Editor’s note: This is the 17th in a series of articles on developing start-up companies in the technology or biotechnology sectors.
Madison, Wis. – In “Early Stage, Step 16,” we discussed the tax consequences of the sale of assets or stock ownership interest. For this discussion, the sale of ownership in an entity will be referred to as a stock sale. It could also be a sale of a partnership interest or ownership interests in a limited liability company. This article discusses the pros and cons from the seller’s standpoint of an asset sale versus stock sale.
In the ideal, sellers prefer selling stock. It can be quick, clean, and simple. The tax consequences as discussed in “Early Stage, Step 16,” are also quite simple – capital gain treatment. This is what large public companies do and this is the essence of stock exchanges.
However, for small non-public companies it is problematic to sell stock. The primary reason is that the buyer does not want to buy “unknown liabilities.” Many small companies do not have adequate financial information on which the buyer can rely. More importantly, many potential liabilities are not recorded on financial statements and, of course, potential liabilities may be “unknown” even to the seller.
Hence buyers are reluctant to buy stock even if they could conduct significant due diligence to buy the company “lock, stock, and barrel,” as they say. They would rather pick and choose the assets that they buy, leaving some assets behind and most, if not all, of the liabilities. The liabilities they typically leave behind include trade payables, bank debt, contingent liabilities for product liability claims, and other claims such as tax claims. The seller remains responsible for those, although the buyer would probably be responsible for some claims, like product liability claims. There is a pretty clear demarcation between the sales of large and small companies.
When buying a large company, a buyer may wish to buy stock because it is too complicated to buy assets, since the assets are too difficult to transfer one by one or when valuable contracts or licenses are difficult to transfer; whereas in a small company, buyers almost uniformly buy assets because of the lower risk involved.
What can you do as a seller to influence this decision? First of all, if you have a buyer who is ready, willing, and able to buy, you should not make any commitments until you consult with your legal advisor. You can find yourself getting “stuck” with statements you have made about what you are willing to sell and at what price. This has happened to me on numerous occasions with small business owners. They meet with a business broker or other party and attempt to sell their business on their own before getting legal advice because they do not want to incur any legal fees.
By the time they get to their lawyer, they have already committed to price and structure. At that point, the lawyer is hard pressed to “redo” the transaction, and it may be too late to restructure it as a stock sale. We have found that many buyers are knowledgeable and understand that they should be buying assets and not stock.
A typical sales contract will include the stock sale price, the payment terms (hopefully, 100 percent cash at closing), closing date, and perhaps some buyer contingencies such as financing, reviewing financial information, and other due diligence.
What most buyers will also want from the seller are some representations and warranties about the business. Recall your first home purchase. You wanted assurance from the seller about the house for things such as the condition of the roof, basement, and various mechanical devices. In addition, you purchased title insurance to protect against unknown claims against the ownership of the real estate.
The buyer of your business will rightfully want these same protections. The seller will be expected to make certain representations about the business and its assets and liabilities. These representations usually “survive” the closing for a time period. In other words, even though you sell stock, you will be expected to make sure that the representations are correct. If not, you will make them right. This usually means that you must compensate the buyer for any expense they incur for breaches of these representations if the condition of the business is not as you said it was.
Next time, I will discuss how you sell assets and “close down” the entity once you choose to do so.
Previous Early-Stage articles by Joe Boucher
The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of Wisconsin Technology Network, LLC.
WTN, LLC accepts no legal liability or responsibility for any claims made or opinions expressed herein.