“If the seller has $250,000 in cash on the balance sheet, does that transfer over?”

“If the seller has outstanding business loans, what happens to those on closing day?”

These are some of the common questions I get from buyers once they’ve started to dig into a company’s financials. Although these are useful questions, most of them boil down to understanding the differences between an asset sale and a stock sale. 

Once you understand if you’re dealing with an asset sale or a stock sale, you’ll know exactly what’s going to happen to the cash and debt post-close. You’ll also know what the tax and legal implications will be of the type of sale you conduct. 

Let’s dig in.  

 

What Makes an Asset Sale Different From a Stock Sale?

 

An asset sale is when the seller sells the tangible and intangible assets of a company to a buyer, whereas a stock sale is when the seller sells his or her shares of the corporation or business entity that he or she owns.

Let’s say a seller owns a company, Seller Company LLC. This legal entity owns assets, potentially debt, and is also responsible for legal obligations and tax payments (hence a balance sheet summing up “assets and liabilities”). Assets can be tangible, such as a printing press or industrial equipment. It can also be intangible, like the brand, logo, company culture, standard operating procedures, intellectual property, and the website.

Now, even though the seller’s ownership of the company is represented by stock in this legal entity, Seller Company LLC, the legal entity itself isn’t what generates cash flow; the assets owned are. Ultimately, as the buyer, you’re interested in the cash flow and assets –  not necessarily the specific legal entity.

 

Asset Sales

 

When it comes to lower middle market and main street transactions, the majority of sales are asset sales, not stock sales. As it gets increasingly difficult to transfer assets with larger businesses, buyers and sellers turn to stock sales or other creative means of financing to get the deal done.

 

Source: MidStreet

As the buyer, in an asset sale, you form your own legal entity and transfer the assets and cash flow from the selling entity into your new entity, leaving the original one hollow.

Sometimes, the seller will own a building or other form of asset that won’t be included in the sale, which will remain with the original Seller Company LLC entity. More often than not, though, the original entity is left empty. The seller will use it for a new business or shut it down entirely by filing for dissolution through the state. 

Through the asset purchase agreement, signed by both buyer and seller at the end of a deal, the assets and the revenue-generating components, including employees, are transferred to the new legal entity. From a paperwork standpoint, employees are usually terminated from the old entity and rehired by the new one shortly after the transaction.

 

Source: MidStreet

 

The primary advantage of an asset sale is that it results in a cash-free, debt-free transaction, which I’ll explain more about later. 

 

Stock Sale

 

Now, in a stock sale, the buyer purchases 100% of the stock of “Seller Company LLC,” taking ownership of the entire company (and entity), including its liabilities and historical risks.

Stock sales are more common in larger transactions or when specific contracts and licenses are non-transferable and essential to the business. More on that below. 

Basically, when thinking about the difference between an asset sale and stock sale, the practical difference on paper is: does the original entity “Seller Company LLC” transfer to the buyer or does the buyer create a new company, “Buyer Company LLC,” and then simply purchase the assets that “Seller Company LLC” originally owned? 

 

Source: WallStreetMojo

 

Why Asset Sales Are Preferable for Buyers

As a buyer, asset sales offer several advantages that primarily benefit you in the process.

 

1. Cash-free, Debt-free

 

Asset sales are what’s called “cash-free, debt-free.” 

Cash-free means that any cash in the original entity remains with the owner. For example, if the business has a million dollars in cash in the bank account on the day of closing, the seller retains that cash while selling the other assets. The cash does not transfer to the buyer. 

Although this may not seem like a benefit, it usually comes hand-in-hand with the next one: debt-free.

In asset sales, the seller keeps any existing debt that’s on the balance sheet. What the seller decides to do with that debt is on them, but the buyer has no responsibility for any outstanding debt the business has.  

Source: WallStreetPrep

In a cash-free, debt-free situation, if the business has a million dollars in cash and $250,000 in debt, as an example, the seller retains both. The buyer does not assume any of the cash or debt. The seller retains all existing cash and liabilities.

 

2. Clean Record

 

In addition to an asset sale being debt-free, it’s also free of historical liabilities of the original entity. On the other hand, if you purchase the stock of a company, you become liable for all its past activities – even if you weren’t there for them. 

For instance, in a stock sale, if toxic waste barrels with the name Seller Company LLC are found years later, or if past products fail, you are responsible as the new owner of the legal entity. By buying only the assets, you avoid liability for events that occurred before your ownership.

That said, if you go through with a stock sale, you can offset these potential liabilities through the representations and warranties and indemnifications sections in the stock purchase agreement – your attorney can help with this portion. 

The “cash-free, debt-free” structure minimizes the risk for buyers, making asset sales the default setting for most small to medium-sized transactions.

 

3. Favorable Tax & Depreciation Implications

 

On top of the “cash-free, debt-free” benefits, asset sales are more favorable to buyers regarding tax and depreciation. 

In a stock sale, there is no depreciation of the assets, but with an asset sale, the buyer is able to depreciate the new assets and generate tax deductions starting from the date of acquisition. This can help reduce taxes sooner and improve cash flow especially during the first few years.

This doesn’t work the same way for sellers. Sellers will be taxed more in an asset sale. Proceeds from a stock sale are taxed at a lower capital gains rate, and depending on the type of entity the seller has, he or she may face double taxation in an asset sale. 

Pro Tip: If you conduct an asset sale, and your new entity needs to operate under the existing business name, you can file a “doing business as” (DBA) with your state government. This process is straightforward and inexpensive, typically costing between $25 and $100 and requiring renewal every few years.

 

Why Conduct a Stock Sale

 

Now, even though asset sales occur by default, particularly in smaller business deals, there are scenarios where you might want to engage in a stock sale instead.

Non-Transferable Contracts: Sometimes, a business will have contracts or licenses, with vendors, government agencies, or otherwise, that cannot be transferred to a new entity. In cases like this, a stock sale ensures the contract remains intact. It also helps you avoid having to register for new contracts or licenses, particularly if the process is arduous or costly. Sometimes a particular contract, license, or permit itself can make a business highly valuable, if it allows the business to get access to a service that would otherwise be difficult to obtain. 

Pro Tip: Before agreeing to a stock sale because of this reason, make sure the contract doesn’t state that a change in control requires consent to the reassignment of the contract, also known as a “change in control provision.” Your attorney should be able to help you with this. 

Minority Investments: If you’ve invested in the stock market, then you’re already familiar with the idea of buying stock. They don’t call it the “asset market” for a reason. Similarly, when investing in a minority role, such as in a startup, you typically buy equity (stock) rather than assets, as it’s easier to divide.

Larger Deals: In larger transactions, stock sales can be more practical and common, as it gets increasingly more challenging to transfer over assets. Additionally, there might be more creative financing in play with larger deals. The seller may choose to retain a portion of the business and sell the rest, which is known as recapitalization. For example, in a private equity situation where the seller keeps 20% and the buyer acquires 80%, a stock sale would make more sense

Buying a Non-US Company: Although this would be somewhat rare (and unable to be financed with an SBA loan), there are a number of companies sold on the market that are based overseas. More often than not, sellers from other countries require a stock sale because the tax implications for them are much more favorable this way. For example, in Canada, if a seller conducts a stock sale (or a “share sale”), only 50% of the proceeds are taxable. However, if the seller does an asset sale instead, he or she may be taxed twice in the process. 

Negotiating Tactic: Because stock sales are preferable for sellers because of the tax benefits, buyers may be able to negotiate a lower purchase price if they agree to a stock sale. Alternatively, sellers may make the purchase price higher for asset sales versus stock sales to make up for the difference. 

 

Asset Sale v. Stock Sale: What’s Right For You? 

Understanding the differences between asset sales and stock sales is important, particularly as you start to gauge what assets and liabilities you’ll have ownership of post-close. 

 

Source: Hansra Law

 

Asset sales, where the buyer acquires the assets and cash flow of a business but not the legal entity itself, are common in lower middle market and main street transactions due to their cash-free, debt-free, and risk-free nature. This structure minimizes the buyer’s exposure to historical liabilities and simplifies the transaction process.

On the other hand, stock sales are occasionally necessary in scenarios where there are non-transferable contracts or licenses involved, minority investments, larger transactions, or international companies. 

Ultimately, the choice between an asset sale and a stock sale comes down to the buyer and seller preferences and priorities. By understanding these factors, buyers and sellers can make informed decisions that align with their strategic goals and risk tolerance.

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