Another reason asset deals are a little more work from a documentation standpoint compared to stock deals and statutory mergers is due to the question of whether or not the buyer and seller need approval of third parties. These third parties may include parties to the selling company’s customer contracts, vendor agreements, leases, etc. The general common law rule is that contracts are assignable. If you and I have a contract that says I’ll buy your 1962 Ford Mustang, the law allows me to assign the contract, and consequently, my obligation to buy the car, to another person (although the assignment may not actually get me off the hook for buying the car if the person I assign it to does not). As with just about every area in the law, there are some exceptions, such as contracts involving professional or artistic skills (if our contract instead says I’ll pay you $100 to sing at my daughter’s wedding, your services are considered unique and personal and you can’t just assign away your obligation in that case). Nevertheless, the general rule is contracts are freely assignable.
In practice, however, contracts often generally freely assignable. This is because it is very common, particularly with commercial contracts, for a contract to contain language to the following effect – “Company XYZ shall not assign this agreement without the prior written approval of Company ABC.” Lawyers call this is an anti-assignment clause (creative name, don’t you think?). The clause we just referenced is a basic, fairly typical anti-assignment clause. A basic, fairly typical anti-assignment clause is triggered by the type of assignment that is done in an asset purchase agreement. In other words, in an asset purchase deal, the buyer and seller often need the approval of third parties to the seller’s commercial contracts. Getting these approvals can be a lot of work and, depending on the terms of the particular contract (i.e., in cases where the seller has a below market deal and the third party wants to get out of the deal), may be near impossible without some renegotiation. And, anything that gives parties to the seller’s contracts, particularly the key customer and vendor contracts, major leases, etc., the opportunity to say no or renegotiate the contract, has the potential to impact the deal. Buyers are generally not interested in paying huge money for your company if they expect that customers and vendors will have a right to rethink their contracts and are likely to do so. That being said, I have seen plenty of deals where buyers were so hot on closing the deal that they were willing to move forward without required contractual approvals to key agreements. Sometimes this is a risk a buyer is willing to take.
In a stock deal, however, the basic, typical anti-assignment clause is not triggered. When a buyer purchases all of the stock of the selling company, the buyer steps into the shoes of the seller and the seller’s assets, contracts, etc. are not technically transferred at all. Although that may be a little confusing, think about a situation where you own all 100 shares of XYZ, Inc. All of the contracts and assets of XYZ are in the name of XYZ. If you sell the 100 shares to me, you transfer the shares to me and now I own 100 shares of XYZ. At the level of XYZ, nothing changed. The assets and contracts of XYZ are still all in the name of XYZ.
Now, let’s take a look at a comprehensive anti-assignment clause – “Company XYZ shall not assign or transfer this agreement, in whole or in part, without the prior written approval of Company ABC. For purposes of this agreement, any change in control of Company XYZ resulting from a merger, consolidation, stock purchase or asset sale shall be deemed an assignment or transfer.” This comprehensive anti-assignment provision specifically captures a stock sale. Therefore, even if buyer and seller structure the deal as a stock sale, they’ll need the approval of the other party to the seller’s contract where those contracts contain a comprehensive anti-assignment clause like this one. In my experience, basic anti-assignment clauses are more common that comprehensive ones.
But, hold on, there are other, perhaps even more important, considerations that go into the decision of how to structure the sale. When I was a baby (young) associate at the law firm, I would often question why we were structuring the transaction one way versus another. When I asked a partner or senior associate, invariably, the answer given was that it was “tax driven.” At times I thought that was the pat answer so the partner could avoid saying “I don’t know.” Turns out, though, that’s actually the driving force of a lot of the reasoning behind transaction structures. And, so it goes with the decision as to whether to do a stock or an asset deal. Sure, the considerations we raised earlier regarding documentation and liabilities are real ones and play into the decision as to how to structure the deal. But, taxes seem to typically carry the day.
At the risk of oversimplifying the complex area of M&A law and accounting, buyers generally like asset purchases. When they purchase assets, the IRS allows buyers to increase (or “step-up”) the book value of those assets. With a higher book value, the buyer will be able to deduct a greater amount of asset depreciation in the coming years. For example, if a buyer pays $100 for all of seller’s assets but the book value of those assets on the seller’s books is only $50, the buyer gets to allocate the extra $50 (the $100 purchase price minus the $50 current book value yields an excess of $50) to the book value of the assets on its books. So, if the buyer depreciates the assets over five years (this is a gross simplification as assets will be depreciated over different lengths of time, that means that the buyer can deduct $20 of depreciation for each of the next five years ($100 book value of the assets divided by five years = $20 per year). If the buyer would otherwise have $100 of earnings before taxes at the end of the first year, after deducting the $20 of depreciation, the buyer effective only pays taxes on $80. If the buyer has a 40% effective tax rate, it will pay taxes of $32 instead of $40. This savings of $8 is a real, tangible cash savings. After paying taxes, the buyer who was able to step-up the tax basis in the purchased assets will have net profit of $68 ($100 earnings before taxes minus $32 in taxes = $68).
In Part 3, we’ll look at stock deals and mergers.
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.