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Structuring a Stock Purchase

In stock purchase acquisitions, the buyer purchases either all or a controlling interest in the outstanding shares of the target company’s stock, effectively making the target a subsidiary of the buyer. A key difference between asset purchase and stock purchases is that the latter leaves the target company intact, making a stock purchase a change of control rather than an assignment. As a consequence, the buyer needs to obtain far fewer consents pursuant to the target company’s existing contracts and any applicable regulatory permits or licenses.

On the other hand, this greatly increases the buyer’s exposure to all of the target company’s liabilities, both current and historic. The buyer has a single mechanism at its disposal to limit this exposure: securing indemnification from the target’s shareholders and incorporating it into the purchase agreement. As the number of shareholders that need to be persuaded increases, so does the difficulty of securing any indemnification. If the buyer’s goal is to acquire 100 percent ownership of the target, the buyer must secure the signatures of every single stockholder, which can be a daunting task if there are abundant minority stockholders with little to gain from the acquisition.

For the buyer’s purposes, stock purchase structures can be less advantageous on a tax basis as well, unless the target has a specific corporate form. If the target is organized as an S-Corp, the target stockholders may make a Section 338(h)(10) election (assuming other requirements are satisfied) to step-up the tax basis of the target’s assets. That election allows the parties to treat the transaction as if it were an asset sale, for federal income tax purposes.

The determination whether to make such an election turns on whether the step up benefit to the buyer exceeds the cost to the seller. But the implication for companies hoping to be acquired is that dissolving the current entity to become an S-Corp in an effort to make the company a more attractive target does not necessarily guarantee any benefit to potential buyers. A much more sensible approach is to wait until a buyer becomes interested but determines the target would be more attractive in S-Corp form. Then, the corresponding change in corporate form would be justifiable and could be consummated before any proposed transaction is completed.

Acquisitions of privately held companies almost always include indemnification provisions requiring the stockholders of the target to compensate the buyer for any liabilities incurred in relation to specific identified issues with the target and its stockholders. These provisions inject uncertainty into the deal, specifically the purchase price ultimately paid to the target’s stockholders, making them one of the most heavily negotiated points in any M&A transaction. Indemnification provisions are highly complex, including matters from scope of indemnification and duration of indemnity obligations to thresholds, deductibles, and caps. To preserve value and protect the interests of the company, it is essential for a company on either side of the deal to secure advice from a knowledgeable and trusted attorney who can provide guidance on how to successfully navigate the deal.

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