If a merger or acquisition is in your future, be sure you take into account some key considerations before entering negotiations with the other party. Among these are transferability of liability, third party contractual consent requirements, stockholder approval and tax consequences.
As you analyze each of the three alternatives for structuring your transaction—stock purchase, asset sale or merger—keep in mind that whether you are the acquiring company or target company, you will have competing legal interests and considerations. It is important to recognize and address any material issues as you negotiate a particular deal structure with the other party.
Transferability of Liability
Unless this is spelled out differently through a successfully negotiated contract, the target’s liabilities are transferred to the acquirer by law, upon entering into a stock sale. Likewise, the new entity in a merger will assume by law all liabilities belonging to the other entity. The process differs in an asset sale, however. In an asset sale, only those liabilities designated as assumed liabilities will be assigned to the acquiring company. Non-designated liabilities remain obligations of the target post-sale.
Third Party Consents
A pre-closing consent to assignment must be obtained, to the extent the target’s existing contracts prohibit assignment. Neither a stock purchase nor merger require such consent, unless the relevant contracts provide specific prohibitions against assignment when there is a change of control or by law, respectively.
The target company’s board of directors can grant approval of an asset sale at the corporate level without the need for obtaining individual stockholder approval. However, all selling stockholders are required to grant approval pursuant to a stock sale.
When unanimity is otherwise unachievable in the stock sale context, a merger can then be undertaken as an option whereby the acquiring entity and target company negotiate a mutually acceptable stockholder approval threshold sufficient to allow for the deal.
However, in some jurisdictions, depending on corporate doctrine, non-consenting stockholders to an asset sale or merger are entitled to exercise appraisal rights if they are uncertain about the adequacy of the deal consideration.
Depending on its structure, a transaction can be taxable or it could be tax-free. Asset sales and stock purchases have immediate tax consequences for both the acquiring and target companies. However, some mergers and/or reorganizations/recapitalizations can be structured so that at least a part of the sale proceeds, in the form of acquirer’s stock, can receive the preferable tax-deferred treatment.
An asset sale is most desirable from an acquirer’s perspective because a “step up” in basis occurs. This means the acquirer’s tax basis in the assets is equal to the purchase price, which is usually the fair market value (FMV). This allows the buyer to significantly depreciate the assets and increase profitability once the deal is closed. A target company would be liable for the corporate tax for an asset sale. In that case, its shareholders would also pay a tax on any subsequent dividends.
In the case of a stock purchase, the selling shareholders would need to pay long-term capital gains, provided they owned the stock for at least one year. However, the buyer would only obtain a cost basis in the stock purchased and not the company’s assets, which would remain unchanged and cause an unfavorable result if the FMV is higher.
There is also a third possibility. You could opt to defer at least some of the tax liability via a merger/recapitalization. Under such a scenario, the acquirer’s stock remains tax-free until its eventual future sale.
Expect compromise to enter the picture long before a deal is inked. Parties may come together with a hybrid version of the above that will have its own tax implications.