Starting a business requires a lot of groundwork, up-front capital, and relationship building. For some, obtaining the resources or the control of an existing company is preferable to surmounting any financial or laborious start-up costs.
There are several ways for an individual or an entity to purchase a business—outside of classic stock acquisitions and bankruptcy auction proceedings, asset and equity deals are the most common. These types of deals can offer vastly different benefits and detriments to the purchaser and the seller, and it is important to consider the financial implications of both before deciding on a method of acquisition or sale.
Typically, the type of executed deal hinges on the buyer's preferences on tax implications, goodwill, and corporate management because they are more advantaged financially.
What is an asset deal?
In an asset deal, the purchaser agrees to buy an existing company's assets—their real estate, equipment, existing contracts, intellectual property, etc. Buyers can pick which of the assets they want to purchase. They may only be interested in real property, or they may want to require all the materials of the existing business.
These deals specifically enumerate all the acquired assets and liabilities the purchaser will assume. The seller keeps anything not listed. In these arrangements, the seller's original company typically dissolves at the time of the sale or shortly after that.
When do people use asset deals?
These deals are most common when the target company is at risk of bankruptcy or being dissolved. Another example is when a smaller business owned by very few shareholders is closing down, and the shareholders want the company to exist only with their input going forward. Think of companies with names like Johnson Family Café and Bates and Sons Moving Company—Johnson and Bates probably don't want their names to continue to be used without their direct input.
What is an equity deal?
In an equity deal, the buyer purchases an equity interest, such as stock, from the seller to become the legal owner of the extant business. Equity deals differ from stock market acquisitions or hostile takeovers because they usually involve privately held companies, not conglomerates like Delta or Apple.
In equity deals, the seller's original company remains in existence, but ownership is simply transferred to the buyer. Equity deals are most common when larger corporations acquire smaller competitors or entities that would expand the business operations of the acquirer. Equity firms are often the buyers in equity deals. These are investment companies dedicated solely to acquiring and selling other companies.
When do people use equity deals?
One example of an equity deal in the media lately is Elon Musk's acquisition of Twitter. Essentially, Musk offered a lump sum to the Board of Directors for complete control of the company—shareholders voted in an overwhelming majority to accept the deal.
Who typically uses these types of deals?
Most parties to these kinds of deals are corporate entities – typically, larger corporate enterprises are the buyers of smaller firms. These kinds of deals can offer benefits to both parties. For example, a smaller company may have aggressive loan repayment schedules that prevent any profit from being realized. If a larger firm purchases the assets of the smaller firm, the seller may be able to recoup their losses instead of defaulting. If a larger firm purchased the equity in the smaller entity, they might be able to pay off the loans from their global profit, putting the smaller operation into the green.
Tax Consequences for Asset Deals and Equity Deals
Tax implications to both asset and equity deals can change the appeal of either form of acquisition. In an asset deal, buyers are advantaged by a lower base price of any assets purchased, which results in less taxation further down the line. In equity deals, buyers assume the value of assets at a price fixed by the seller's accounting, and sellers pay capital gains taxes (which are typically lower) on any equity sold.
An Example of Taxes and Asset and Equity Deals
One hypothetical example that explains this tax phenomenon is this: Seller owns a laundromat that contains laundry equipment purchased for $75,000. The equipment has depreciated since its purchase, valued at $70,000.
In an asset deal, the buyer offers to purchase the seller's equipment for $50,000, and the seller agrees. The seller must pay income tax on the $50,000, and the buyer can list the equipment for a value of $50,000 on their books.
If the buyer sells the equipment in the future, their gain on the sale will be smaller, and their income taxes will be lower. In an equity deal, the seller would pay capital gains taxes on the entire value of the sale, but capital gains tax rates are substantially lower than ordinary income tax. The buyer would lose the ability to adjust the value of assets in their books but would maintain the operational functionality of the business sold.
Ultimately, taxes for sellers are lower in equity deals, and in asset deals, they are lower for buyers, but that discount isn't realized until far after the purchase is completed.
Major Difference Between Asset and Equity Deals – Minority Shareholders
Another major difference between asset and equity deals is the involvement of minority shareholders. In most U.S. jurisdictions, asset deals can be approved by the selling company's Board of Directors—often, these are majority shareholder appointees.
Equity deals, however, require buyers to convince a majority of the shareholders to sell their equity. It may be difficult to visualize this concept, but the following example should clarify the difference. Imagine a company with three shareholders, 2 of which own 45% of the total equity, and the last owns only 10%.
When each board member is appointed to the Board of Directors, each shareholder gets a vote equal to the weight of their share. The third shareholder's vote serves as a tiebreaker and independently does not weigh on the decision.
What would happen in an asset deal?
In the event of an asset deal, a majority of the Board of Directors would either approve or decline the sale. This means that the third minority shareholder essentially does not have a voice in an asset sale.
What would happen in an equity deal?
In an equity deal, however, the buyer must convince at least two shareholders to sell their shares. A smart buyer would target the minority shareholder with a deal too good to refuse, which would ultimately be cheaper than buying out both of the larger shareholders while still resulting in majority control of the company.
Which type of deal is better?
Asset deals can be logistically easier to orchestrate if the Board of Directors is friendly, especially when multiple shareholders hold the target entity. Equity deals, however, can offer more continuity and transfer more value in the control of the target company to buyers. Asset deals can often boost the value of the acquirer's extant company – but an equity deal offers buyers the goodwill, brand recognition, customer continuity, and establishment of the target company.
Pros of an Asset Deal
The largest advantage of an asset deal is the buyer's flexibility in what to acquire. Equity deals do not allow buyers to pick liabilities to acquire, but asset deals can exclude every liability if the parties agree.
Further, equity deals require certain regulatory safeguards, including disclosures about the securities purchased, including any sensitive information obtained by the acquiring company. If a buyer is interested in the materials that compose a company rather than the customer-facing value of the entity, an asset deal is their best bet.
What Sellers Should Know
Sellers should know the values of their assets and liabilities to maximize their profits when executing either type of deal. Further, understanding a Buyer's incentives for acquiring assets or equity and their future plans can impact a Seller's preference for sales. If a Seller is a mom-and-pop entity, they may be weary of executing an equity sale that allows another entity to control their name and business goodwill. However, some selling entities are only concerned with eliminating debt or turning a profit.
What Buyers Should Know
Buyers should know the value of a business's continuance in the market and the value of their assets. Buyers should further be aware of the implications of assuming any corporate entity's liabilities, including any outstanding contracts or accounts payable. Buyers must also be apprised of the shareholder dynamics of their target corporations, not limited to just the breakdown of shares.
Understanding the relationships between shareholders, especially in a smaller company, is essential to completing an equity deal and can inform Buyers of any potential future complications in managing the entity. Purchasing 1/3 of the equity in a corporation where there are two other shareholders who each own 1/3 may be fruitless if those shareholders have formed an impermeable alliance.
Both buyers and sellers seeking to acquire or distribute any piece of an existing company should consult a corporate attorney before entering into negotiations or starting official transactions.
Attorneys versed in this area of the law can keep parties well within any SEC or state regulations regarding disclosures, tax compliance, and antitrust issues. The larger an entity is on either side of the deal, the more complicated any sale or acquisition becomes – the expense of a good corporate lawyer often far outweighs the risks associated with botched deals and financial regulatory violations.
Contact our experienced transactional lawyers today for a free consultation.