There are two paths that can be taken to acquire/dispose of a business- you can combine (merge) with others or you can purchase/sell the business. Although the destination of each path (a change of ownership of the business) is the same, the journey is significantly different.
In a merger two companies come together to form one. There are several ways mergers can be structured:
- One company may survive and the other disappear completely
- The two companies can create a third company
- One company can form a subsidiary and the other company can merge into the subsidiary
The bottom line in a merger is that the owners of the target company wind up with stock (or membership units) of another company. In essence, they have changed what they own, but not how they own it. Accordingly, except to the extent that cash is received, there are no tax ramifications to the owners of the parties to a merger.
The upside to a merger is that the owners have a share of the ownership of a larger business without having to pay taxes on the exchange. The downside to a merger is the owners will individually have less control of the business of the company.
Operationally, a merger normally results in:
- An increase in market share and an acceleration of sales growth
- A reduction in overall costs by the elimination of duplication (economies of scale)
- Growing pains from integrating processes and cultures (normally the growing pains last at least two full business cycles)
It is a common practice to establish an exit strategy as part of the overall merger transaction. Normally an exit strategy provides some, or all, of the owners of the merged entity to sell their stock (or membership units) if they need/want cash or are dissatisfied with the results of operations of the merged entity. The exit strategy normally involves a buy/sell agreement (a put/call agreement) or an understanding that the merged entity will go public The anticipation is that the value of the stock (or membership units) of the combined entity will be greater than the value of the stock (or membership units) of the businesses as separate entities.
There are two primary ways a purchase/sale of a business can be structured:
- The buyer may chose to purchase only the assets of the business
- The buyer may purchase the stock (or membership units) owned by the seller
The bottom line in a purchase/sale of a business is that the buyer winds up with the resources necessary to operate the business, and the seller winds up with cash (and, in most cases a promissory note from the buyer subordinated to bank financing). In essence, the parties to the transaction have changed BOTH what they own, AND how they own it. Accordingly, unlike a merger, a purchase/sale of a business produces significant immediate tax ramifications. The seller is taxed based on cash that is received (any income attributable to a buyer’s promissory note can be, and usually is, deferred). The buyer gets a step up in tax basis to the purchase price.
The upside to a purchase/sale to the buyer is that they get complete control of the business and all of the potential increase in value of the business. The upside to a purchase/sale to the seller is that the seller receives cash and does not suffer from any decrease in the value of the business (unless the buyer’s promissory note does not get paid).
The downside to a purchase/sale to a buyer is that the operations of the business may not maintain its prior levels and the buyer bears all the burden of the decline. The downsides to a purchase/sale to the seller are that the value of the business may be far greater in the future (i.e. the sale price was too low) or mismanagement of the business by the buyer may preclude payment of any promissory note.
Operationally, a purchase/sale normally results in:
- Change of management style which can cause either rejuvenation or alienation of employees
- A review of policies and procedures which can result in more effective/efficient operations and an increase in profit
It is a common practice for buyers to protect their purchase of the business by prohibiting the seller from competing with the business which was purchased/sold. Contrary to popular opinion, non-compete agreements are binding and enforceable contracts.
When buying a business it is important for the buyer to have experience in the industry and the market which the business serves. It is a common practice for the seller to remain as a consultant to the business in order for the buyer to become acclimated.
If you need the assistance of a guide on your acquisition journey, please feel free to contact us through our website or by calling 515-727-0900.