What to Expect When Buying or Selling a Business Part II
This article continues from the previous one about selling and a business. Last time we talked about buying and selling a business we discussed the types of professionals and general agreements involved. Today, we are going to look at the difference between an asset purchase vs. a stock purchase, and are going to pick up where we left off, so we being at #5.
Disclaimer: The following information does NOT constitute legal advice and is only for general educational purposes. Each situation is different and specific legal issues usually require additional research and investigation, so do not rely on this article to address a particular legal issue; use this as a starting point to gain a general understanding. This article, although educational in purpose and substance, nevertheless, might be deemed attorney advertising, and prior results do not guarantee future success.
5. Asset v. Stock Purchase Generally
Generally, there are two ways to acquire a business, as it is commonly understood.
An individual or company can buy stock in the corporation that owns the business, such as buying shares of Wal-Mart. Limited Liability Companies (and partnerships) don’t have stocks, but usually sell “Membership Interests” or something sometimes called “units” which they pretend are the same thing as stock shares, but they aren’t - not quite. For convenience sake here I am going to use the terms “stocks” “shares” “units” or “membership interest” interchangeably to indicate some kind purchase of ownership into an existing business, rather than just buying the assets of a selling company. Obviously, you really don’t think of yourself as much of an owner of Wal-Mart if you own a few shares, but if you own 100%, 50% or even 25% of a local store, I bet everyone believes you to be the owner or at least one of the owners.
The other way to buy a business is to purchase its assets, take over its lease, its brand name, the intellectual property it owns (formulas, patents, recopies, software, trademarks), accounts receivables, contracts and relationships, and so on. If the business targeted for purchase was owned by a single individual, not incorporated, (i.e. Mr. Jones who “owned” the local candy store) a purchase of assets would be the simplest way to go. In this situation the selling company is still owned by the original owners, but they have sold some or all of a large part of it. Keep in mind, in a business with more than one product or service, or multiple brand names, the business might only be selling off a line of products / services, not the whole the thing.
Both ways of buying / selling a company come with their own pluses and minuses, and we are going to cover some of them, but the reasons for one method over another are usually determined in this order: (i) liability (ii) tax consequences (iii) convenience and privacy.
6. Liability Concerns in Buying / Selling a Business
Probably the first issue a Purchaser and Seller will look to in making a decision whether they want to exchange stocks or assets, is what happens to liability. If a Buyer buys only assets, the Buyer theoretically escapes a lot of the liability of the Seller. Not always and not all the time. There are some things the Buyer cannot get out of easily.
The classic example is if an oil company (say Acme Oil Co.) sells its inventory, trucks, and customer lists to a Buyer who uses them to open an oil company (NewCo), down the street; typically, Buyer is not responsible for the Seller’s toxic waste issues at the original oil company site. However, if the Buyer bought shares of the oil company itself, the Buyer likely *would* be responsible for the toxic spills, even though the Buyer “inherited” the liability.
In that situation, it’s a bit like if you ever were in supermarket and dropped a bottle of pickles on the floor which shattered and you quickly scampered away. Maybe someone else walks over to where you were standing and then they get in trouble because they are standing where you were, in front of the pickles on the floor. That’s essentially what happens when a Buyer buys shares of a company; they “stand in the place” of the former owners.
7. Shifting Liability in the Sales Agreement
Is this dichotomy always a done deal? No. For one thing, the Buyer and Seller can contract who gets or keeps what liability, at least between themselves. What do I mean by “between themselves?” Let’s look at two examples in more detail.
7a. Example: Asset Sale
Buyer is a company called “NewCo, Inc.” Seller is “OldCo, Inc” but Seller operates under a trademarked “doing business as” trade name called “Acme Oil”. Acme Oil has thousands of drums of oil as inventory, several acres of land, a building, several trucks, other trade secrets and intangible assets in the form of customer contracts, accounts receivables, supplier deals, and know-how by several key employees.
NewCo wants to purchase everything except the land and building, because NewCo is afraid the land is polluted with toxic oil and the building is old and might contain asbestos and have other issues. In addition, NewCo makes the sale contingent on several key employees signing employee contracts to work for NewCo for a minimum of several years (to preserve the “know-how”). OldCo retains the land and building and hopes to sell those off and disband the company. NewCo opens a new clean facility down the street.
Two years later, after the sale, NewCo is operating down the street under the same trade name as OldCo (i.e. “Acme Oil”). OldCo technically still exists, but really is just acting as a holding company for the land and building it can’t sell due to their polluted condition. A former employee of OldCo (not NewCo) Pauline Plaintiff sues both OldCo and NewCo. Pauline isn’t working for anyone right now but claims to be disabled by the toxic waste of the polluted land of OldCo.
NewCo probably isn’t liable because NewCo did not buy the land or building or have anything to do with the operations that polluted the land of OldCo before the sale. It’s like if Otis accidentally ran over a pedestrian, Victor, with his car, then sold his car to Newman, and Victor later sued Newman; what did Newman do? Nothing. He just happened to now own Otis’s asset - the car. Same with NewCo and Oldco. Therefore, the fact that NewCo only purchased assets not stock, provides *some* insulation against a lawsuit against liabilities and problems that OldCo created.
However, Pauline Plaintiff has a clever attorney who argues that somehow NewCo is really OldCo. After all, NewCo still uses the trade name OldCo used (Acme Oil). Pauline also argues that some of NewCo’s key employees (the ones that NewCo demanded come along as part of the sale) were the ones responsible for unsafe toxic waste working conditions. Now, is NewCo on the hook? I dunno. Certainly, they need to put a legal defense, possibly a very expensive one. Also, some of these clever legal theories might hold up. So, what could have Newco done differently?
Well, for one thing, besides only buying assets which is again *some* protection from these lawsuits, Buyers, such as NewCo, often will demand that OldCo *indemnify* NewCo. Indemnification colloquially means that OldCo will (1) defend NewCo in court and (2) pay for any damages that NewCo would owe Pauline Plaintiff, on account of OldCo’s old operations.
Technically speaking, indemnification usually only refers to someone’s right to be made whole for damages, and does not include a legal defense. Those are two separate “rights” or “benefits” that one party bargains for from another party. However, people and even legal practitioners tend to use the two concepts (reimbursement of money damages and a legal defense) interchangeably. But be careful! They often are not. A proper legal defense can be *more* expensive than the actual money damages awarded to a plaintiff, so make sure you know what kind of protection you are getting.
In any event, this means that even though NewCo might be dragged into court, a proper indemnification will ensure that OldCo picks up some or all of the bill for the legal defense (or provides one) and pays any damages suffered by Newco. Can this ever work in reverse?
7b. Example: Stock Sales
Well, let’s say Buyer purchases all the shares in Seller’s company. Theoretically, Seller could demand that Buyer indemnifies Seller (basically the opposite of the above example). Why does this happen?
Let’s take a smaller example than before. Suppose Mr. and Mrs. Shaw have a partnership, not a corporation, and they jointly own a Laundromat, “Washing World” which they operated for 40 years. They are older and don’t want to worry about anything when they sell the business; rather they want to retire and move to the Catskills and bird watch in peace and quiet. So, Mr. and Mrs. Shaw Seller demand that Bobby Buyer who is buying 100% of their partnership interests indemnify them for everything going forward, meaning if there are any lawsuits, Bobby will provide them with a legal defense and pay any damages on their behalf.
Later, poor Victor gets sucked into one of the machines. Victor survives but sues everyone, including Bobby, Mr. & Mrs. Shaw. Mr. & Mrs. Shaw *could* be on the hook, at least to Victor, because they did buy and maintain the machines for many years. However, since Bobby is indemnifying them and providing a legal defense, they can rest easier knowing someone else will pick up the bills if they are sued. Remember, just because you are indemnified by another person or company, doesn’t mean you can’t be sued yourself - again, indemnification colloquially means someone will defend and/or pay your damages if you are sued.
8. Final Thoughts About Liability in Buy / Selling a Business
The common wisdom is that if you buy only the assets of a business, and not ownership (such as stocks, membership interests, or units), you will shield yourself from prior liability issues, whereas if you buy ownership into the business you “step into” the shoes of the previous owners and are still on the hook for everything. This is often true, but not always the case as the above examples show.
Parties can structure the agreements of sale between them to shift liability or add extra layers of protection for themselves. However, nothing is ever bulletproof. For one thing, remember, just because someone is covering your legal expenses or paying out the lawsuit damages for you, doesn’t mean they have the ability to do so. For instance, if Victor sues Bobby, and Mr. & Mrs. Shaw and won $2M in damages, but Bobby only had insurance and assets totaling $500,000, then Mr. & Mrs. Shaw are still liable for the rest.
Still, the best Buyers and Sellers can do is draft some good agreements and get the *most* protection they can, *without* killing their own deals.
Next article we will pick up and talk about taxes, convenience and privacy when deciding to buy or sell assets or shares.