Transaction
Structure

INTRODUCTION 

Buyers and sellers need to determine how to structure transactions when purchasing and selling target businesses.

From a legal perspective, there are many different potential ways to structure transactions—from reverse triangular mergers to direct exchanges of equity and indirect transfers of assets to various other combinations and varieties.

From a business perspective, a transaction’s structure is fundamentally about risk allocation, tax planning, closing certainty, and operational integrity.

TWO PATHS

There are two ways to structure a transaction:

• equity transactions, where a target business is exchanged between a buyer and a seller by changing its equityholding base; and

• asset transactions, where a target business is exchanged between a buyer and a seller by transferring assets to the buyer.

KEY CONSIDERATIONS

Whether an equity transaction or asset transaction is preferable for a deal depends on a variety of factors, principally:

• DESIRED RISK ALLOCATION

The default allocation rules are: (i) in an equity transaction, a buyer inherits all liabilities (including pre-closing ones) of a target business; and (ii) in an asset transaction, a seller retains pre-closing liabilities and a buyer is responsible for post-closing liabilities.

In other words, a buyer “steps into the shoes of the seller” in an equity transaction, but in an asset transaction each party is only responsible for liabilities that relate to its ownership period (the “my watch, your watch” approach). 

The rules above are general. Negotiation dynamics, party preferences, industry standards, and due diligence findings help parties reach an appropriate allocation of risk.

Even if an equity transaction is selected, it may be possible to allocate risk as if the transaction were structured as an asset transaction.

• TAX PLANNING

Tax objectives are an essential factor when deciding on a transaction’s structure.

As a general rule, a buyer will prefer an asset transaction (to achieve a step-up in tax basis), whereas a seller will prefer an equity transaction (to secure capital-gains treatment, if available, and avoid double taxation in certain scenarios). Parties will usually weigh both and arrive at economic terms that result in the highest aggregate tax savings for all parties.

The legal structure of a transaction does not necessarily dictate its tax treatment. It is possible to structure a deal as an equity transaction yet have it treated as an asset transaction for tax purposes. Therefore, tax treatment can be negotiated separate from the mechanics used to complete a transaction.

In any event, it is imperative to consult with tax professionals, including specialist attorneys and experienced accountants, when evaluating possible structures and tax treatments.

• CLOSING CERTAINTY

Equity transactions generally trigger change of control provisions in commercial agreements with third parties like landlords, customers, suppliers and vendors, while asset transactions trigger assignment provisions.

Change of control and assignment provisions may require transaction parties to seek consent from third parties or at least provide notice of the transaction to them. However, change of control provisions are less common than assignment clauses.

Accordingly, equity transactions usually implicate fewer third-party consent and notice requirements as compared with asset transactions. Choosing to structure a deal as an equity transaction may increase closing certainty by removing these technical consent requirements.

But contract technicalities are less important than commercial realities. If a material landlord, customer, supplier, vendor, or other third party desires to hold up or otherwise frustrate a potential transaction, that party will likely be able to do so regardless of what its contract technically says and irrespective of the transaction’s structure.

Note that regulatory clearances are a different matter. Generally, regulators look past the transaction’s legal structure. If the transaction otherwise requires regulatory consent, the parties cannot typically structure around the requirement by picking either an equity transaction or asset transaction. (Regulatory clearances are an important factor when determining a transaction’s timing.)

• OPERATIONAL INTEGRITY

The extent to which a target business is commingled with other businesses and assets that are not part of a transaction will weigh on its structure.

If a target business operates on a standalone basis, both transaction structures are available.

If a target business requires services from related parties—like other business lines or key employees—that will not travel with the business following closing, the structure will be more complex.

Transferring a target business that is commingled with others might require a seller to effect a pre-closing reorganization (which may involve internal transfers of equity, assets, or both) followed by an equity transaction of the target business with a buyer. Or, the parties may determine to complete the deal as an asset transaction, no matter how complex.

In any of these scenarios, negotiating transition and other post-closing support services will usually be required to ensure the separated business can operate as a going concern following closing.

For example, a target business is a subsidiary of a parent business. The parent wants to sell the subsidiary. Although its website and public-facing image make it appear that the target operates as a standalone company, a buyer’s due diligence reveals that the target’s operations are heavily commingled with its parent. Target employees are on the parent’s payroll, and employee benefits plans are maintained by the parent as well. The parent technically owns all the target’s intellectual property. The parent provides back-office support to the target.

To complete a transaction, the parent and the buyer will need to disentangle these arrangements. The employees will need to be moved to the target, which will need to establish benefits plans. The intellectual property will need to be assigned to the target, and the parties will need to determine whether the parent will continue to provide back-office support following closing as transition services.

• WORKFORCE TRANSFER

Because an asset transaction does not involve the transfer of equity, all legal entities that house a target business prior to closing will be left behind with a seller. This includes the entity that holds third-party contracts, as well as the one that employs the workforce needed to operate the target business.

Therefore, the workforce needs to be transferred. From a mechanics standpoint, this requires a technical interruption of employment.

Although the interruption does not usually have a material impact on employment terms and benefits, it does create additional action items and workstreams that need to be completed prior to closing. These include drafting offer letters, rewriting employment agreements, coordinating with benefits providers, ensuring HR records and systems are properly transferred, and explaining to employees why they will have a new employer after closing.

CONCLUSION

Structure, from its initial development to its final implementation, is one of the most consequential aspects of any transaction. Its feasibility, tax implications, and long-term propensity for growth require due diligence, planning, and informed decision-making.