In Sickness And In Health
On today’s show we’re talking about how to buy a business.
We are in the middle of negotiating the purchase of a business. The seller’s accountant proposed that rather than purchase the assets of the business we should consider buying the shares of the company instead. So on today’s show we’re going to do a deeper dive on the merits of a share purchase versus an asset purchase.
When you buy a business in its entirety, you’re buying everything within the business, all of its assets and all of its liabilities.
This has some risk to the buyer because liabilities come in two different forms. There are actual known liabilities, and then there are contingent liabilities that can be hiding beneath the surface.
I’ll give you a simple example to explain the difference between the two.
Let’s say that you borrow $100 from the bank. Then you owe the bank $100 and that gets listed on the company’s balance sheet as a liability.
But let’s say that you signed a contract and that contract has a clause which says you’ll defend the other party in the contract if they get sued for whatever reason. In legal terms, this is called an indemnity, in which you agree to indemnify or hold harmless the other party against a risk. For example it’s common to have an indemnity for the employees of a business in case they get sued in the course of doing their job. The employer would agree to defend the employee against a law suit that was brought against an employee if that suit was connected with the work they were doing for the company.
Now let’s say that a so far, there are no lawsuits against the company, or its employees. Let’s say that a year later, one of the employees gets slapped with a lawsuit connected with their work for the company. That potential for a lawsuit would be considered a contingent liability. But in truth, not only is it a contingent liability, it’s also an unknown liability.
Another form of contingent liability is a future tax liability. The tax owing is a function of a number of complex factors. Let’s say that the company has been claiming depreciation and that has the effect of lowering the cost basis of some of the inventory or equipment in the business. Let’s say that you then decide to sell that equipment and because it might have been depreciated for tax purposes faster than it actually depreciated in the open market, you now are facing a capital gain on the sale of a piece of used equipment. It could be a piece of equipment or a building. It doesn’t matter. The principle is the same.
So when you buy a company bu purchasing the shares of the company, you’re buying all of the assets of the company and all of the liabilities. In practice, it’s almost impossible to know the liabilities of the company.
When you purchase the assets of a business alone, you still have enough to continue the operation of the business. It’s a bit like saying I want to buy a deck of cards, but I only want hearts and spades because they’re an asset. You can keep the diamonds and clubs because they’re a liability. Oh and you can keep the joker as well because I don’t know what that is. I can operate the business just fine with just the hearts and spades.
A share sale looks so simple on paper.
An asset purchase may seem more complex at first. You need to dissect the business and list the parts of the business you want to buy. You will need an asset purchase agreement.
If the business you’re buying is going to have some intellectual property, then you may want to govern that with an intellectual property agreement.
If the seller is going to provide services to the buyer for a period of time, then you’ll need a transitional services agreement. The added cost and complexity of dissecting the business now is worth the benefit of knowing that the business cannot contain any landmines in the future.