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The company or the assets?

Once the decision to sell or buy a business owned by a company has been made, the next most fundamental question is whether to sell or buy company shares or business assets.A sale of shares is the simplest and most efficient way of transferring the full benefit of a company’s business, but it also entails the assumption of the company’s liabilities.Invariably the seller wants to sell company shares whereas the buyer will usually prefer to buy the assets.Which preference should win out will depend on a range of factors, but that assumes there is a choice which can be negotiated. The seller may only be prepared to sell shares or the buyer may only be prepared to buy assets (such that the alternative is a deal breaker) or else there may only be one structure which can be implemented from a practical perspective.This article examines the reasons underlying the seller and buyer preferences and some of the factors which will influence the more logical structure for given circumstances.

Why do sellers prefer share deals?

A share deal provides the seller with a clean and complete exit without the hassles associated with an asset sale.A simple share transfer delivered to the buyer will transfer the full benefit of the assets and business owned by the company (without any external registration requirements). Nothing else needs to be transferred as all assets, contracts and employees simply remain with the company, which will then be owned by the buyer. Consents will only be required under any company contracts which have ‘deemed assignment’ provisions, triggered by a change of control of the company (usually limited to real estate leases and certain other key contracts).Importantly the buyer assumes the company with all of its liabilities as well. This contrasts with an asset sale under which the seller keeps all of the liabilities unless the buyer expressly agrees to assume certain liabilities (and even then the seller will remain principally liable to the creditor if the buyer fails to pay, whereas a share sale offers a complete exit).Under a share deal the proceeds of sale are paid directly to the company shareholder(s) and the buyer assumes full responsibility and risk for the company going forward. By contrast under an asset sale the sale proceeds are paid to the company and must be extracted from the company by the company’s shareholder(s). The shareholders are also left with the liquidation of the company and the settlement of all liabilities and any disputes in order to achieve liquidation.A share sale minimises tax issues for the seller. The share sale proceeds are usually tax free (unless the company shares were acquired for the principal purpose of sale in the short term), whereas for an asset sale:

  • The apportionment of the consideration is important and may be a contentious area of negotiation with the buyer. If individual assets have been depreciated or amortised below market value there may be tax claw-back.
  • The shareholders may have to liquidate the company to extract any goodwill element of the purchase price tax free.
  • Any consideration assigned to patents which exceeds the legal and registration costs of obtaining those patents will be taxable (without any deduction of the costs of developing the intellectual property which the patents seek to protect).

Why do buyers prefer asset deals?

The main reason a buyer prefers an asset deal is because an asset deal does not expose the buyer to any risk associated with unknown liabilities. A buyer will only assume any liabilities it expressly agrees to assume, usually future liabilities under contracts it takes on.An asset deal may also provide the buyer with an opportunity to cherry-pick assets and only pay for the assets it wants (that’s if the seller will allow that to happen). For example, the buyer can seek to limit the stock it takes on if the seller is overstocked or exclude an asset if it duplicates what the buyer already owns.An asset deal is also generally preferred by the buyer from a tax perspective. There is an opportunity to revalue assets which are worth more than their depreciated book value and create a higher depreciation base going forward. While this is likely to trigger a corresponding tax liability for the seller which will be reflected in the purchase price it is prepared to accept, that is not always the case (see discussion below where the seller has tax losses).

A Comparison

A share purchase is a bit like buying a package holiday. A package holiday can be a no fuss way of getting the key holiday benefits the buyer wants, but there may be certain components which particularly attract the buyer, while there are probably others it could take or leave. The buyer also thinks it know what it is getting but is not completely sure – there could be hidden surprises. An asset deal is more like buying the holiday components individually. It may cost more but the buyer gets just what it wants and there are no hidden surprises.

What questions should be asked when evaluating the two options?

The factors discussed below are just some of the factors and questions which should be considered when determining the preferred structure (from a collective seller and buyer viewpoint) and each party’s preparedness to negotiate away from their individual preferred structure.

  • Contractual consent requirements
  • Just what additional consents are required for an asset deal and are there likely to be any difficulties obtaining them (e.g. do the consent clauses stipulate that consent cannot be unreasonably withheld)? Is there a risk that the contractual counterparties will seek to use the consent requirement as leverage to extract other commercial advantages (irrespective of whether they are entitled to do so contractually)?
  • Regulatory licences/ approvals
  • Does the company which owns the business have any regulatory licences required to operate the business and, if so, are they transferable (with or without approval)? This is less often a factor for New Zealand businesses (lesser regulation in most industries than elsewhere and relatively transparent approval processes) but can be a significant hurdle for any overseas business (in particular).
  • Transfer processes and costs
  • How many of the business assets are registered and are the procedures and costs of transfer significant? In New Zealand, registration is generally limited to land, motor vehicles, securities and IP (trademarks, patents, domain names, etc.) and registration formalities are relatively straightforward and inexpensive. However that is not necessarily the case, particularly if there are significant overseas assets.
  • How great is the risk of unknown liabilities?
  • While a buyer can never be sure that it won’t assume unknown liabilities with a company purchase, there are factors which will indicate whether this risk is significant or not. For instance, have the accounts have been independently audited by a credible accounting firm? Is the seller credible and of good repute? Has the seller been aggressive or conservative in its tax planning and policies and its provisioning for liabilities? Is the nature of the business one where the risk of claims relating to performed contracts or products supplied is high or not? Are there any current unresolved claims? Has the company been tax audited? How long has the company been in existence for and do the current owners know all of the company history?
  • What protection is available for unknown liabilities?
  • What is the financial strength of the company owners to stand behind warranties? Alternatively, can adequate protection for the unknown liabilities risk be obtained through retention of part of the purchase price in escrow for a period? Is the nature of the business one where any latent liabilities will become evident in a relatively short period after completion?
  • Does the buyer want all of the assets and employees?
  • If the buyer doesn’t want all of the assets owned by the company, the company sale option may be more complex than an asset sale (the seller may have to first spin off the unwanted assets into a separate vehicle or spin off the desired assets into a new company which is then sold to the buyer). If the buyer doesn’t want all of the employees then it won’t want to buy the company and have to deal with redundancies post completion (unless perhaps there is a price adjustment which more than compensates for the likely cost and reputational issues).
  • Is one structure more tax efficient for the parties collectively?
  • If a significant portion of the purchase price relates to patents then the asset sale option might carry a hefty tax cost premium. However in other cases an asset sale may be more tax efficient. For example if a key asset is worth significantly more than its original book value, the future tax benefit to the purchaser of revaluing that asset in an asset purchase may exceed the depreciation claw-back suffered by the seller. Alternatively, if the selling company has tax losses, there may be a significant opportunity to revalue assets upwards in an asset sale to utilise those losses.
  • Do all of the shareholders of the company which owns the business support the sale?
  • A share sale may not be achievable if the company which owns the business has minority shareholders who do not support the sale (assuming the buyer requires 100% effective ownership, as is usually the case). Each individual shareholder must sell their shares and can only be forced to do so in limited circumstances (under contractual “drag along” rights if they exist or, for listed companies and other “code companies” under the Takeovers Code, if a buyer has acquired 90% of the shares). By contrast, an asset sale can take place if it is supported by 75% of the shareholders and will deliver effective 100% ownership and control of the assets.
  • Timing Requirement
  • Is completion of the transaction urgent (such that it may not be practical to obtain any additional consents or approvals required for an asset deal within that timeframe)?

So is there really a choice and, if so, which option makes more sense?

Logically the option which makes more sense is the one which optimises the aggregate economic benefits for the buyer and seller collectively, but that assumes there is a choice.An asset sale will only be tenable if the required additional consents (contractual and regulatory) can be obtained on reasonable terms and the additional transfer costs and logistics are manageable.On the other hand a share sale will only be tenable if it is supported by all shareholders and the buyer can be satisfied that any risk associated with unknown liabilities is low (or the protection offered by the warranties is adequate to cover that risk).By way of generalisations (which may not hold because of other factors):

  • smaller and simpler businesses are more likely to be sold by way of an asset deal for various reasons (e.g. fewer assets to transfer, accounts are often unaudited and less reliable, there may be more fluidity between the company’s affairs and the company owners’ affairs and a portion of the business may be of a barter or cash nature such that the accounts do not tell the full picture, the company owners may not be as substantial, etc.);
  • businesses where a substantial portion of the asset value is attributable to IP or overseas assets are more likely to be transferred by way of a company share sale;
  • an asset sale will be preferred if the buyer does not want all the assets or does not want to take all of the employees or wishes to merge the business it is acquiring with its own business under its own branding (as opposed to the seller’s branding).

The role of the sale and purchase agreement in bridging the gap and making the deal possible

Some of the risks or obstacles to the preferred sale structure can be ameliorated by the terms of the sale and purchase agreement.In respect of the key undisclosed liabilities risk inherent in a share purchase, warranties and indemnities can be included in the sale and purchase agreement which will enable the buyer to claim against the seller for its full loss associated with any undisclosed liabilities or claims arising from prior trading, (irrespective of whether the seller was aware of the undisclosed liability or potential claim). The buyer’s risk is then reduced to the risk that, should such a liability arise, it is not recoverable under the warranties for any reason. The liability will not be recoverable if the seller and any seller guarantors lack the financial resources to meet any claim. That risk can be reduced by obtaining guarantees from financially sound parties associated with the seller (if there are any) or by requiring a portion of the purchase price to be retained in escrow for a period so that it is available to meet any claim. The escrow option should give absolute protection up to the escrow amount if the liability arises during the period of escrow, but will be strongly resisted by the seller (as part of the sale proceeds will be tied up and unavailable to the seller for the escrow period).There is also scope to deal with the principal hurdle to an asset deal, the lack of certainty that all third party approvals and registrations will be obtained in the required completion timeframe, such that completion can proceed without them and the buyer is not exposed to undue risk. The sale and purchase agreement might provide that completion will proceed on the basis that the beneficial rights to the relevant contracts or assets (which cannot be legally transferred) are assigned to the buyer, but the legal rights to such contracts or assets will be retained by the seller and held by the seller for the sole benefit of the buyer (pending the legal assignment, which the parties will continue to take all available steps to achieve). The seller might further indemnify the purchaser against any loss which may arise from the delayed legal transfer of the relevant contracts or assets.Other disadvantages of an asset deal for the seller or a share deal for the buyer can largely be dealt with by adjustments to the purchase price, how the purchase price is apportioned and the way in which risks and responsibilities relating to the sale and purchase agreement are allocated.

Conclusions

There are good reasons why sellers prefer to sell shares but buyers prefer to buy assets.A buyer will only consider a share purchase if the assessed risk of undisclosed liabilities associated with a share deal is relatively low (or at least can be adequately covered by warranty protection), whereas an asset deal will only be tenable if the transfer requirements (in particular the obtaining of any requisite third party consents or regulatory approvals) can be completed on reasonable terms and at a reasonable cost. If both options are tenable then there should be flexibility on each side to negotiate the sale and purchase structure which maximises the economic benefits for the parties collectively (in which case an appropriate purchase price adjustment should ensure both parties are better off than under the alternative structure).The structure which will make more sense from a collective viewpoint will depend on a range of factors relating to the particular business and assets being sold, the company which owns that business and the company ownership.The terms of the sale and purchase agreement can play an important role in bridging the gap and making the optimal structure (for the parties collectively) more palatable to both sides and achievable.

Andrew Lewis Law
September 2011