Merger and Acquisition Deal Structure – Stock Purchase, Part II

In my last segment, I mentioned a recent deal involving a Northern California company structured as a stock sale. Having tax advisors assist at the early stages helped keep the transaction on track. The next major issue was allocating the risk of business liabilities between the buyer and the seller.

Like any stock purchase transaction, liabilities of the seller stay with the business. This is often a significant disincentive to the buyer, because it must hold an entity that cannot escape its past liabilities. Two mechanisms are commonly used to alleviate the buyer’s risk.

First, a working capital cushion may be created to provide a source of funds to pay the ongoing debts of the business. The amount of the cushion is agreed in the purchase documentation. A portion of the purchase price is then held back at the closing in an escrow. The amount of net assets as of the closing is determined through a post closing audit, and the held back amounts are distributed following the audit to the buyer or seller depending on any difference between the agreed amount and the amount determined under audit.

Second, the seller may cover the buyer for any damages arising out of the inaccuracy of any of the seller’s representations made in the acquisition agreement. These provisions, typically structured as an indemnification, are very heavily negotiated and can be quite complex. Issues covered in these provisions include the extent of the liability relative to the purchase price received, the length of time the seller is exposed to the liability, and the responsibility for defending any resulting litigation.

There are other risks associated with stock transactions which are not an issue in asset acquisitions. For example, securities regulations may be a concern. Because an ownership interest is a security, any transfer of the ownership interest will raise securities law issues. Where the buyer is owned by an individual or individuals active in the business, and the buyer is financially substantial and sophisticated, the securities issues are minimal. If there are a large number of shareholders not otherwise involved in the business, and the buyer is not otherwise financially substantial and sophisticated, compliance issues may arise that will add time and expense to the transaction.

An acquisition structured as a stock sale is relatively easy to close administratively, but is more difficult to negotiate because of the liabilities that remain with the business.

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