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The “M&A” acronym is frequently – and often frivolously – referenced in a corporate setting; however, while the notion of an M&A may be generally understood, too often the mechanics and requirements involved in any given M&A are not well known to the general audience (unless they’ve had first hand experience which not all functions within an organization are afforded). Therefore, it makes sense to start at the beginning, with a framework, as to what an “M&A” really is comprised of.

M&A Definition

“M&A” refers to a merger and acquisition. A merger entails two companies consolidating, directly or indirectly, into a new entity. Discussion on and around mergers will be the topic of the second part of this blog series. An acquisition occurs when the target company is acquired and absorbed, in whole or in part, into the acquiring parties’ business.

Often that target company ceases to exist as a separate entity, with the acquiring target taking over all operational management decisions, as well as capitalizing on identified synergies in order to attain an immediate return. An acquisition can occur by way of an asset acquisition, or a stock acquisition. Each of these methods are described below.

What is an Acquisition?

As noted above, an acquisition is typically one of two methods: stock acquisition, or asset acquisition.

Stock Acquisition

A stock acquisition is when the acquiring company acquires all of the assets, rights, and liabilities of the target company – that is, warts and all. Unlike an asset purchase, the acquiring company cannot selectively choose which particular assets and liabilities when purchasing stock, and as such assume all of the target company’s assets, rights, and liabilities.

This additional liability creates risk for acquiring companies, which should be mitigated by a comprehensive and coordinated due diligence coupled with tailored and robust contractual provisions, together with other assurances that may be requested, in the definitive purchase agreement.

From a seller’s perspective, a stock purchase is preferred so as to not be left with any residual company liability, and sellers typically receive more favorable tax treatment than when selling solely assets in that the shareholders may be subject to only a single taxation level rather than potentially double jeopardy in taxation at both the shareholder and the entity level as seen in asset acquisitions (although, with the newly effective nominal federal corporate tax rate of 21% due to the passage of the Tax Cuts and Jobs Act of 2017, any material deviation has been mitigated).

A stock acquisition is typically more streamlined than an asset acquisition, in that the acquiring company will more often attain 100% ownership and control of the target company. Following closing, the target company may be maintained as a separate, wholly owned subsidiary, or it may be merged with the acquiring company (or another one of its subsidiaries).

In the event the acquiring company acquires less than 100% of the target company’s stock (but generally at least 90%), it may be able to use a short-form merger which permits the buyer to purchase and acquire all remaining stock and minority interests in absence of a stockholder vote. Moreover, little additional steps are required in the transition of existing contracts, given that there is no assignment of contracting entity.

However, parties must be cognizant of any Change of Control provisions in material contracts, which typically require prior written consent of the other contracting party prior to the effective date of the change of control. This consent – or at least verbal assurances – is typically sought during diligence.

In addition, there are few statutory requirements related to stock acquisitions. Approval from the target company’s board will likely be required, but often a formality as the decision to seek offers is usually been suggested and/or approved by the board long before the approval formality. Ordinarily, stockholders do not need to give consents unless they are a party to the purchase agreement.

Asset Acquisition

The procedure in connection with an asset acquisition is much denser than a stock purchase transaction, or even a merger, simply because the parties are contemplating the ownership of identified and specific assets. As such, the transfer of ownership (and considerations related thereto) must be carried out on a line item, pertaining to each asset.

This involves an assignment and assumption of certain contractual obligations, in addition to seeking out prior consent from contracting parties that require notice and consent pursuant to an assignment provision in the contract, as well as a bill of sale for the transfer of legal title of any tangible property, as well as undertaking any license or assignment or other legal requirements necessary for the transfer of intellectual property ownership.

But prior to such administrative necessities, the parties must endure due diligence – and I say that both parties must endure it, as the target company must take the steps, in anticipation of a sale, to identify and prepare the company and company assets and records for inspection, and further questioning. Such assets may include material contracts/accounts, intellectual property, and key employees.

In addition, the acquiring company will want to know about the status of the selling company, particularly whether there are any irregularities or risks (either threatened or actual), including financial information, key contracts, tax liabilities, and actual or pending litigation.

Thereafter, the acquiring company will share the scope of the assets to be acquired based off the due diligence, in conjunction with tailored representations and warranties and indemnities to be set forth in the asset purchase agreement.

There are also key divergences in tax treatment between an asset acquisition to a stock purchase, as private company asset acquisitions generally are structured as taxable transactions for business reasons.

Generally speaking – as the intricacies of tax issues go beyond the scope of this article – the target company generally recognizes taxable income, gain or loss on the sale of its assets.

In addition, the owners/stockholders of the target company will ordinarily recognize taxable income, gain or loss on the distribution of any proceeds from the sale. This potentially results in double taxation (at both the entity and stockholder level), rather than as a single level of taxation (at the stockholder level) typically realized in a stock acquisition.

For this reason, selling companies generally prefer to structure a transaction as a stock acquisition. However, as noted above, the implication of two levels of taxation is somewhat mitigated by the newly effective nominal federal corporate tax rate of 21% due to the passage of the Tax Cuts and Jobs Act of 2017.

There are other general methods to avoid any degree of double taxation, including having the target company as a pass-through LLC or an S-corporation, then any taxable income, gain or loss realized from the sale of the assets generally passes through to (that is, is taxed directly to) the target company’s owners or stockholders, thus avoiding the entity level tax in most cases.

In addition, the transaction may be structured to reduce or otherwise eliminate entity level tax by carrying forward, or back, any net operating losses to offset taxable income.

From the acquiring company’s perspective, the buying company acquires a cost basis in the acquired assets equal to the purchase price paid plus certain other items. In a stock acquisition, the target company’s basis in its assets generally remains unchanged.

The cost basis that the buyer receives in the acquired assets is often higher than the basis the target company had in those assets. If the target company’s basis in its assets exceeds their fair market value, an asset acquisition results in a step-down in the basis of the acquired assets.

This article is made available by Carpenter Wellington to provide a general understanding of the topic set forth therein. In no way should this article be construed as specific legal advice, nor does the receipt of this article create no attorney client relationship in on itself, between you (the reader) and Carpenter Wellington. This article, in whole or in part, should not be used as a substitute for competent legal advice from a licensed professional attorney in your jurisdiction.