Andy Shawber, a partner at Summit Law Group in Seattle, concentrates his practice on corporate and securities law, representing companies in all stages of their lifecycles, through formation, venture capital finance, IPOs, public company reporting, and mergers and acquisitions.
Likewise, Laura Harper’s practice at Summit Law Group focuses on corporate and securities law, with a wide range of corporate finance and acquisition transactions.
Pitchbook caught up with Shawber and Harper to learn more about the basics of business combinations for the first in our M&A 101 series.
The interview below has been edited for length and clarity.
PitchBook: What’s the difference between a merger and an acquisition? What are the different types of acquisitions?
Shawber and Harper: There are three main legal structures for acquiring a business: 1) asset purchase, 2) stock purchase (or membership unit purchase in the case of a limited liability company), or 3) a merger. All three of these structures are different types of acquisitions. A merger is a type of acquisition that has a particular legal meaning, which is discussed below.
In an asset purchase, the buyer purchases specific assets of the target that are listed within the transaction documents. Buyers may prefer an asset purchase because they can avoid buying unneeded or unwanted assets and liabilities. Generally, no liabilities are assumed unless specifically transferred under the transaction documents. Because the liabilities remain within the selling company, buyers can eliminate or reduce the risk of assuming unknown liabilities. Further, buyers typically receive better tax treatment when purchasing assets as opposed to stock. If buyers are able to take a stepped-up cost basis in the acquired assets, they may reduce their taxable gain, or increase their loss, when they later sell or dispose of the assets.
The main risk to buyers in an asset purchase transaction is that a buyer may fail to purchase all of the assets it needs to effectively run the company. There are also various aspects of an asset sale that can be time-consuming and drive up transaction costs: like listing specific assets and determining their value; for some assets, third-party consent may be required before the assets can be transferred to the buyer; and the manner in which title of an asset is passed to the buyer will vary depending on each kind of asset, and title to each purchased asset must be transferred individually. Finally, there is a risk that the seller could retain sufficient assets to continue as a competing going concern. This risk is usually mitigated by requiring the seller to covenant not to compete with the buyer.
Sellers generally disfavor asset transactions because the seller is left with potential liabilities without significant assets it could otherwise use to satisfy those liabilities. Also, the tax treatment of an asset sale is generally less favorable to sellers than a stock sale. The company and its shareholders can each potentially incur taxable income, which could result in double-taxation of the sale proceeds. Entities that have pass-through taxation (partnerships, LLCs and S-Corporations) can avoid the problem of double-taxation, and thus may be more likely to accept an asset purchase structure.
Generally, only approval of the majority of the shareholders or members is required for an asset purchase transaction. However, in Washington state and other states (not including Delaware), shareholders who vote against the asset purchase may have the right (called dissenter’s rights) to petition a court to obtain the fair market value of their shares in connection with the asset sale.
In a stock purchase, the buyer purchases the stock of the target company directly from the target’s shareholders. The company remains an existing going concern after the purchase, and its business, assets and liabilities continue unaffected by the transaction. A buyer may prefer a stock purchase when the buyer wishes to continue the operation of the target company after the purchase. Further, absent unusual circumstances, consent from third parties would not be needed to approve the transaction.
However, by buying the entire company, assets and liabilities, the buyer may be exposed to unknown risks. Buyers can reduce its risk by holding back some of the purchase price in escrow to satisfy any liabilities that arise after closing. Also, obtaining approval for a stock purchase can be problematic if the target has a large number of shareholders. Unless there are agreements in place beforehand, buyers cannot force shareholders to sell, and thus a holdout shareholder could refuse to sell to the buyer. This result can be very undesirable for buyers and could end up causing the deal to fall apart.
Buyers may have less-preferential tax treatment in a stock purchase. Generally, buyers would prefer to have a stepped-up cost basis in the target company’s assets than a stepped-up cost basis in the target company’s stock. However, in certain circumstances, buyers can make an election to treat the stock purchase as an asset purchase, thus preserving the preferred tax treatment of an asset purchase.
In a merger, two separate legal entities become one surviving entity. All of the assets and liabilities of each are owned by the new surviving legal entity by operation of state law. There are several structures that mergers can take. The simplest is a forward merger, whereby the selling company merges into the purchasing company, and the purchasing company survives the merger. Often, buyers will wish to keep the target company as a separate legal entity for liability reasons, so the buyer will instead merge the target into a wholly-owned subsidiary corporation of the buyer, called a forward triangular merger. When complete, the subsidiary survives the merger, holding all of the assets and liabilities of the target company.
Both a forward and a forward triangular merger generally require third-party consents, as the target company ceases to exist after the merger and all of its assets are owned by the surviving entity. A reverse triangular merger is similar to a forward triangular merger, except that the target company is the surviving entity, instead of the wholly-owned subsidiary of the buyer. Under Delaware law, a reverse triangular merger does not constitute an assignment, as the targeted company continues as the surviving entity, and thus no third-party consents are required.
In terms of needed corporate approvals, mergers generally require approval only of the seller’s board of directors and a majority of its shareholders (absent other requirements in its charter documents). This lower threshold is particularly appealing when a target company has multiple shareholders. However, shareholders who vote against the merger will generally have appraisal rights under state law. Appraisal rights (or dissenters’ rights) enable dissenting shareholders to petition a court to obtain the fair market value of their shares. This can complicate transactions and increase the buyer’s costs.
How a merger is taxed depends on its structure. Generally, forward and forward triangle mergers are taxed as asset purchases, while reverse triangular mergers are taxed as stock purchases.
Why would parties to an acquisition choose one type of structure over another?
Asset purchases generally work best when the buyers are interested in only select assets of the target company, such as certain intellectual property (e.g., patents). If the buyer is not concerned about the company continuing as a going concern, an asset purchase is likely the best approach. The seller in an asset purchase transaction must be careful to ensure it receives sufficient consideration to cover any future liabilities. Further, the taxable income the corporation receives may be subject to double-taxation in a C-Corporation, both at the company level and then at the shareholder level, when the proceeds from the sale are distributed.
Generally, when pieces of a business are sold, the price will be lower than when the entire business is sold as a going concern. However, buyers sometimes choose an asset purchase structure even when wanting to continue the business as a going concern, but are particularly concerned about acquiring unknown or contingent liabilities. Also, an asset purchase can be more difficult where there are a large number of contracts with third parties whose consent would be required to transfer those contracts to the buyer.
A stock purchase generally works best when the buyer wants to acquire the target entity as a going concern, and there are few shareholders. Negotiations are more straightforward when there are fewer parties involved, and holdouts are less likely. Buyers will prefer to obtain all of the outstanding stock of the target company if possible. When there are minority shareholders who do not agree to sell, the buyer can approve a merger after the acquisition, although as noted above, this can trigger appraisal rights. Sellers will generally prefer the tax treatment of a stock purchase, while buyers will prefer the transaction be taxed as an asset purchase. As noted above, it might be possible to classify a stock purchase as an asset purchase for tax purposes by filing a special tax election, thereby affording the seller and the buyer the best of both worlds.
A merger generally works well when there are multiple shareholders in a target company that a buyer wishes to acquire as a going concern. Instead of having to negotiate with multiple shareholders, once a majority of the shareholders consent to the transaction, the buyer can be assured of having control of the business going forward. In a reverse triangular merger, buyers can retain limited liability, by separating the target company in a wholly-owned subsidiary, obtain all of the assets by operation of law, and generally avoid having to obtain third-party consents.
What types of laws give rise to the differences between the three acquisition types?
M&A is largely a creature of the laws of the state in which the company is incorporated/formed; however, tax laws impact the analysis significantly as well. For example, the Delaware general corporation law (“DGCL”) governs asset sales, stock sales and mergers for all acquisitions of Delaware corporations. The business and legal terms of an acquisition will be negotiated and agreed among the parties, but the underlying state law provides a framework for, and the basic requirements of, how each of those transactions must be conducted. The essential features of each deal type are a function of state law as well. For example, the DGCL has separate sections of its code dealing with asset sales, stock sales and mergers. Federal tax laws also weigh on the determination of whether the parties choose to enter into an asset sale, stock sale or merger, as discussed above.
So, why sell?
The reasons a company decides to market itself for a sale are as varied as the reasons for starting a company. Family-owned businesses are often sold because no one in the younger generations wants to continue in the business. Some disruptive technology companies were founded with the aim of being acquired by competitors or partners. In VC- or angel-backed companies, the shareholders may see an opportunity to realize a return on their investment and encourage the directors to market the company. Founders may wish to pursue new business ventures, and thus want to divest and start a new project. In some instances, a company may not be actively considering selling when it is approached by an investment banker or even by a potential purchaser directly. Because of their duty to act in the best interest of the company and its shareholders, boards of directors must carefully consider even unsolicited offers.
A buyer’s reason for targeting a company for acquisition can be equally varied. The target may have developed a market into which the buyer wishes to expand, whether a geographic expansion, price point, customer base, or a new product. The target may have disruptive technology that the buyer believes would be valuable to its business operations. Often larger companies can maximize the efficiency of a smaller concern or create other synergies by in-housing administrative or other functions that otherwise eat away at profits of smaller businesses. A buyer may also attempt to literally buy market share by purchasing a competitor.
Regardless of the motivations from the buyer or seller’s side, the ultimate driver for an acquisition is price. A seller wants to realize a return on investment (as that term is used in the broadest sense), and a buyer wants to realize value in the long term through the target’s business or assets.
Ultimately, we would argue that M&A is the culmination of capitalism, as stakeholders (founders, investors, employees, etc.) attempt to realize a return on their investment and reinvest those funds back into the economy at large.