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Buying a Business — When a Stock Purchase May Be Better

Buying a business rather than building one from the ground up has pros and cons. It may be more expensive at first, but it may also be profitable very quickly. There are two very basic ways to buy a business – asset deals and equity deals.

The standard thinking is that sellers of businesses prefer equity transactions and buyers prefer asset transactions. The usual advice for buyers focuses on limiting potential liability. Sometimes, however, precisely the opposite is true. When buying an existing business, the purchaser might actually benefit by buying its stock. To understand why, let’s first take a look at both kinds of deals.

Equity vs. Asset Purchase 101

In an asset acquisition, the buyer gets all the things the existing business owns, but only things — the pizza oven, tables, chairs and a large inventory of napkins and boxes. Absent other negotiation, the buyer does not step into the seller’s shoes on the lease, or with respect to existing supply contracts or outstanding liabilities. For the buyer it’s a fresh start.

In an equity, or stock, deal the buyer gets the entire fictional entity – the corporation, its reputation, name and all of its debts. Buying a business by purchasing all of its stock can be more complicated for the buyer. For the seller, it’s a clean getaway.

Two Reasons for a Buyer To Prefer a Potentially Messier Stock Deal

Buying Out a Co-Owner. Start-ups are famously volatile. For a new business with multiple owners, imagine a situation in which one owner simply wants out of the relationship for whatever reason. Serial entrepreneurs can become bored with success. The simplest move may be for the other owners to buy his stock, but this requires careful negotiation. Valuing the stock may be tricky. A non-compete agreement may be part of the deal. If all goes well, the existing business can continue without disruption. The formerly restless co-owner will simply walk away with money in his pocket to start a new unrelated venture.

Buying a Business with Very Valuable Intangible Assets. Imagine instead, that the most valuable asset of the business you want to buy is a long-term contract under which it can purchase rare earth metals at dirt-cheap prices or an automatically renewable lease on a very valuable Fifth Avenue storefront. On the more mundane level, consider items like the existing entity’s tax losses or credit history. The lease, purchase agreement or solid gold credit will likely not transfer in an asset purchase. Of course, neither will the entity’s massive unfunded pension liability.

Knowing whether a stock deal is a good idea for a buyer depends on extensive due diligence and careful analysis of tax consequences. Suit up the attorneys and accountants! This may be more expensive than an asset transaction. The value of the intangible assets acquired should be disproportionately greater than any accompanying liabilities, just to be on the safe side. You should probably also assume that the sellers intend to relocate to a very remote and inaccessible region of the world immediately after the closing, so further adjustments or legal recourse may be impossible.

If you are considering buying a business, make sure to structure the transaction in a way that takes into account where the value and the risks are.  Usually, that means buying assets, but not always.  In a transaction where the parties are co-owners or where the intangible assets of the business are important, consider a stock deal instead.

Nasir Pasha, Esq.

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Managing attorney and co-host of podcast Legally Sound | Smart Business

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