What is it that you actually buy when you acquire a company? This question comes up frequently when talking to first-time buyers. It’s vital to understand the two distinct approaches available, and how they are different.

The two approaches are known as the equity purchase and the asset purchase. Gaining a good understanding of these two approaches can be hard. I have searched for a suitable metaphor to use in discussing this topic, and settled here on a box of chocolates. Hopefully this metaphor is useful in conceptualising the two approaches.

So let’s unwrap these two acquisition strategies, and discuss the benefits and drawbacks of each approach, and hone in on making a sweet choice when buying a business.

A Business is a Box of Chocolates

Any business is made up of lots of parts. There are assets and liabilities, customers and employees, financial resources, operational processes, and a unique brand identity that defines its presence in the market. Each element contributes to the overall composition and success of the business. The business in its entirety has owners.

Now, think of that business as a box of chocolates: an exquisite box, with foil enclosures inside the box, a delicate plastic inlay that cushions each individual delicious chocolate treat. Some chocolates are enclosed in their own foil wrapper. Each chocolate is different, offering a unique taste and experience. You have your favourites (strawberry hearts!), and those that are less to your taste.

The Equity Purchase – Savouring the Entire Box

Imagine you’re presented with this delightful box of chocolates, each piece uniquely crafted and representing the entire assortment. When you opt for an equity purchase, it’s akin to buying and savoring the whole box of chocolates – each piece, its flavors, and the entire experience, good and bad.

Acquiring the equity of a business means you get it all. You replace the current shareholders, and take ownership of the entire firm: the box, the foil wrappers, the plastic inlay and each and every chocolate.

Equity purchases are relatively uncommon when buying a small business in New Zealand. When you buy shares in a company (private or public), you are acquiring a slice of the equity. The acquisition of larger businesses is also more likely to be an equity transaction.

Benefits of an Equity Purchase

Even though the ownership of the box of chocolates has changed, the box (and its contents) have not. You have paid the previous owner for the whole box. The identity of the company is unchanged. It has the same name and company number.

Acquiring equity means you gain total control of the entire business. This includes all assets, liabilities, customers, employees, and the established brand. The assets are all the tangible and intangible assets of the company.

This approach results in less disruption to the business. Existing processes, customer relationships, contracts, inventory, and employee roles remain intact, ensuring continuity. This is a key aspect of the equity approach. Every contract the company has with suppliers and customers remains intact. There is generally no need to get anyone to agree to a new contract.

You take over the running of the business and immediately benefit from the established systems, employees, brand recognition, and reputation built by the previous owner. There is no disruption to cashflow: the business keeps going.

In most cases, financing an equity purchase is more straightforward. Lenders generally view an established business with a proven track record as a lower-risk investment.

Vendors tend to prefer selling their equity. They receive the proceeds of the sale directly. Given that New Zealand has no capital gains tax, any increase in the value of the firm over what the owner has invested into it are to their benefit. As a result, the buyer may be able to negotiate a lower price for the business.

Drawbacks of an Equity Purchase

Buying the equity of the business has numerous downsides for the purchaser. Foremost is that the business retains all the liabilities, and therefore these become the responsibility of the new owner. These debts and obligations can be substantial (technically they are unbounded, meaning there is no cap to the level of risk the purchaser is taking on), and stretch back to the founding of the firm. Historical claims regarding product safety, product guarantees, employee OSH, and employee grievances stay with the firm. As the new owner, you have inherited all of these liabilities.

The new owner also inherits the firm’s capital structure and balance sheet, although these can be changed over time. In some cases, benefits the company has received may not carry over (e.g., imputation credits in the case of a 100% ownership change), and some may be clawed back (e.g., some government or regional economic grants). These factors should be looked at during due diligence, and appropriate tax advice sought.

In order to mitigate some of these risks, a prudent buyer will undertake a much more rigorous due diligence. More rigor means more cost (and in many cases time). The buyer will also attempt to limit some liability where possible through contractual warranties and guarantees from the vendor. This means the contract is far more complicated, more likely to be bespoke, and therefore more expensive to negotiate and draft.

Unfortunately, inexperienced buyers lacking appropriate advice may not undertake either, and find themselves in a mire of hidden issues post-acquisition.

The Asset Purchase – Selecting The Individual Chocolates You Want

Now, let’s explore the other approach. Instead of indulging in the entire box of chocolates, you decide to handpick specific chocolates – the ones that appeal most to your taste. You leave behind the box and the foil, and shift what you want to your own container. This is the essence of an asset purchase – cherry-picking the assets of the business you want, and leaving the rest behind for the current owner.

This leaves the vendor still holding the chocolate box, and maybe even some of the chocolates. But in that box is something new: the payment for the purchase. When you buy the assets of a company, you pay the company – not the shareholders. The owner then needs to extract that cash from the shell of their business, and therefore the payment is likely to be taxed when it is transferred to the shareholders.

This is by far the most common approach used when buying a small New Zealand business, and is favoured by buyers. In almost every case, the buyer acquires the brand and related collateral, internal systems, the customer base, and a reasonable store of inventory to enable the new business to be up and running quickly.

Benefits of an Asset Purchase

While in theory the buyer of the assets of a business can cherry-pick what they want, in many cases they end up taking all assets. Specifically, all assets involved in the generation of revenue and earnings. The vendor may opt to keep a few assets, like their car, computer, and mobile phone, but this is subject to the negotiation between buyer and seller before the contract is signed. If the vendor keeps any assets, the value of these items is essentially deducted from the value of the business – but in most cases the advertised price for the business has already allowed for these assets not to be sold.

The major benefit to the buyer of an asset purchase is that they can leave the historical liabilities of the firm with the vendor, although this should be explicitly stated in the contract. As the buyer, you move the acquired assets into an existing business, or create a new company to undertake the transaction. Your business has a fresh start, and you can ring fence or cap any liabilities you do assume.

In an asset purchase, the buyer is free to do what they like with the assets they buy. They are not constrained by history. The buyer can use a new brand, or even change the existing brand they have acquired, however they like.

This discontinuity of legal entity, where the risks can be left with the old business, can lead to a streamlined due diligence and a much simpler contract. As a result, the transaction can often take place sooner, and with less spent by both parties on transaction costs.

Where the buyer is able to pick and choose the assets they acquire, they can better manage the price they pay. This can also be a benefit to the vendor (assuming there is a market for the remaining assets), as they can match the price the buyer is willing to pay to the value of the assets sold.

If the buyer has an existing business and they plan on integrating the existing and acquired companies, this tends to be easier in an asset purchase. It is also easier to establish a shared company culture.

Where the buyer has already determined their staffing needs in advance of the deal being closed, they can move any termination or redundancy costs for surplus roles onto the vendor.

Drawbacks of an Asset Purchase

The biggest risk an asset buyer faces is the potential for disruption, which could see some of the business value they have bought evaporate. The legal entity has changed in the purchase – even if the brand remains. This can require new contracts to be agreed with suppliers and customers, which may weaken the new firm’s position during negotiations. Similarly, the new business needs to hire the employees they want in the new firm. Some buyers will actually view these as benefits where they have an existing business the acquired assets are being folded into. They can then offer the acquired customers their pre-existing standard contract rather than maintain the contracts in place in the acquired company.

Without a trading record, the buyer is likely to find financing more difficult. Convincing the bank that nothing has changed – when clearly everything has – is difficult, and may result in a lower level of credit and higher cost of debt.

For many vendors, selling the assets of the firm, leaving them with a cashed-up shell, means they need to extract this cash as salary or dividends. If this is the case, these payments get taxed. This tax impact often results in the vendor being less willing to negotiate on the price of the business. If this is the case, the buyer should ensure the vendor maintains and enforces non-competition clauses in their employment contracts for these employees.

Common Issues to Consider

There are a number of issues you need to consider irrespective of the approach selected. For example, if the sale price is above NZ$1M, the parties need to agree to the assignment of the price to the assets, inventory, and intangibles. This gets reported to IRD, and the values used need to be the same for the buyer and seller.

If the value of the assets agreed is above the depreciated book value, the vendor can be liable to pay tax on the restated value. The buyer wants as much of the purchase price attributed to inventory and hard assets as possible. The hard assets sit on the balance sheet with predictable depreciation schedules. Intangible assets – in many cases – do not depreciate (the depreciation of intangibles like brands, goodwill, and IP is called amortisation). Amortisation periods are generally much longer than depreciation periods on tangible assets, and some intangibles are deemed not to reduce in value, and therefore sit on your balance sheet at their purchased value indefinitely. It is essential that both the buyer and seller get appropriate tax advice as they work through these issues.

The transaction approach being applied to a deal should be clearly stated in the Sale & Purchase Agreement, and then consistent through the other contract terms.

Which Box is Right for You?

So, the whole box, or a cherry-picked selection? The approach selected may be driven by the vendor, so you may need to accept what they have chosen and factor the risks into your offer price and deal terms as appropriate. If the vendor is nonplussed, you should weigh your unique goals and circumstances to determine the approach that is right for you. For example, you might consider some of the following:

• Your Business Goals: What are you looking to achieve with this acquisition? Is your primary aim to expand quickly and leverage existing assets, or do you want the flexibility to mold the business according to your vision?
• Your Financial Position: Examine your financial position closely, and sound out lenders on the level of debt they would be comfortable with.
• Existing Liabilities: Carefully evaluate the existing liabilities of the target business. Are you comfortable embracing them along with the assets, or would you rather start with a clean slate? Assess the potential impact of these liabilities on your financial stability and business plans.
• The Risk of Disruption: Does the business rely on customers and suppliers being contracted in annual (or multi-year) terms? Is it easy for customers to move to another provider? Will key suppliers be willing to move supply contracts to you without material costs? This can be a factor in considering the current lease.
• Other Risks: Are there other risk factors that are critical that favour one approach over the other?
• Transaction Costs: What will the cost of due diligence be? What will it cost for the sale and purchase agreement? How much more will it cost to deal with an equity purchase?
• Buyer Competition: Would an equity offer make your offer significantly more attractive to the vendor?
• Asset Values and Makeup: Are there excess assets, or any that are a liability?

Avoid a sugar rush. Get professional advice and work through these issues and any others that might be unique to your situation.

A Deal as Smooth as Chocolate

When considering a business sale or purchase, make sure you understand which approach will be used, and consider the pros and cons. The choice of transaction approach has consequences for both parties. How the transaction will affect you needs to be clear. Make sure you get appropriate professional advice before locking in the deal structure.

Either approach can be made to work, but the risks you are taking on need to be clear. M&A advisors will be able to work through the mechanisms you can put in place before the deal closes to manage your risk. I haven’t spent any time here going through these mitigation strategies as they are quite specific to the final deal structure agreed.

I hope I have managed to clearly explain the differences between an equity purchase and an asset purchase, and therefore are clear on what you are actually buying.