Asset Sale vs. Equity Sale: Key Considerations When Selling Your Business

Introduction

Selling a business involves crucial decisions, including selecting the right transaction structure. This choice, fundamentally between an asset sale and an equity sale, greatly impacts everything going forward. Whether it’s an equity sale or an asset sale will influence the after-tax proceeds netted by the Seller, the structure of any earnouts, and the operations of the business post-transaction.

By “equity sale” we mean a sale of the ownership interests in the business. If the business is a corporation, an equity sale would be a sale of the stock of the corporation. If the business is an LLC, an equity sale would be a sale of the LLC units.

If you’re a business owner considering selling your company, it’s critical that you understand and weigh the advantages and disadvantages of asset sales versus equity sales. While it’s true most small and medium-sized businesses sold are asset sales, you should be aware of equity sales as well because some structures can offer the best of both worlds. Familiarity with the nuances of each option is essential to optimize returns and ensure a seamless transition.

What is an Asset Sale?

In an asset sale, the business entity sells only specified assets of the business. These selected assets could include both tangible and intangible assets. In asset sale the liabilities of the business that will be assumed (taken over) by the buyer are also specified. By definition, this means that in an asset sale some of the company’s assets and usually most of its liabilities remain with the existing business entity.

Imagine you’re interested in selling specific parts of a car. In an asset sale, you’re selecting and transferring only certain components – like the engine, seats, tires, – but not the entire vehicle. Anything you don’t transfer, like the chassis or the radio, remains with the company. This is akin to picking and choosing specific assets of your business to sell, while retaining others.

On the other hand, an equity sale is like selling the entire car. You’re selling everything -the engine, the tires, seats, intangibles like the extended warranty you purchased, and even the air freshener handing from the rearview mirror. This transaction includes all components of the car, along with any existing issues or obligations the car might have, like unpaid parking tickets, maintenance needs, or the car loan. In an equity sale, you’re selling the whole business entity, including all its assets and liabilities, known or unknown.

What are the Advantages of Asset Sales?

Flexibility: Sellers can choose which assets to sell and retain others. For instance, if a seller wishes to retain ownership of her Porche and or one location, say, in a chain of restaurants, structuring the transaction as an asset sale will allow the seller to sell all other business assets while retaining ownership of the assets they want to keep.
Control over Liabilities: Asset sales allow sellers to retain liabilities which can facilitate managing and settling those obligations. In general, liabilities included in an asset sale must be specifically assumed by the buyer under the terms of the agreement.
Negotiable Pricing: Sellers can hammer out the price of specific assets, potentially resulting in higher prices for assets that may be unique to the business and/or have strategic value for the buyer.
Managing Tax Considerations: An asset sale puts a focus on allocating purchase price among the different asset classes according to IRS rules which will dictate how much of a seller’s gain is taxed at capital gain tax rates and how much is subject to the higher tax rates on ordinary income. See the post on Purchase Price Allocations for more about this important topic.

What are the Disadvantages of Asset Sales?

Tax Burden: Sellers usually face higher taxes in asset sales, with tax impacts varying based on the business structure and purchase price allocation. LLCs taxed as partnerships and S corporations and cash basis entities are more likely to have significant differences between the tax consequences of assets sales as compared to selling equity.
Negotiation Complexity: Asset sales involve more extensive negotiations because of the intricacies of valuing individual assets, and the difficulty of separating a business’ liabilities. Thus, asset sales can be more time-consuming and resource-intensive than equity sales.
Business Continuity: The original business entity continues to exist post-sale in an asset sale. The Seller remains responsible for any unsold assets and any liabilities not transferred to the buyer.

What is an Equity Sale?

In an equity sale, the business owner sells their shares of stock or LLC interests in the company. An equity sale involves transferring the entire business entity, including all assets, liabilities, and contracts to the buyer. Equity sales continue the existing business, just under new management.

In our analogy above, an equity sale is like transferring the entire car.

What are the Advantages of Equity Sales?

More Favorable Tax Treatment for the Seller: Equity sales almost always offer more favorable tax treatments for sellers compared to asset sales. Unlike asset sales, where the sale of certain assets can result in gain taxed at ordinary income tax rates, equity sales allow sellers to receive long-term capital gains tax treatment on most proceeds received from the sale of their equity, assuming the seller has owned the equity for more than a year.

If the equity is in the form of stock in a C corporation or S corporation owned for more than a year, then all of the gain is taxed at long-term capital gain tax rates. If the equity is in the form of units in an LLC taxed as a partnership, then there could be some amount of gain taxed at ordinary income tax rates to the extent of “hot” assets. Hot assets are beyond the scope of this post, but the important takeaway is partnerships are trickier than corporations when selling equity.
Simpler Process: Equity sales provide a more straightforward transaction structure for sellers compared to asset sales. Unlike asset sales, where each asset and liability must be identified, negotiated, and valued, equity sales involve valuing the entire business as a going concern. Equity sales offer a streamlined approach to valuation that can save sellers considerable time and resources and allow them to close the deal more efficiently.
Complete Transfer: An equity sale facilitates a comprehensive transfer of contracts, licenses, and permits without additional formalities.
Clean Break: Sellers can fully disengage from the business post-sale as the buyer assumes all assets and liabilities. Of course, this assumes the seller wants to disengage; sometimes the seller stays involved as a consultant or even an employee and the seller remains incented to achieve certain targets reap earnouts or even a second bite of the apple by retaining some of the equity iin the business.

What are the Disadvantages of an Equity Sale?

Potential for Lower Sale Price: Buyers may negotiate lower prices due to the lack of stepped-up tax basis benefits in an equity sale. Sellers will usually receive a lower sale price on an equity sale because of the buyer’s foregone tax benefits.
Regulatory and Legal Hurdles: Certain industries may have restrictions on ownership, for example, professional services firms like law or accounting firms, and medical practices that have to be owned by licensed physicians. In these cases, an equity sale might not be feasible if the potential buyer doesn’t meet the necessary ownership criteria.
Depending on the industry, an equity sale may also require regulatory approval or clearance, which can lengthen the timeline and complicate the sales process.
Assumption of Unknown Liabilities: Buyers in equity sales assume the risk of undisclosed liabilities, often requiring escrow arrangements or additional seller assurances. Examples include tax liabilities, pending lawsuits, or other contingent liabilities that weren’t identified or known during due diligence. Check out this post on how pre-sale tax due diligence can mitigate these exposures and provide buyers comfort and reduce holdbacks and even purchase price adjustments.

The Best of Both: How an F Reorganization can Achieve Nirvana

What if it were possible to achieve some of the benefits of both an asset sale and an equity sale, and fewer of the disadvantages? This is often possible when the selling company is structured as an S corporation, and the seller agrees to restructure via an F Reorganization. See What is an F Reorganization and Why Are They So Popular for more information.

Conclusion

The choice between an asset sale and an equity sale should be made after careful consideration of your specific situation, the nature of your business, and your objectives. Both options have unique advantages and disadvantages that can significantly impact the outcome of the sale of your business. Perhaps the right answer if your business is an S corporation is an F Reorganization, or a similar hybrid approach. It’s crucial to consult with a knowledgeable M&A attorney and tax adviser to evaluate the consequences of different deal structures.