I just asked AI what percentage of business sales in the Lower Middle Market (LMM) are asset sales. Its response was 70 – 90%. I would anticipate that stock sales for the largest companies in the LMM dilute those percentages.
It feels like 90% of the sales in the 5,000,000 to 40,000,000 strata are asset sales.
Regardless, the point is that the transaction format is not a topic that the seller can simply declare.
Asset Sale – under this model the buyer identifies the assets (tangible and intangible) that they are willing to acquire. In certain cases, buyers will also accept certain very clearly defined pre-closing liabilities such as accounts payable or payroll liabilities. The purchase agreement is called an Asset Purchase Agreement (APA). This agreement provides absolute definition and clarity as to what is being acquired for the purchase price.
The inverse applies as well. Everything else related to the company that is not listed is purposely NOT included. For example, the tax ID number is not included.
Stock Sale – a stock sale is the exact opposite of an asset sale. Under this model the buyer acquires the legal ownership of the company. It may be represented by shares of stock or member interests. The buyer is purposely acquiring everything related to the company.
Typically, you do not have an excluded assets schedule under this model. If the owner wants to keep the 400,000 Aston Martin that was charged to the company, it will need to be legally removed from the company (sale/dividend/distribution) prior to the transaction closing.
Why are asset sales so prevalent? Liability.
It allows the buyer to carve out exactly what they want and what they believe will have value to them in the future and not take on any exposure that they do not want.
There are known liabilities, contingent liabilities and completely unknown liabilities that the current owner does not even have an awareness of. A new owner has absolutely no interest in taking on contingent or unknown liabilities from the past and why should they. They are paying a purchase price to acquire a defined list of assets and liabilities so that they can plan on a fresh start day one. Any liability known or unknown that cannot be quantified as of the closing date should stay with the seller.
Example, a week after closing a former employee files a discrimination case against the company or the Department of Labor files an action for failure to pay overtime or the IRS conducts an audit and requires 800,000 in back taxes due to a filing error or a product liability suit is filed. This list is endless.
In many cases the seller will acquire “Tail Insurance” or runoff coverages to protect from future, post-transaction lawsuits arising from past activities.
There are other examples of where a buyer may exclude certain items from acquisition.
Example. Say there is 4,000,000 of quality inventory and 100,000 of obsolete inventory with negative value (cost of disposal is greater than liquidation value). The buyer can exclude the obsolete inventory from the asset list being acquired.
There are other favorable attributes such as tax benefits for the buyer under an asset purchase.
However, tax benefits for the buyer may be tax detriments for the seller.
This is an example of why the seller needs a good tax CPA on their transaction team.
The buyer and seller are required to agree on and file IRS form 8594. It is called an Asset Acquisition Statement. It seems procedural but its impact is HUGE!
This form defines the buyer's new tax basis and the seller's taxable gain.
I do not provide tax services so I am going to be purposely vague and only provide a generic example.
The seller's company has 1,000,000 of fully depreciated assets.
The market value of these assets is 500,000.
In real life the seller would like to assign zero to these assets on form 8594. The buyer would like to assign 1,000,000.
Why zero? The seller has already taken the tax advantage of 1,000,000 of depreciation expense on these assets so his or her tax basis is zero. If the buyer and seller agree that market value is 500,000 the seller is looking at 500,000 of depreciation recapture at ordinary income rates not the capital gains rates that apply to the transaction gain amount. That could easily be 150,000 of additional taxes.
Why 1,000,000? The buyer will always want the highest amount possible because they can depreciate the entire amount starting day one. In most asset transactions the total asset value is lower than the purchase price. The excess amount is called goodwill. It is the intangible part of the purchase price being paid for brand, reputation, employees, customers etc.
The period of time over which equipment can be depreciated is usually significantly shorter than the depreciable life for goodwill. So, there is a huge tax advantage to put as much as possible into equipment instead of goodwill.
This is another area where you need a strong M&A advisor. Many disputes (even significant enough to destroy a transaction) occur over the joint accounting for Form 8594. The concept is always a tough swallow for the seller and many times the buyer's definition of market value is nowhere close to reality. There is a lot of positioning and negotiating that goes on over this topic IF the seller understands it in advance. Many uninformed sellers take the lazy approach and let the seller define the numbers and they get a massive tax surprise after the transaction is closed.
Why would any buyer ever do a stock purchase?
Many times, not by choice but by requirement.
There may be certain legal or operational elements that cannot be acquired, transferred or assigned. I have seen operating contracts, employment contracts, credentialing, licensure, legal conditions and more where there is no legal path from the seller to the buyer.
The only way the buyer can obtain these rights is by acquiring the actual ownership of the company and continuing to operate the company under its tax ID number. That does not trigger a change of control or breach or termination per the prevailing conditions.
A stock sale is much more cumbersome, time consumptive and costly in most situations.
The buyer has to be very focused during their due diligence process to ensure that they are not acquiring liabilities that they do not want to accept.
A rigorous conversation should occur between the seller, M&A advisor, tax CPA and transaction attorney before the seller ever agrees to a transaction type.