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Stock Versus Asset Deals- What's the Difference?

When it comes to middle-market M&A, there are two primary forms that deals take—either a stock deal or an asset deal. If you’ve never bought or sold a business before, the distinction may not mean anything to you … yet. This article will summarize the differences and similarities between the two.

Stock deals
As most people know, a corporation (or limited liability company or partnership) is a separate legal entity. It is separate and distinct from its owners. In the case of a corporation, the stock of that corporation represents its basic ownership unit. If I own all of those shares of stock, then I control the company. Just as with shares of a large public company, an owner of a corporation’s stock can sell that stock to another person. And that’s just what a stock deal is: an owner of a corporation sells his or her shares to a buyer of those securities.

Now, let’s think about that corporate shell. Within the corporate shell are assets and liabilities. Assets can be either tangible or intangible, and may or may not be on the balance sheet. For example, most assets that are acquired by a corporation are recorded on its balance sheet, but internally developed assets and assets whose value is contingent upon some future event may not be. The same can generally said about liabilities. Some are on the balance sheet, and others may not be. Think about potential legal liabilities. Generally accepted accounting principles require that a liability be recorded when it is probable that one exists, and it is reasonably estimable. That’s not always the case with many types of potential liabilities.

The potential problem with a stock deal (from the buyer’s perspective) is that buyer gets everything within that corporate shell, whether good, bad, or truly ugly, and whether known or unknown at the time of the transaction. What happens if an employee sues the company two days after the transaction closes? It’s generally the buyer’s problem. What happens if a taxing authority comes after the corporation for unpaid employment, sales or income taxes? It’s generally the buyer’s problem.

That being said, there are ways that buyers can potentially mitigate the effects of unknown liabilities, primarily through hold-backs of a portion of the purchase price, or indemnification provisions (which could hold the seller accountable). But those are generally only effective if the transaction is significantly larger than some potential liability that may be lurking, which is often not the case in a middle-market M&A transaction. Plus, given the risk of the unknown, many buyers of middle-market businesses are simply not willing to take the risk.

Asset deals
There is, however, an alternative transaction structure that allows buyers the ability to pick and choose which specific assets and liabilities they are willing to take as part of the deal. It is known as an asset deal. In an asset deal, I like to think of the corporate shell as a bucket that contains all of the corporation’s assets and liabilities. The buyer can look into the bucket and say something like, “I’d like purchase all of the receivables, inventory, fixed assets and intangible assets, and I’m willing to assume the payables, but you keep everything else.” In that case, the corporate shell remains the property of the seller, along with everything in it that is not specifically acquired or assumed by the buyer. The buyer is using this transaction structure to effectively limit their potential exposure to unknown liabilities.

In the previous example, what happens if an employee sues the company two days after the transaction closes? It’s generally the seller’s problem. What happens if a taxing authority comes after the corporation for unpaid employment, sales or income taxes? It’s generally the seller’s problem. So, you can see why many buyers, especially in the middle market, prefer an asset deal over a stock deal.

From a seller’s perspective
Conceptually, most sellers can understand the rationale of an asset deal from a buyer’s perspective. When it comes to potential unknown liabilities, I would venture to guess that most sellers would agree, at least conceptually, that saddling a buyer with a legal or other obligation for something that occurred prior to the closing date would be unfair.

So, if that’s the case, why might a seller be opposed to an asset deal? One word. Taxes.

Unfortunately, an asset deal and a stock deal may be treated very differently for tax purposes, and—depending on a variety of factors—an asset deal could result in significantly higher taxes, and therefore significantly less walk-away money for the seller, compared to a stock deal.

This is especially true in the case of a C corporation (as opposed to an S corporation). In a C corporation structure, the corporation itself is a tax-paying entity. This is different than an S corporation (and a lot of LLCs), whereby the income or loss of the corporation is passed through to its owners and taxed at a personal level. From the tax perspective of the seller, an asset deal in a C corporation structure is about as bad as it gets.

Let’s look at an example.

For simplicity’s sake, let’s assume a seller owns a C corporation that he started from scratch, and let’s further assume that he capitalized it with a $100,000 cash infusion at inception. Let’s go on to assume that he sells the corporation (in a stock deal) for $1 million. In this case, he has a gain of $900,000 ($1 million - $100,000 basis). For federal tax purposes, this gain is taxed at capital gains rates, which are currently 20 percent for those in the highest tax bracket. Applying that capital gains rate to the $900,000 gain results in $180,000 of taxes. Deducting $180,000 of taxes from the $1 million selling price results in $820,000 of net proceeds to the seller. We’ll ignore state income taxes for the sake of simplicity.

Now let’s look at the same set of facts under the lens of an asset deal. In order to do so, we need to make some additional assumptions. Let’s assume that the corporation’s only assets are $200,000 of accounts receivable and $300,000 of inventory, and its only liabilities are $500,000 of accounts payable. Let’s further assume that the buyer agrees to take all of these assets and liabilities (and only these assets and liabilities) for the same $1 million purchase price.

The first step is to calculate the gain (and related tax) at the corporate level. In this fact pattern, the corporation’s net assets are $0 ($200,000 plus $300,000 minus $500,000). If the corporation sells those assets and liabilities for $1 million, the corporation will have a gain of $1 million. This gain will be taxed at the federal tax rate for C corporations, which is currently 21 percent. So, the corporation will pay $210,000 in federal taxes, and will be left with $790,000 that can be distributed to the seller.

The second step is to calculate the gain (and related tax) at the individual level. In this case, let’s assume the corporation distributes the remaining $790,000 to the seller. Since the seller’s basis in the underlying stock is $100,000, the seller will have a $690,000 gain ($790,000 distribution less $100,000 basis), which is taxed at the 20 percent rate described above. So, in addition to the tax paid at the corporate level, the seller will also pay $138,000 of tax ($690,000 times 20 percent) at the personal level.

To summarize, the $1 million stock deal resulted in total taxes of $180,000, while the same $1 million asset deal resulted in total taxes of $348,000 ($210,000 at the corporate level, plus $138,000 at the personal level). In this example, the seller’s after-tax proceeds would have been $820,000 under the stock deal and only $652,000 under the asset deal. The after-tax proceeds are almost 26 percent higher under the stock deal!

And therein lies the reason that entity type and deal structure matter to the seller. And, unfortunately, just because the seller gets a better tax answer under the stock deal, doesn’t mean that potential buyers are willing to assume the additional risks related to doing a stock deal. And while I won’t go into the details in this article, the buyer generally gets a worse tax answer when the deal is structured as a stock deal. So, the seller is basically stuck with a bad tax answer.

Now, there are things that can be done to mitigate this issue, but none of them is a quick fix. All take planning (and time) on the part of the seller.

If you’re thinking about selling your business and are curious about tax consequences or anything else described in this article, please feel free to contact us.

Jeffrey Lewis is a partner based out of our Rochester, NY office.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.