Question: I’m considering buying a competing equipment dealership. I’m being told that I should buy the assets rather than the equity of the target business because, if I do that, my company won’t assume any of the seller’s liabilities. Is that true?
Answer: For most business buyers, purchasing the assets rather than the equity of a target is a good place to start, but doing so does not necessarily protect the buyer from all liabilities of the seller in most states.
The basics. When buying a business, you will generally have the option to purchase either the equity or the assets of the selling or target business. From the perspective of most buyers of privately held, non-publicly traded businesses, asset purchases tend to be more favorable than equity purchases with respect to both tax effects and liability exposure. To answer your question directly, I’m going to focus on just the liability issues for the purposes of this discussion.
- Equity purchases. If you purchase equity, you’re buying the ownership interests in the legal entity that operates the business — for example, all the shares of the issued and outstanding stock of a corporation. Consequently, all the liabilities associated with the seller’s business that are not paid off as of closing will continue to exist and bind the purchased business entity after closing because that entity will continue to exist; it will just be owned by you or your company, perhaps as a subsidiary, rather than by the former owners.
- Asset purchases. By contrast, if you purchase only the assets and do not expressly assume the liabilities of the target business, then in theory, only those assets would transfer to you or your company. Consequently, a buyer — typically, a corporation or limited liability company (LLC) — should be able to avoid responsibility for the selling entity’s liabilities because those liabilities remain with the seller and perhaps based on the assumption that the cash you use to pay for the assets would then be used by the selling entity to pay off its liabilities. In any event, most people would assume that, in an asset sale, the retained liabilities of the target entity would remain the seller’s responsibility and would not become liabilities of the buyer merely because the buyer bought some or even all of the selling entity’s assets.
Successor liability. For asset purchasers, over the past two decades, courts have whittled away at the notion that business purchasers can avoid liability for the obligations of their target sellers merely by purchasing their assets rather than their equity. Utilizing a wide and expanding variety of facts and circumstances, courts around the country now have established successor liability as a legal theory that, in an increasing number of cases, enables the seller’s creditors to hold a purchaser of all or substantially all the seller’s assets liable for the seller’s debts.
An exception for every rule. Successor liability typically is premised on one of four exceptions to the general rule that asset buyers are not liable for the debts of their targets:
- The buyer expressly or implicitly assumes the liabilities of the target.
- The buyer is a mere continuation of the seller.
- The transaction constitutes a de facto merger — a transaction that, regardless of form, is in substance, a merger or consolidation of the buyer and seller.
- The parties to the transaction intended to defraud the seller’s creditors.
Throw in a dash of subjectivity. Perhaps surprisingly, the de facto merger theory is among the reasons most commonly cited by the courts for applying successor liability. Though each case is different, factors that tend to support these rulings include:
- Operation of the same or a substantially similar business by the buyer.
- Continued operation of the business at the same location utilized by the seller.
- Retention by the buyer of the same or substantially the same management staff engaged by the seller, i.e., continuity of management.
- Assumption by the buyer of the seller’s ordinary course of business trade debts.
- In some cases, common equity ownership after closing.
- The seller’s insolvency, either before, or shortly after closing.
- The seller’s dissolution following the closing.
Add more subjectivity. Adding to the uncertainty is the fact that state laws as well as judicial interpretations of successor liability theories vary dramatically. Texas, for example, has eliminated successor liability altogether, except where a buyer expressly assumes such liability in a purchase agreement. Indiana, on the other hand, has adopted a statute that obligates future owners of health clubs occupying the same locations as their predecessors to honor the memberships those predecessors sold to their customers, this, after a state representative’s health club closed. Somewhere in the middle are states like Delaware, which have adopted the de facto merger theory, but apply it only sparingly.
A dish best served hot. This, coupled with the realization by business buyers and their attorneys that, save only with respect to bankruptcy court orders and some judicial sales, a seller’s creditors will not be bound by the terms of most asset purchase agreements, has resulted in a growing recognition that asset purchases no longer afford buyers the liability shields they once believed existed. Consequently, buyers have been refocusing their efforts to be prepared in advance for the vast and expanding array of potential post-closing issues associated with asset purchases. Such efforts now, more than ever, tend to include:
- Additional pre-closing due diligence.
- New and more robust requirements with respect to representations and warranties to be made by sellers in asset purchase agreements.
- Increased use of holdbacks, earnouts, promissory notes and other mechanisms for retention of reserves to fund undisclosed and/or unaccrued as of closing post-sale liabilities, defects, deductibles and self-insured retentions.
- Post-closing guarantees by sellers.
- Requirements that target entities remain in existence after closing until the applicable statutes of limitations expire.
- Requirements that sellers maintain various forms of insurance, including general and products liability coverage, after closing.
- In some cases, insistence that sales be conducted through bankruptcies, receiverships or other judicially prescribed processes that afford buyers court-sponsored protections from creditors.
- Structural protections such as the use of special purpose acquisition entities (SPEs or SPACs) which enable business buyers to protect their core assets from a given seller’s liabilities by housing purchased business assets, as well as associated liabilities, in separate subsidiaries.
- Dovetailing on this is renewed interest in Section 336(e) and 338(h)(10) elections in which stock purchases are taxed as asset purchases, as well as tax-advantaged reorganizations, such as forward and reverse triangular mergers which effectively isolate the seller’s liabilities after closing while limiting taxes — perhaps a much bigger issue going forward if and when the new tax provisions accompanying the Biden Administration’s Build Back Better Act take effect.
Although asset purchases generally remain more favorable than equity purchases for most business buyers, the distinctions are beginning to blur as the rules surrounding both taxes and successor liabilities continue to evolve. This makes careful planning, due diligence, negotiation and drafting critical for both buyers and sellers from the outset.
On that note, be extremely cautious about signing letters of intent (LOIs), term sheets and other apparently harmless or unenforceable agreements — they may be neither. Consider for example, the ostensibly benign LOI that contains only two enforceable provisions: A watered-down confidentiality requirement and an obligation to make due diligence information available to the other party for at least 90 days.
Wait a minute. Upon signing the LOI you will be legally obligated to disclose all your financial, tax, contract, customer, supplier, credit and other information to a potential competitor who is not obligated to buy your business or pay you a deposit. Is that what you meant to obligate yourself for? This is where stringent non-use, non-disclosure and return requirements, deposits, limited or staged disclosures and attorneys’ fee provisions can be lifesavers by making it potentially too expensive for the other side to hurt you.
For this and a long list of other reasons, it is recommended that you contact your certified public accountant (CPA) and an experienced mergers and acquisitions (M&A) attorney well in advance of starting down this path. Doing so can be immensely helpful in getting your deal closed and save you a tremendous amount of time, expense and legal trouble if your deal winds up being one of the 70 to 90 percent of business sales that don’t close.
James Waite is a business lawyer with more than 25 years in the equipment rental industry. He authored the American Rental Association’s book on rental contracts and represents equipment lessors throughout North America on a wide range of issues. He can be reached at 866-582-2586 or firstname.lastname@example.org.