Purchase & Sale of Business in California

What is the difference between a Stock Sale and an Asset Purchase?

Among the first decisions a seller must make is what to sell from the business.  That decision impacts how the deal is structured, as well as the price for the sale.  The two most common ways to transfer ownership of a business are a stock sale and an asset purchase.  In a stock sale, the buyer acquires all of the assets and liabilities of the target business as a matter of law (including any unknown or undisclosed liabilities), whereas in an asset purchase, the buyer only acquires the assets and liabilities it identifies and agrees to acquire.  Each has its advantages and disadvantages for buyers and sellers.

Stock Sale

A stock sale (sometimes called an equity acquisition) involves the sale of the company’s ownership interests rather than specific business assets.  The buyer acquires all of the outstanding stock of the target business directly from the business’s stockholders, acquiring all of its assets, rights and liabilities as a matter of law.  Stock sales tend to be faster and less expensive in comparison to an asset sale since the business is valued and sold as a whole.

Generally, sellers prefer stock sales because they sell the entire business, including its current and future liabilities.  Buyers may object to this type of sale for the same reason – they do not want to absorb those liabilities.  However, some liability can be mitigated through the use of appropriate representations, warranties and indemnities in the contract.

Asset Purchase

An asset purchase involves the purchase and sale of some or all of the company’s assets and liabilities.  These assets may include anything that the business owns, such as inventory, equipment, vehicles, machinery, land, leases, copyrights and other intellectual property.  The buyer and seller can negotiate exactly which assets will be part of the transaction and the specific terms of the deal – like whether payment will be in installments or a lump sum, liens and encumbrances on the assets, conditions to the closing, etc.

Sellers benefit from this approach because they can choose to retain certain assets, such as copyrights or intellectual property.  However, they also may face the prospect of retaining current and future liabilities related to the business or difficult tax treatment, both of which are more beneficial in a stock sale.

Generally, buyers favor an asset purchase because of the flexibility in negotiating which assets and liabilities they wish to purchase.  This allows the purchaser to avoid paying for unwanted assets and undesirable liabilities, in addition to better tax treatment.

However, asset purchases can be more time consuming and complicated than stock sales because each significant asset may need to be individually valued and transferred, could involve several third-party consents or require compliance with bulk sale laws.  In California, both parties must comply with the California Bulk Sales Act for asset sales and purchases.  Additionally, both parties have specific tax liabilities under California state law.  If this is not done correctly, a party may have problems enforcing contracts, among other issues.

Federal Income Tax consequences

An important consideration in whether to pursue an asset or stock sale is the tax consequences.  Stock sales favor sellers with significant tax advantages.  If a shareholder sells stock for more than the purchase price, the income is taxed as capital gains, which have a lower tax rate than the ordinary income rate which would apply to an asset sale.  Additionally, stock purchases can be structured with only a single level of taxation.

Asset sales offer more tax benefits to buyers.  They receive a stepped-up tax basis in the assets, resulting in future depreciation and amortization tax deductions, while sellers can be double taxed.  Throughout the process, both buyers and sellers should speak with tax counsel and/or their accountants in order to protect their interests from a tax perspective.

Why is due diligence necessary?

Before buying or selling a business, it is essential that the parties learn more about each other to avoid unnecessary risks and ensure fair terms.  This investigative process is known as due diligence.  While typically the buyer commences due diligence, the seller can also make due diligence documents available at the outset or limit certain disclosures.  This process enables both parties to assess potential risks by examining the other side’s assets, liabilities, operations, legal documents and business relationships.  Buyers want to minimize the chance of unknown risks and sellers want to ensure the buyer’s willingness and ability to perform and protect against a purchaser trying to gain confidential information about the seller.

During due diligence, various types of information will be requested by the buyer, including documents related to the seller’s corporate structure, financials, contracts and other legal documents, intellectual property rights, and compliance with relevant laws.  Sellers must cooperate but buyers should independently verify information received when possible.  A qualified attorney is key throughout this process for both parties.

What provisions should be in the purchase agreement?

Once the parties have agreed in principle on the basic terms of the purchase or sale, a more extensive Purchase Agreement (either a Stock Purchase Agreement or an Asset Purchase Agreement) will be drafted.  This agreement will contain all of the terms and conditions of the transaction, including what is included and excluded from the deal, as well as representations and warranties, restrictive covenants and other provisions.

Essential provisions include:

• Identification of the parties
• Assets and stocks to be included
• Purchase price and method of payment
• Closing terms or conditions that must be met
• Representations and warranties
• Limits on liabilities assumed by the buyer
• Restrictive covenants (non-competition, non-solicitation, confidentiality and non-disclosure)
• Ancillary documents (typically for transfer of title or assets)

Representations and warranties

Both the seller and buyer make representations (“reps”) and warranties in the agreement.  The buyer’s reps and warranties typically relate to its ability to comply with the agreement.  The seller’s reps and warranties encompass various items, including the following: the seller has the right to sell the stock and assets free of any encumbrances, the business is solvent and there are no outstanding contracts regarding the business.

These statements, if found to be untrue, can lead to major disputes between the parties.  The repercussions are why the reps and warranties are so important and often so heavily negotiated.  Buyers typically want extensive reps and warranties of the seller to protect themselves with a remedy if anything the seller said turns out to be untrue.  On the other hand, sellers typically want the reps and warranties to be as narrow as possible.  This helps to limit their risk of liability after the deal closes.  Sometimes, one or both buyers may request reps and warranties (R&W) insurance to enhance these provisions.  An experienced attorney should be consulted to ensure that the reps and warranties are comprehensive, accurate and reasonable in scope.

Conclusion

There are many business and legal issues that need to be addressed during the sale or purchase of a business to ensure a successful transaction.  Without strong legal advice, parties can incur significant expenses and loss of the benefits of the deal.  Buyers and sellers alike should work with experienced attorneys to help tailor the transaction and agreements to each party’s best interests while providing the least risk.

Romano Law can provide guidance on purchase and sale of businesses in New York, California, and Florida.

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