The Pros and Cons of a Share vs. Asset Sale as well as a Third Option
by Bruce Tannas
Navigating the legal and tax issues of a business purchase or sale of a business is not in the average entrepreneur’s skill set. Yet it is important to understand that there are Pros and Cons to how a sale of a business is structured for each party to the sale. That way you can understand where the other party in the business sale transaction is coming from. You can also ask good questions of your professional legal and accounting advisors.
As you consider either a business purchase or selling a business in Canada, you need to understand the three main ways that small business sales are structured. The sale of shares in the company is usually the simplest way to sell a business and is often favored by sellers for its tax advantages. Whereas the sale of a company’s assets tends to be preferred by many buyers as they are able to acquire the assets at fair market value. There are also hybrid sale structures which involve both the sale of company assets and shares. These hybrid sale structures may be a compromise that suits both parties, but they are more complicated to negotiate and implement.
This article will clarify each type of sale structure as well as the Pros and Cons of each way to buy or sell a business in Canada.
Asset Sale:
The sale of a company’s assets and “book of business” is where the company sells its assets, trade name, and customer lists to the buyer. The buyer and seller need to negotiate the value of the hard assets vs. the value of the intangible assets such as good will as the allocation of these items will have implications for both parties.
Pros:
- Buyers’ perspective
- Assets are sold at fair market value (FMV) which allows the buyer the maximum depreciation on them. Also having assets at FMV allows the buyer to use them at their maximum collateral value for loans.
- The amount allocated to goodwill can be amortized up to 15 years therefore potentially lowering future tax obligations.
- All previous debts remain with the seller though there may be some adjustments made in the final sale contract for current liabilities on inventory and accounts payable.
- Unless stipulated in the sale contract, the buyer can select which employees to retain (or not) without having to pay severance in lieu of notice.
- The buyer may not want all the assets or inventory of the company. In an asset sale, the buyer can negotiate which assets are included in the sale and which are not included (e.g. stale inventory, old equipment, etc.).
- Many small business lenders prefer this type of sale due to a clear valuation on the assets and the lack of contingent liabilities (e.g. historical tax liabilities or pending law suits).
- Seller’s perspective
- May be easier to find a buyer because this is the preferred method of purchasing a business for many buyers.
Cons:
- Seller’s perspective
- As assets in a business are amortised over time, the value becomes depreciated. If the value of assets is higher than the deprecated value, then they could become subject to depreciation recapture taxes.
- There is no capital gains exemption on sale of assets through a corporation. Gains on the sale could be taxed both on depreciation recapture to the company and then on the dividend distribution to the owner.
- The seller could incur higher accounting costs in order to reassess asset values from current depreciated value.
- Buyers’ perspective
- Because the buyer’s company is a different corporate entity the contracts of the seller’s company will not automatically carry forward. They will have to be assigned to the buyer’s company with permission from the other party in the contract. This may involve additional negotiation and legal fees.
- Buyer will have to re-establish trade accounts based on their credit rating.
- Seller may insist on a higher sale value to compensate for their higher tax liability on this type of sale.
Share Sale:
A Share sale is a business purchase where the shares of the company are transferred from seller to buyer. The total shares that the seller holds are valued at the agreed purchase price.
Pros:
- Buyers’ perspective
- Contracts automatically carry forward unless otherwise stipulated (e.g. some commercial leases can’t be assigned to new company ownership without the landlord’s permission).
- The buyer should inherit the company’s established credit rating and trade accounts.
- Seller’s perspective
- Sale of shares are taxed on an actual cost basis (ACB). With qualified small business corporation (QSBC) shares, generally you can claim a lifetime capital gains exemption to shelter all or part of the gain from tax. This lifetime capital gains exemption for QSBC shares was $883,384 for Canadian residents in 2020.
- Simpler sale structure than an asset sale, as shares are valued and transferred.
Cons:
- Buyers’ perspective
- Inherit all loans and debts of the business. Separate agreements are necessary if the buyer wants to transfer these liabilities to the seller.
- Inherit contingent liabilities such as historical tax liabilities and potential legal liabilities such as lawsuits arising from past disputes, product liability, or other issues. Therefore, additional rigorous due diligence needs to be completed to avoid this pitfall.
- Goodwill can’t be deducted until the seller sells the stock in the business.
- Buyer has to provide appropriate severance to employees they wish to terminate.
- Seller’s perspective
- Buyer may insist on a lower sale value to compensate for their higher future tax liability and higher level of risk on this type of sale.
- May not be the appropriate sale structure when selling part of a company such as a location or a division.
- May not be the best sale structure if the company has previous losses that can be carried forward against the sale price.
Hybrid Sale:
A hybrid sale structure is where the buyer and seller agree to both an asset sale and a share sale. This structure is, by definition, a compromise for both parties and will involve detailed negotiation of the specifics.
According to an article by BDO “…in one commonly used hybrid approach, the business shares are sold for a gain, and the seller can claim the capital gains exemption on the share sale if the shares qualify for the exemption. Next, business assets with an accrued gain are sold through an asset sale, which allows the purchaser to have a stepped-up cost basis in those assets. The purchaser can then consolidate both the shares and individual assets through a reorganization.”
There are other hybrid forms that can be looked at and you should speak to your advisors to discuss the best approach to a hybrid sale structure if you are wanting to proceed with it.
Pros:
- A compromise between buyer and seller.
- This structure allows the seller to lower their tax burden vs. a pure asset sale.
- It also allows the buyer to get key assets at fair market value thus allowing for higher collateral value for loans and future write downs against profits.
Cons:
- The transaction must be carefully setup to take advantage of tax considerations such as capital gains exemptions.
- Detailed negotiation of the specifics will need to be undertaken between buyer and seller.
- Higher costs for tax and legal advisors for both the buyer and seller.
When selling a business in Canada, the sale structure has serious implications for both buyer and seller from several perspectives. That is why it is so important to understand the Pros and Cons of each way a business sale could be structured. It is also important for you to discuss the implications of the available structures with your professional advisors. That way you will be prepared to structure a purchase or sale of a business when the time comes.
References: Kalfalaw.com, BDO.ca, FBC.ca
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