Editor’s note: Linda Markus Daniels is a founder of and principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A. TechLaw is a regular feature in Local Tech Wire.
________________________________________________________________________________________As the economy continues to recover, more businesses are likely to be bought and sold. If your business is one of these, there are certain things you should consider in determining whether you have the right potential transaction partner and whether the deal makes sense for you.
Major Issues in the Purchase Transaction
While early meetings are likely to focus on the fit of the buyer’s business with the seller’s as a merged entity, some of the fundamental issues that should be discussed are as follows:
The overall structure of the transaction is likely to be driven by tax and liability considerations. There are three basic forms that the purchase can potentially take, and each has different income tax and liability consequences, as follows:
The first form is a sale of assets. This form is the favored method of purchase by most buyers for both income tax and liability reasons. From the tax side, the buyer allocates most of the purchase price to highly depreciable assets or to wages and noncompetition payments. In this scenario, all or virtually all of the income the seller receives will be taxable as ordinary income, i.e., at the highest tax rates. From a liability side, the buyer can (if the seller permits it) elect to purchase only specifically selected assets, leaving behind assets that could result in any liability. To be clear, the buyer would not be purchasing the seller as a company, but rather the company would remain in existence and owned by its current shareholders. Any liability not actually assumed by the buyer would remain the company’s problem.
The second form is a sale of stock. This method is more beneficial to the seller, and probably the least favored by potential buyers. From a tax standpoint, the seller’s shareholders will receive capital gains treatment on the difference between the basis in their stock and the purchase price. The amount paid by the buyer for the stock, however, will not be deductible to the buyer. As to liability, the buyer is taking ownership of the stock which means it takes ownership of the company as it exists, including any potential liability. As a result of this situation, sellers may prefer to take a lower price if the buyer will buy stock rather than assets.
The final form is a merger, which in its simplest form means that the shareholders of seller end up as shareholders of the buyer. In most cases this is done as a “tax-free exchange,” meaning that the seller’s shareholders are not taxed on the shares of the buyer received at the time of the exchange. Instead tax is only due (at the capital gains rate) at such time as the buyer’s stock is eventually sold. This allows the seller’s shareholders to control the timing of the tax hit if they wish to do so. The other tax and liability aspects are the same as with respect to sale of stock.
Of course, it is important to know when the seller’s shareholders will be allowed to sell the shares received, since if they are locked up for a period of time this could result in a substantial change in the value between the closing of the sale and the time when the stock can be liquidated.
Buyer’s Review of the Seller
Before any business information is exchanged the parties should have a nondisclosure/nonuse agreement in place. Anyone interested in potentially buying another business is likely to be doing so because of perceived, unique aspects of that business. Disclosure of information on those aspects, including customers, could be used against the seller if the transaction is not ultimately consummated and there is nothing to prevent such an abuse of the information. In any event, the buyer will undertake “due diligence” and collect a large amount of information about the seller’s business. In general, however, the following are a sample of the types of questions that will be reviewed:
Seller’s Review of the Buyer
It may seem strange, but if a seller is going to be employed by or a consultant to the buyer, to rely on the buyer to take care of its employees, or to rely on the financial stability of the buyer for further payments or to support the value of stock received in the transaction, then a careful examination of the buyer is important to the seller. Depending on how the transaction is ultimately structured, some of these issues may not be relevant, but understanding the buyer up front will still be useful.
Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Linda Markus Daniels concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, technology and international matters. Comments or questions can be sent to firstname.lastname@example.org.