute (although each agreement must be reviewed to check that the terms do not specify a consequence in case of merger or acquisition)
- Minority shareholders can be “squeezed-out” by a majority of the voting shares, and no one stockholder can hold the others “hostage” or hold up the transaction pending a concession to them, and not every stockholder and option holder must sign a document
Sale of Stock
In a stock sale, the buyer purchases each share of your company’s outstanding stock directly from each stockholder, with options being cancelled, accelerated and cashed-out or assumed by the buyer.
Your company’s legal status will remain the same, and your company name, contracts, operations, etc., stay in place unless otherwise agreed upon by the acquisition agreement. It is not uncommon for buyers to consolidate your company’s operations into the buyer’s operation after closing.
The advantage of this kind of sale is that there is no need to take specific actions required in a formal merger, and stockholders are paid directly for their shares. The downside can be the effort required to obtain the signature and agreement of each and every holder of stock and options to consent to the transaction, particularly for companies with widespread stockholder and optionholder constituencies.
In an asset sale, the seller does not dispose of the legal entity. Still, a buyer can obtain some or possibly all the company’s assets, and seller may continue to exist and potentially operate following the closing of the asset sale. Asset sales typically are comprised of trade names, trade secrets, licenses, inventory, contracts, customer names, sources of distribution and supply, not to mention goodwill and covenants not to compete, not to solicit clients, customers, suppliers or employees, and the like. Additionally, the buyer may assume none, all or a part of your company’s liabilities. Liabilities not assumed by the buyer remain with your company post-closing.
From a risk mitigation perspective, buyers prefer asset deals. Asset deals allow a buyer to cherry-pick desired assets and leave known and unknown liabilities behind. The buyer can get significant tax benefits in an asset sale by electing to take a “step-up” in basis.
Suppose only a portion of the company’s assets is being sold. In that case, it can be time-consuming, expensive, and impractical to separate assets to be acquired from the rest of your company. Assets and contracts are not confined to a single line of business, and many assets, including intellectual property assets, may be shared between business lines. While these challenges can sometimes be addressed through “transition services agreements” or even “reverse transition services agreements” that allow assets to be shared between the buyer and your company for some time, such agreements may themselves be complicated and challenging to negotiate.
However, if your goal is to sell the entire company, an asset sale will not automatically wind down the company. After the asset sale, you will still need to figure out how to deal with the company’s remaining assets and liabilities, and wind-down the entity.
If you are selling a company that is a corporation or a disregarded entity, an asset sale is often poisonous for a seller from a tax perspective. This is because the corporation will pay tax on the difference between purchase price allocated to each asset and the book-value or tax basis in such asset. Then, when the corporation distributes the after-tax profits of the asset sale to equity holders, each equity holder then pays tax on the distribution.
An asset sale is disfavored because it represents double-taxation. On the other hand, if the seller is an LLC, an S corporation or other form of disregarded entity, an asset sale can be very efficient for all parties.
One of the most complex areas of negotiation in an asset sale can be the allocation of purchase price to specific assets. Unless contracted otherwise, each party could allocate purchase price to assets differently, leaving the tax authorities to resolve discrepancies and causing headaches. Buyers will want to allocate a maximum of purchase price to assets that are expected to appreciate. Sellers will want to allocate a maximum or purchase price to assets with the highest carrying value and highest tax basis for sellers. Interests are not always and not necessarily aligned in this process.
How a seller holds her equity interests in her business will have an important impact on her return, both in quantum of time and money. A myriad of estate-planning vehicles exist, and in multiple jurisdictions. What might save money from a federal income tax perspective may not hold true for your state of residence, and what might merit a tax deferral or deduction in your state may not hold true for your federal tax return. While in most cases, sellers will elect to defer the payment of taxes, in the climate of 2021 where taxes are expected to increase federally and in many states, accelerating taxes may in fact be the better answer. Your M&A lawyer will not likely be an estate planning lawyer, but hopefully can refer you to the right person.
Summing it all up…
The optimal transaction structure for the sale of your business will vary widely according to your specific circumstances. Each structure offers advantages and disadvantages. Being clear with a buyer what structures are acceptable (and what structures are non-starters) will save you time and frustration.