This post will take a dive into the concept of asset sales, an important concept in the domain of private business sales/transfers and their valuation.
In an asset sale, a company sells some or all of its business assets to a buyer, but the company itself (as a legal entity) is not sold. Further, the buyer has the right to cherry-pick the company’s assets and liabilities (if any) that he wishes to acquire. As the buyer is purchasing the assets and not the existing legal entity, they will generally purchase the assets from a newly incorporated entity/company, or merge the assets and liabilities acquired into an existing entity.
In other words, the seller continues to retain ownership of the legal entity and must pay out all the existing liabilities and debts before taking or distributing the net cash proceeding from the sale of the various assets.
What Are Assets?
The International Financial Reporting Standards (IFRS) framework defines an asset as follows: “An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.”
Further, assets can be segregated into tangible and intangible assets:
Tangible assets refer to a company’s assets that have a physical form and have been purchased by an organization to produce its products or goods, or to provide the services it offers. Tangible assets can be categorized as either fixed assets (which cannot be readily converted into cash), such as structures, land, and machinery, or as current assets (which can be easily converted into cash within the span of one year), such as cash, accounts receivable, and inventory.
- Intangible assets do not have a physical form, but still provide a future benefit to the company. They may include patents, logos, franchises, relationships, know-how, and trademarks.
Buyer’s Perspective for an Asset Sale:
From the buyer’s perspective, an asset sale is a safer option compared to a stock/equity sale, mainly because they can easily avoid “inheriting” potential liabilities—especially contingent liabilities in the form of product liability, contract disputes, product warranty issues, or employee lawsuits that remain with the legal entity after the assets are bought/moved to a new entity. Therefore, the due diligence can then focus on vetting the fair market value of the assets acquired, as well as the quality of the contracts and employees being transferred over.
Further, asset sales allow the buyer to “step-up” the company’s depreciable basis in its assets. The total assets purchased are allocated to the new company at certain values, and by allocating a higher value for assets that depreciate quickly (such as equipment, which typically has a three- to seven-year life span). By allocating lower values on assets that amortize slowly (such as goodwill, which could have up to a 15-year life span), the buyer could gain additional tax benefits. This practice could help in tax management and could improve the company’s cash flow during the vital first years after the asset acquisition.
On the other hand, asset sales may also pose complex situations and problems for the buyer, as certain assets are more difficult to transfer due to issues of assignability, legal ownership, and third-party consent. Apt examples of such assets include intellectual property, contracts, leases, and permits. Obtaining consent and refiling permit applications can slow down the transaction process considerably.
Seller’s Perspective for an Asset Sale:
Sellers tend to prefer stock sales over asset sales, as the latter often generates higher income taxes for the selling party. While intangible assets, such as goodwill, are taxed at capital gains rates, other “hard” assets can be subject to higher, ordinary income tax rates.
Furthermore, if the assets sold are held in a C-corporation, the seller usually faces double taxation. The corporation is first taxed upon selling the assets to the buyer, then the corporation’s owners are taxed again when the proceeds transfer outside the corporation as dividends or in another form.
This is often why the assets are kept separate from the trading entity in a holding company, which allows a stock sale as the trading liability has been kept separate from the assets and is not transferred upon a sale.
Stock Sale vs. Asset Sale:
Company A acquires company B for $10 million. Company B has five million shares. If this deal was structured as a stock sale:
company A would acquire all the assets and liabilities (including legal liabilities) belonging to company B (through the purchase of the five million shares) and would effectively become its new owner
- the company B shareholders receive the $10 million distributed amongst them according to their share interest
On the other hand, if this deal was structured as an asset sale:
company A would choose which assets or liabilities of company B it would acquire. Let us assume that company A chooses to acquire all of company B’s assets and liabilities for $10 million
- company B (not its shareholders) would receive the $10 million, paying any potential taxes based on the gain of the sale, and then the remaining would be paid in dividends to its shareholders (where taxation on dividends can occur)
- after the sale, company B shares would not be cancelled or cease to exist, but as they are shares of an empty corporate shell (with all of its assets and liabilities having been transferred to company A), they are worthless, and the company can therefore be liquidated