When a startup decides to pursue an exit, whether through a merger or acquisition, the deal structure involves many variables. These decisions aren’t one-size-fits-all; they depend heavily on factors like the negotiating power of each party, the specific needs and goals of the entities involved, and external elements such as required third-party approvals. With such diverse circumstances, no two deals are identical, and the structure must adapt to the unique situation at hand.
This guide offers a high-level overview of essential considerations when navigating the exit process, with a focus on mergers, acquisitions, and the associated tax treatments. While we'll provide a framework to help you understand the basics, remember that each deal will have nuances that might require tailored strategies. This article centers on C Corporations, particularly venture-backed startups, as they explore exit strategies that align with their growth trajectories and financial goals.
When it comes to exiting, there are several structural approaches a company can take, each with different implications on assets, liabilities, tax treatment, and the future operations of the seller. Here’s a look at some of the primary exit structures:
In an asset purchase, the buyer selects specific assets to acquire (and specific liabilities to take on) from the selling company. This structure allows the buyer to pick and choose what they want, such as intellectual property, contracts, or customer lists, while leaving behind any unwanted liabilities.
In a stock purchase, the buyer typically acquires all of the seller’s shares, effectively taking control of the entire company, including its assets and liabilities. This structure transfers ownership without needing to retitle assets or assign contracts (except in some circumstances), making it a straightforward approach for assuming full control of the selling entity.
Mergers involve combining the seller’s and buyer’s entities, either through a classic merger, a triangular merger, or a reverse triangular merger. Each approach has its unique structure and tax implications.
In a classic merger, two companies come together, merging their operations. They agree on terms, including which entity will survive the merger. This approach is often used when two entities want to combine resources and continue under a single corporate structure.
In a triangular merger, the buyer creates a subsidiary, and the seller merges into this subsidiary. While similar to a classic merger, this approach is less common due to the tax benefits associated with the reverse triangular merger for selling shareholders.
In a reverse triangular merger, the buyer still creates a subsidiary, but instead of the seller merging into it, the subsidiary merges into the seller. This structure often results in better tax treatment for the selling shareholders as compared to a triangular merger.
An acquihire focuses on acquiring a team or talent rather than the company’s assets or operations. While there may be asset transfers involved (or other waivers/licenses involved), the main goal is to onboard key employees.
Tax considerations play a significant role in determining which exit structure is most advantageous for both buyers and sellers. Depending on the structure, a transaction can either be tax-free or taxable, with distinct impacts on capital gains, QSBS eligibility, and basis adjustments.
Exit transactions can be structured as either tax-free reorganizations or taxable events. Tax-free transactions are often reorganizations where, for example, the selling company exchanges assets for stock in the buying company, subject to specific IRS requirements. Most transactions that involve cash payouts to the seller are taxable, resulting in capital gains or ordinary income for the seller.
Stock purchases and reverse triangular mergers (RTMs) are generally the most favorable structures for sellers because they can result in more favorable capital gains and QSBS (Qualified Small Business Stock) tax treatment.
Important Considerations:
From a buyer’s perspective, an asset purchase offers a potential distinct tax advantage by allowing a step-up in basis. This means that the buyer’s basis in the acquired assets is “stepped up” to equal the purchase price. If the buyer later sells the assets, only the gain above this basis is taxable, potentially reducing future tax liability.
The treatment of contracts is another key aspect to consider when planning an exit. Different exit structures handle contracts in distinct ways, affecting how seamlessly ongoing agreements, such as customer and vendor contracts, can transfer post-acquisition.
In stock purchases and RTMs, the selling company continues to exist as a legal entity after the acquisition. As a result, contracts held by the selling company remain intact, without a requirement to assign the contracts to a new entity (unless the contract itself specifies otherwise). This is especially advantageous when the selling company has a large number of contracts, such as customer agreements, vendor relationships, or licensing deals, since there’s no need to re-negotiate or transfer each contract individually.
In an asset purchase, only selected assets and contracts transfer to the buyer. This structure often requires that each contract is individually assigned to the new owner, as the seller entity is not transferring in full. This can be a time-consuming (and in some cases a very challenging) process if the selling company has many agreements in place, as it likely requires the consent (or notice, depending on the contract) of each counterparty involved in the contracts.
Regardless of the chosen exit structure, it is essential to review all existing contracts before finalizing the transaction. Even in cases where the contracts are preserved intact, as with stock purchases and RTMs, there may be contractual provisions that require counterparty consent (or notice) or provide for termination upon change of ownership or control.
Understanding the approval requirements of each exit structure is essential for planning a smooth transaction. Here’s how approvals typically work for stock purchases, mergers, and asset purchases, along with considerations for different stock classes.
A stock purchase generally requires the consent of all stockholders to sell their stock, meaning unanimous approval is often necessary. This requirement can be challenging to fulfill, especially for companies with a large or dispersed shareholder base. If there is any uncertainty about securing 100% stockholder consent, alternative structures, such as a reverse triangular merger, may be more practical, though they can involve additional steps.
Mergers typically demand a lower threshold of stockholder approval compared to stock purchases. This structure is advantageous for companies with many shareholders, especially if obtaining unanimous approval is unlikely or could cause significant delay. Mergers offer a more flexible approval process while allowing the combined entity to move forward under new ownership.
For an asset purchase, if the company is selling “all or substantially all” of the assets, stockholder approval is likely required but would not require 100% of stockholders to approve. However, companies that have raised capital through preferred shares or other specific stock classes should review any related stockholder agreements. These agreements may include provisions that grant certain classes of stockholders, such as those with preferred shares, rights to approve or veto specific actions, including asset sales.
In addition to the requirements of each transaction type, it’s important to consider any special approval rights held by different classes based on the company’s specific financing agreements and governing documents. For example, preferred stockholders often have protective provisions, especially if the shares were issued in connection with financing rounds. These rights may include the ability to approve or reject any sale of the company. Reviewing stockholder agreements and understanding these rights in advance can help avoid unexpected roadblocks during the acquisition process.
The treatment of liabilities from a selling company vary significantly depending on the exit structure chosen. This in turn heavily influences the level of due diligence required and the negotiation of indemnification terms in the agreement governing the transaction. Understanding how liabilities transfer in each type of transaction can help determine the appropriate structure for both buyers and sellers.
In an asset purchase, the buyer assumes only the specific liabilities associated with the assets they’re acquiring (and sometimes even those liabilities may not be inherited). These liabilities must be explicitly named in the purchase agreement, meaning the buyer is generally shielded from any unforeseen liabilities related to the selling company. This selective transfer is one reason why buyers often prefer asset purchases, as they can focus on acquiring valuable assets while avoiding broader exposure to the seller’s potential liabilities.
In a stock purchase or merger, the buyer typically assumes all of the seller’s liabilities, both known and unknown. This comprehensive transfer includes liabilities related to contracts, operations, and any outstanding debts or obligations. Due to the inherent risk of assuming all liabilities, buyers in stock purchases and mergers usually perform extensive due diligence to identify any potential issues. This process helps the buyer understand the full scope of liabilities they are acquiring and minimizes the risk of unexpected obligations.
Regardless of the exit structure, indemnification clauses in the purchase agreement can help mitigate liability risks. Indemnification provisions allow the buyer to have coverage from the seller for specific liabilities or claims that may arise post-transaction.
The conventional wisdom is that buyers favor asset purchases due to the tax benefits and the ability to assume only specific liabilities. Sellers, on the other hand, often prefer stock purchases or reverse triangular mergers, as these structures usually provide more favorable tax treatment for shareholders and transfer all liabilities to the buyer.
However, preferences can vary depending on the specifics of the transaction, such as contract requirements or the nature of the business.
For personalized guidance on preparing your company for a future transaction, reach out to our team.