Entity Choice and Deal Type when Buying a Business – What, Why and When?

Mar 7, 2017

IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses.  The following blog has been provided by David Cook of Sovereign Legal (www.sovereignlegalgroup.com):

Entity Choice & Deal Type when Buying a Business –
What, Why & When?

I’m regularly asked by business-buyer clients a series of questions about entity choice and structuring the purchase and sale transaction. Our counsel focuses on three basic considerations:

  1. Minimizing risk exposure through customary deal term and entity structuring strategies
  2. The client’s tax planning strategy (as typically directed by their CPA/tax adviser)
  3. Practical operating conditions

Q: Stock or Asset Purchase and Sale? What’s the difference, and why does it matter?

A: This question involves all three of the above-referenced considerations. From a risk exposure standpoint, the buyer will almost always prefer an asset purchase transaction because it transfers all, or almost all, of the assets of the target business (tangible and intangible assets) without the buyer “stepping into the shoes” of the seller with respect to existing liabilities. Rather, the seller’s business typically survives as a “shell” entity (typically after changing its name to remove the brand), and they continue to remain liable for pre-closing liabilities that were not expressly assumed by the buyer. Buyers typically also prefer an asset purchase transaction from a tax planning perspective, largely because they benefit from the stepped-up basis in the tangible assets, with the ability post-closing to start depreciating the assets down again, thereby decreasing their taxable income from the business in the early years. Rarely – but sometimes – practical operation conditions will warrant considering structuring a deal as a stock purchase, for instance where certain licenses or contracts cannot be effectively transferred to a new company (but can continue with the existing company through a stock purchase). If a stock purchase structure is pursued, it typically involves more extensive (and thus more expensive) due diligence, drafting of representations, warranties, and indemnification, and security mechanisms such as escrow hold-back, since the buyer will typically be assuming all liabilities of  the seller, past and present, known and unknown.

Q: I Have an Existing Company; Why Would I Want to Form Another One for This?

A: Savvy business owners attempt to segregate, or ‘build walls around’ their separate assets, so as not to unnecessarily place assets within the reach of creditors. Think of it like a prenuptial agreement, where one spouse brings significant separate assets into the marriage, but seeks to clearly identify and segregate their separate assets from any new community property assets created during the marriage. Similarly, when ABC Manufacturing seeks to buy XYZ Distribution, they will typically want to create a new entity (perhaps a subsidiary wholly-owned by, but legally separate from, ABC Manufacturing), so that in the event their XYZ Distribution “Newco” is sued by creditors, there is no risk that they can also reach into ABC Manufacturing’s pockets.  However, there are certainly situations where it simply makes sense for the existing operating company to absorb the acquired business, and to avoid the unnecessary administrative burden of “keeping things separate” with back-office overhead allocations, etc. The point is, this is a consultative process that requires case-by-case examination of the “facts on the ground” and the client’s objectives.

Q: What Type of Entity Should I/We Form?

A: This is highly, if not entirely, dependent upon tax considerations. The most typical consideration is whether to take the subchapter-S election, which allows an owner-operator to establish a reasonable salary, and avoid self-income taxes on distributions over and above that reasonable salary level (as opposed to an LLC owner that would otherwise pay self income tax on all distributed earnings. It is rare that we see businesses electing to form a C corporation, primarily because it results in two levels of taxation (at the corporate earnings level, and again when earnings are distributed to the individual). However, there are some instances where this is preferable. One such instance is where 401(k) rollover business financing is used (so called “ROBS”). This may change, however, if the Trump administration’s corporate tax reforms are implemented, since they may result in the reduction of corporate taxes to levels where the net difference between C and S Corp taxation at the individual level is negligible.  It is important to note here that you can form an LLC and take the S election, or form a corporation and take the S election. In short, we encourage clients to consult with their CPAs early and often regarding choice of entity.

Q: When should I form this entity? Can’t I just wait until right before the deal closes?

A: Ideally, as soon as possible, because in the process of pursuing the transaction, you may incur liabilities or obligations which, for the reasons stated above, you want to prevent from reaching your existing assets. It also demonstrates to your counterparty that “you have your act together” and are ready to go, as opposed to being another pre-closing “TBD” item. This is especially important if the new company will have a separate capital structure (different ownership) from the existing company – for example a new investor – and may necessitate drafting a new operating agreement specific to that new company.

David Cook is founder and managing attorney at Sovereign Legal Group, PLLC, a law firm specializing in small and mid-sized business transactions. Since 2009, SLG has advised clients on nearly 100 business purchase, sale, or divesting transactions. They also advise business owners on a wide range of day-to-day operating matters, including employment, commercial leasing, customer, vendor and supplier contracting.  Mr. Cook is available to answer questions related to this article or buying or selling a business by telephone at 206-788-5222 or email at dcook@sovereignlegalgroup.com.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.