Buying a business for many is an opportunity for a fresh start without having to “start from scratch”. There is an appeal in purchasing an existing business because most purchasers believe they can do a better job, or have a newer, fresher vision that will lead to tremendous financial success without the initial two to three-year trial period so many startups face. For some who are buying a business it is a second or third business that is part of a greater financial plan to increase their passive income. For others it is about investing in other people to start a new and exciting venture together.
Whatever the reason for purchasing an existing business there are numerous principles that are common to every transaction. Every business acquisition is either a stock purchase or asset purchase and the reasons for choosing one versus the other will vary depending on your budget and goals. Here, we will discuss the nuances of both, and some suggestions and pitfalls based on extensive litigation, transactional, and consulting experience in these matters.
STOCK PURCHASE OR ASSET PURCHASE?
It’s critical that you understand the difference between an asset purchase and a stock purchase as both have very different implications for your contract drafting and due diligence process.
A stock purchase agreement means you are purchasing the stock, shares, or membership interests of the seller company. If you purchase all of the shares of a company, then that that means generally that you are also assuming everything that the company owns i.e. all of the company’s assets, contracts, equipment, vehicles, inventory, intellectual property, etc.
One might consider a stock purchase when purchasing an existing restaurant or bar because then the liquor license process is easier and less expensive, generally speaking. A stock purchase might also make sense if you are acquiring a business where you already have an extensive understanding of the business’s financial and legal structure, operations and risks. Stock purchase agreements also often come up in the context of succession planning i.e. transferring your business to family members as part of your overall estate/financial plan.
The downside of any stock purchase is that you run the risk of owning and assuming all of that company’s liabilities whether known or not. Therefore, you could be assuming potential lawsuits against the company whether those lawsuits come from clients, third parties, or even employees. The potential for assuming risks, liabilities or other undisclosed debt means that with a stock purchase you will generally be conducting more financial and legal due diligence than you would with an asset purchase deal. As such, a stock purchase can be a more expensive process when considering the additional time and effort dedicated to the due diligence process. This will become more apparent momentarily when discussing an asset purchase.
An asset purchase on the other hand means you (or actually a new company that you are forming to purchase the assets from the seller-company) are purchasing all or specific assets of the seller company such as the equipment, inventory, customer lists, contracts, leases and intellectual property.
The plus-side to the asset purchase agreement, and the reason that I tend to advise clients to purchase a business through an asset purchase agreement rather than a stock purchase agreement, is that you aren’t taking on the seller company’s liabilities (unless you specifically agree to in writing as part of the overall consideration/value you’re paying the seller). You don’t have that same risk of unknowingly or accidentally assuming undisclosed liabilities as you would with a stock purchase.
Even though both stock purchases and asset purchases require at least some basic due diligence, it stands to reason that most business acquisitions in the small business world make sense as an asset purchase not a stock purchase because of the additional costs and additional risks inherent in most stock purchase deals.