Let us examine the basic structure and alternatives and then discuss some of the twists on these issues. First of all, what is the company selling? Is it selling its stock or is it selling its corporate assets? What is the buyer paying with—cash or stock? What legal structure will the transaction take?

The terms can get confusing. For example, is a stock deal a transaction in which the buyer purchases the stock of the selling company, or is it one in which the buyer pays with stock? It can mean both; however, most of the time a stock transaction refers to the purchase of stock.

In some sales of intangible companies the full potential of the selling company has not been realized at the time of the transaction. In such cases it is common to use an earnout to bridge the gap between what the buyer is willing to pay and what the seller thinks the company is truly worth. There are pluses and minuses to using an earnout and we examine these in Chapter 13.

The two primary structures are a sale of assets and a sale of stock. A third transaction structure, the merger, is rarely used in the sale of an intangible company. The seller usually wants a stock sale and the buyer usually wants to purchase assets. Normally, from a tax and corporate liability standpoint, what is favorable for the buyer is not favorable for the seller and vice versa.

SELLING ASSETS

For smaller transactions, less than $10 million or $20 million in purchase price, buying the assets of the company can be the simplest transaction structure. Assets might include software, technology, and other intellectual property; patents, brand names, and trademarks; as well as contracts with customers and the typical business assets such as accounts receivable, inventory, equipment, computers, and so on.

An asset sale is practical for transactions involving intangible companies because a company with intangible value generally has few physical assets. A sale of assets is not a complicated deal structure. Asset sales are best for companies that sell for relatively low prices because the tax impact will be minor. If a company sells for a high price an asset sale will not be attractive because the corporation (if it is a C corporation) must pay tax on any gain and corporations are taxed at ordinary income rates, not capital gains rates. Taxes would also apply when the proceeds of the asset sale are liquidated and paid to the seller’s shareholders. This is the so-called double taxation that applies to C corporation shareholders in this context. The S corporation and limited liability company forms are taxed differently and generally more favorably to the selling shareholders.

A purchase of assets is attractive from the buyer’s perspective because it eliminates or reduces the possibility of hidden liabilities—claims and other actions against the corporation that occurred before the purchase.

The Bulk Sales law may apply to a sale of assets depending on the state. The term bulk sale refers to the sale of a majority of a company’s assets not in the ordinary course of its business. The Bulk Sales law prevents owners from defrauding creditors. In order to comply with the Bulk Sales law a company must notify each creditor regarding the sale of assets. The Bulk Sales law only applies to asset transactions, not stock transactions. Most states have repealed their bulk sales laws in recent years because they were viewed as too onerous.

SELLING STOCK

The purchase of stock is a fairly straightforward transaction structure. If there are a large number of shareholders, the deal can get more complicated. One of the major issues surrounding the purchase of stock is the presence of unknown liabilities or off-balance sheet liabilities. Because of this additional potential risk, due diligence can require a longer time for the buyer to become comfortable with the potential risks of the transaction.

If a company sells its stock in exchange for stock in the buyer the transaction will be tax free in most situations. If stock is sold for cash the shareholders will have to pay tax on the capital gain. One of the advantages of selling stock is that gains are taxed at the capital gains rate of 15 percent. If the transaction includes payment in the form of both cash and stock, only the stock portion is tax free.

Sometimes when a company sells its stock there may be an issue of who gets the cash left in the company’s account. If a seller has an appreciable amount of cash it is important to make it clear who gets this cash. Sometimes the buyer assumes that it will get the cash while the seller also assumes that it will keep the cash. The best way to solve this problem is to work off a balance sheet as of a specific date. The parties may also simply agree on the amount of cash that will be left in the company’s account. It is important that this issue be negotiated early so as not to cause problems down the road.

FORMS OF PAYMENT

The currency used to pay for an acquisition of an intangible company is cash, stock, notes, or a combination of these. The buyer can also assume liabilities from the seller or make future payments based on performance, known as an earnout.

Cash is very straightforward. It is usually paid in full at closing. Typically, the funds are wired from the buyer’s bank to the seller’s bank. Sometimes the buyer may place 10 to 15 percent of the purchase price in an escrow account in case any problems surface after the transaction has closed for which the buyer seeks reimbursement.

Sellers almost always state upfront that they want all cash. However, most of the time, they do not really need all cash. Stock from a sound and well-capitalized public company can be just as good as, or sometimes better than, cash because of tax reasons. If the selling shareholders are primarily individual investors they do not really need the cash back. Typically, any cash received will be invested in another investment. The point is that sellers always think they must have cash and most of the time they do not actually need the cash.

Getting Paid in Stock

Getting paid in stock may be much more attractive for sellers than they might initially think. No, it is not liquid. But it may be more liquid and less risky than the stock they currently hold in the seller. There may be a reasonable chance that the stock of the buyer could become liquid in the next few years. Plus, the stock could increase in value. In addition, taxes can be deferred until the stock is eventually sold.

It is important to understand the shareholders’ objectives. For individual investors, or angel investors, they may be better off with a different stock that might grow in value. Wealthy investors rarely need their money back. They knew they were buying an illiquid stock when they made the investment and if they receive stock in a larger and more successful company, they are better off.

Accepting stock puts an additional burden on the seller because now it is becoming a shareholder of the buyer. In this case the seller needs to do some homework to determine the issues surrounding the buyer’s stock. If the stock is publicly traded, is the price a sensible one? Is the price-earnings ratio in line with the industry? If the buyer is a private company, what valuation is being used to determine the price of the buyer’s shares?

The transaction proceeds can be a combination of stock and cash. The cash portion should be less than 20 percent of the total deal consideration in order to qualify as a reorganization for tax purposes, which is tax free for the sellers. The cash portion is not tax free.

WAR STORY: OVERVALUED BUYER’S SHARES

I had initially negotiated the price of this transaction in terms of shares of the buyer’s stock. We had reached tentative agreement on a price of $48 million in stock. At this point the two primary shareholders of the seller began to look more closely at the buyer’s stock. This was a fairly risky stock.

The buyer was on a roll. It had been growing rapidly and achieving strong growth in both revenues and earnings. As a result the stock market had responded favorably and bid up the price of the company’s shares. The market capitalization was around $250 million. Of course the buyer wanted to use this high-priced stock as its acquisition currency.

The price-earnings ratio was fairly high and the company had experienced very rapid growth. Even though the transaction price was quite attractive, the sellers decided that this stock was much riskier than they were comfortable owning. They had just spent the last 12 years building their company, overcoming all kinds of difficulties and dealing with risks. They were now ready to retire and reduce their level of risk.

So it was back to the drawing board on negotiating price. My first step was to take a hard look at the buyer’s stock. Was it overvalued? Was the price-earnings ratio in line with the industry? Was management capable of growing the company to the next level? Was there much danger of the price falling significantly and thereby reducing the value of my client’s stock? After considerable analysis and industry research I came to the conclusion that the stock was overvalued and that there was a very real possibility that the share price could drop. Knowing my client’s preference for less risk, I concluded that taking stock was not in my client’s best interest. The next step was to determine what amount of cash the buyer could afford to pay that was high enough to satisfy the sellers. This is not the kind of analysis that is appropriate for a spreadsheet. It is more holistic in nature, taking into consideration all the subtleties and nuances of the transaction and the personalities involved. I concluded that $30 million in cash was the appropriate number. I reopened negotiations and the buyer accepted the deal. The transaction closed successfully and both parties were very happy with the deal.

A few months after the closing of the transaction, the share price of the buyer began to decline. It edged down gradually and over the ensuing eight months the buyer had lost about a third of its market value. It is easy to look back with hindsight and say how smart we were. On the other hand, one could say we left $18 million on the table. In the end the preference for cash instead of stock was not about money, it was about risk. The sellers were smart to recognize their own risk preferences and close the transaction for significantly less money but they were able to sleep soundly.

When the buyer is a public company and makes an offer with its shares of stock as consideration, it can make the offer in terms of number of shares or in dollars. If the offer is made in dollars and if the price of the stock changes between the letter of intent and the closing date, the buyer will adjust the number of shares upward or downward so that the dollar goal is met. If the offer is made in number of shares, it may be wise for the seller to negotiate a collar. A collar is a maximum or minimum number of shares that the seller will receive.

For example, a collar can be established with a minimum price per share of $30 and a maximum of $35. If the stock price falls below $30 before the closing date, the seller will receive more shares. Similarly, if the price exceeds $35 the seller will receive fewer shares. If the price stays within the $30 to $35 range then no adjustment is made. The collar protects both sides from extreme or even moderate swings in the share price.

The price of the seller’s stock is usually determined as the average of the last 20 days of trading. This is a common practice; however, there is no reason that it needs to be this way. The stock price can be established in any way that the parties agree. I have seen transactions in which the stock was valued using the average closing market price over the two-day period before and after the sale was announced.

WAR STORY: STOCK OR CASH? ARNIE AND BERNIE

Two founders sold their software company to Microsoft for $5 million. Each founder received $2.5 million. One founder, Arnie, opted to receive cash, the other founder, Bernie, chose to take Microsoft stock. Arnie was going to enjoy his new-found wealth. Within six months Arnie had purchased a new house, a new car, and taken a month-long overseas trip. He also paid a considerable sum in taxes. Bernie, on the other hand, held onto the Microsoft stock.

A few years later a look at Arnie’s and Bernie’s net worth showed remarkably different pictures. Arnie’s net worth was $2 million. Microsoft stock had tripled in value and Bernie’s net worth was now $10 million. So Bernie’s net worth was 5 times that of Arnie. Sure, Bernie was a little lucky but he also was thinking about the future.

All stock deals do not work out this favorably. In fact, I have heard plenty of horror stories from founders who took stock in less than stellar buyers that ended up being totally worthless. There are a number of points to this story. Do not be greedy. Look to the future. And make sure you understand the risks as well as the upside potential associated with the company whose stock you are accepting.

Assuming Liabilities

Assuming selected liabilities of the selling company is an effective way for a buyer to raise the price of the transaction without having to put up additional cash. The buyer usually does not assume all of the seller’s liabilities, but selected liabilities. For example, if the buyer will be taking over the seller’s business it makes sense for the buyer to assume the accounts payable—because it wants to make sure these bills are paid. The buyer will usually assume the accounts receivable and service contract liabilities as well because it wants to maintain the relationship with customers. The buyer may assume the building lease or a bank loan. The buyer will not likely assume previous payroll obligations, deferred compensation, investment banking fees, accounting fees, or attorney’s fees.

In some cases the assumption of liabilities can be a significant portion of the transaction value. For closely held and family owned companies it is not unusual for the principals to sign personally for any bank loans or lines of credit. In one transaction the founder and his wife had personally guaranteed a $3 million line of credit. About $2.5 million had been drawn down at the time the company was sold. The transaction terms stated that the buyer would pay $2 million in cash and assume the outstanding debt. Thus, this was a $4.5 million transaction and the assumption of debt accounted for more than 50 percent of the purchase price.

Promissory Notes

Occasionally, a deal will be structured in which the buyer pays the seller a portion in cash and a portion in a promissory note. The note will usually have a moderate interest rate and be payable over a period of two to five years. Buyers like using promissory notes because they can purchase a company without requiring as much cash upfront. Although a promissory note is a very straightforward form of payment, notes are rarely used in acquisitions of intangible companies.

WAR STORY: TOO MANY SHAREHOLDERS

The number of shareholders can be an issue. In this case, Zeta Software Corp. had 47 individual investors as shareholders. The buyer, Alpha Corp., only had five shareholders, including the three founders and two venture capital firms. It did not want to add 47 new shareholders to its shareholder list. It would be too cumbersome if Alpha Corp. were to be acquired in the near future, as it expected.

The buyer chose to pay for the acquisition with stock. It was on a fast growth track and wanted to conserve its cash to finance this growth. Alpha Corp. insisted that the structure be such that it did not acquire 47 new shareholders. So, Alpha simply purchased the assets of the seller and the seller’s corporation remained intact.

Zeta Software essentially became a holding company with one asset—shares of stock in the buyer, Alpha Corp. The seller also changed the corporate name as part of the deal requirements.

This was not a liquidity event for the shareholders of Zeta Software. However, they now own shares of Alpha Corp., a much better capitalized and faster growing firm. Alpha Corp. is likely to be acquired or go public within the next two or three years and the shareholders of Zeta Software will then achieve liquidity. In addition, Alpha Corp. might sell at a higher price than the valuation at the time of the Zeta Software acquisition.

The events played out in exactly that way. Two years later Alpha sold at a much higher valuation and Zeta’s shareholders were rewarded handsomely.

Tax Issues

In an asset sale, the corporation must pay taxes on any gain. The gain is the amount that the sales price exceeds the assets’ basis. The corporation then distributes the remaining proceeds to its shareholders and the shareholders must pay tax on any capital gain. Thus, the tax cost can be significantly higher for an asset sale.

Double taxation can be a problem when a C corporation sells its assets. It must pay tax on any gain at the corporate level and then the shareholders pay tax on their capital gain. A limited liability company (LLC) or S corporation will not have a problem with double taxation since neither entity pays any tax itself.

In a stock sale, the corporation does not pay any taxes. The proceeds are distributed to shareholders and shareholders pay capital gains tax on the amount of the gain that exceeds their basis. If shareholders sell their shares of stock in exchange for shares of the buyer, the transaction is tax free.

One section of the IRS Code (Section 338) allows the buyer to treat a stock acquisition as an asset acquisition for tax purposes. The buyer acquires the stock of the seller. Then it records the seller’s assets on its books as if it had completed an asset transaction. This transaction structure is beneficial when the seller has a net operating loss or tax credit carry forward that the buyer would like to take advantage of. The buyer can also step up the tax basis for the acquired assets. (A stepped-up basis gives the company a higher value for depreciation, which is a tax advantage.) One disadvantage is that technically for liability purposes this is a stock purchase so any liabilities of the seller, known or unknown, still remain.

The tax issues surrounding the sale of a company can become quite complex. Get the advice of an attorney and an accountant who have experience working with merger and acquisition transactions.

Securities Issues

Securities issues apply to any issuance of securities by a buyer. The issuance of the securities is treated as an offering to the seller or the seller’s shareholders, depending on the structure of the transaction. Any such offering is subject to the same federal and state securities regulation as an offering of the buyer’s securities to raise capital. Thus, a private buyer must consider whether the number of seller shareholders, or the number of lower net worth shareholders who do not qualify as accredited investors under applicable securities laws, makes such an offering impractical. If the offering cannot be made as a private offering exempt from registration, few private companies will wish to make it. A public buyer has the advantage of being able to more easily register securities offered to complete an acquisition. Selling shareholders receiving stock of a publicly traded issuer also have an easier path to liquidity.

WAR STORY: SHAREHOLDER DILEMMA—STOCK OR CASH?

This software company had been in business for 10 years and it was time to sell. The company had progressed reasonably well, but not well enough to be a strong player now that the industry had matured and competitors were larger. Individual investors had invested several million dollars in the company and they knew they should either sell the company or bring in a new management team and contribute additional capital.

The sale proceeded on schedule and the shareholders realized that they would not be getting a high price for the company. The company’s software was good; however, the buyers had their own software. The primary asset was the company’s customer base. With no buyer willing to pay a premium for the software technology, the price would simply be mediocre.

After a comprehensive search, we met with the board to discuss four potential buyers that had shown an interest. All four of the buyers proposed transactions using their shares of stock as the acquisition currency. One of the buyers, actually the least promising buyer, was a young company with an optimistic growth plan. However, the board did not believe the company could execute the plan so we informed the buyer that we were not interested in doing a transaction with them.

Another buyer was based on the East Coast of the United States and was larger and more profitable than the others. The choice seemed like an easy one until we received an all cash offer from the first buyer, the least promising firm. Now the shareholders had a decision to make. Do they take stock in a private company that is based on the opposite coast and hope for a larger liquidity event, or do they take the cash and be done with it? The stock deal was about 35 percent higher in value than the cash deal. Plus this company was on an aggressive growth track. After some deliberations the board decided to accept the stock deal from the East Coast buyer. The shareholders did not need their cash returned immediately and the idea of holding shares of a growth company was consistent with their original investment objectives.

Two years later the buyer was acquired for $150 million—an excellent price. The shareholders were rewarded for their patience and earned an attractive return on their investment.

CREATIVE STRUCTURING

Creative structuring can solve transaction problems when there are issues that are somewhat unusual. Over the years I have employed a wide variety of creative structures that solved exceptional problems. In one transaction we structured the deal as a marketing agreement, not a sale of the company, because the primary asset was the company’s customer base, which was gradually transferred to the buyer.

Royalties can be an appropriate structure if the selling company’s primary assets are its product lines, or perhaps a technology. Royalties are more directly related to the success of specific products in the marketplace. Royalties are used when acquiring products; they are not typically used in the acquisition of entire companies.

In one transaction a Canadian software company was seeking to sell off some of its software technology in order to concentrate on its primary area of expertise. An in-depth search did not turn up any buyers that were serious about acquiring the software. Several companies had shown interest in licensing the software however, so we shifted our focus to putting together a licensing transaction. Zeta Software, a large software company, appeared to be the best candidate to license the software.

As a large company, one of the problems that Zeta had encountered over the years was lawsuits regarding the ownership of intellectual property. As a result, Zeta was hesitant to license this software technology. In order to overcome this obstacle I proposed a rather creative structure. Rather than Zeta licensing the software from the Canadian company, I suggested a reverse deal—Zeta could purchase the software and then license it back to the Canadian firm. Now Zeta would own the technology outright and the ownership issue would be clearly established. This transaction went full circle: from selling to licensing to selling and some creative thinking brought about a successful transaction.

WAR STORY: BUYING CUSTOMERS ONE AT A TIME

Nu Software was a small software company and it had developed a nice niche software application for a specific vertical market. Like many small software firms, they could not effectively achieve the next level of growth on their own. They needed to be part of a firm with greater sales and marketing resources. Their technology was good, but it was a little dated. The primary asset was the company’s customer base.

In our search for potential buyers, we discovered that buyers were not interested in acquiring Nu’s software technology. However, the customer base was an asset that buyers responded to. So we ended up structuring a transaction in which the buyer paid a specific dollar royalty amount for each customer when that customer converted to the buyer’s software. Nu Software remained in business until all the customers converted to the buyer’s software. The founders of Nu Software received royalties for several years and were pleased to capitalize on their efforts. This was a much simpler transaction structure than a purchase of assets or stock.

CONSULTING CONTRACTS AND NONCOMPETE AGREEMENTS

Consulting contracts and noncompete agreements can be very useful instruments in structuring transactions. Although not specifically part of the purchase agreement, these contracts can be an effective way to distribute the proceeds disproportionately. With the proliferation of preferences on venture capital investments, I have witnessed many deals in which the founders have received very little for their common shares. Consulting agreements can give key management people, who do not have significant shareholdings in the company, a bonus that is separate from the shareholders’ proceeds.

A consulting contract typically has a term of one or two years and the consultant’s compensation is specified. There are a few additional terms and conditions, but the primary points are how much and for how long. A consulting agreement has the added benefit that it often does not fall under the buyer’s internal salary structure or normal budget category. A company’s internal salary structures can limit the amount of salary that can be paid to an employee. Especially for smaller acquisitions where a buyer has set firm limits on the purchase price, a consulting agreement can be used by the buyer to work around those limits (and salary parameters) in a way that is beneficial to both parties, plus consulting payments are deductible to the buyer.

In one instance I negotiated a very lucrative two-year consulting contract for a senior management person from the seller. The amount of the annual compensation was well in excess of his previous salary. He had been an instrumental part of the team but did not have any ownership stake in the selling company. The buyer wanted to reward him as well as keep him on board after the acquisition.

A noncompete agreement is a fairly standard instrument used in the context of an acquisition. By signing a noncompete agreement an employee agrees not to work for a competitor for a period of time—usually two years and sometimes as long as three years. Key employees will often know sensitive and confidential information that could be damaging if it got into the hands of a competitor. In California a noncompete agreement is not enforceable unless the person is a selling shareholder. The argument is that it deprives a person of the right to make a living.

The buyer can attach a dollar amount to a noncompete agreement. It is not unusual for a buyer to pay from $50,000 to as much as $400,000 as consideration for a noncompete agreement. It is important to note that the amount paid for a noncompete agreement is not extra cash paid out because the buyer is generous. Rather, it is an allocated portion of the total purchase price that was previously negotiated.

WAR STORY: A NONCOMPETE AGREEMENT PROBLEM

In this transaction the two founders were asked to sign noncompete agreements by the buyer. Both founders were offered employment by the buyer and their hiring was an important component of the transaction. However, the buyer was unwilling to offer them employment contracts for a specific length of time. It was simply employment at will. In addition, the buyer expected both founders to sign noncompete agreements with terms of two years.

Neither founder was very excited about this situation. Either of them could be dismissed at any time with only normal severance pay and they could not work for a competitor for two years because of the noncompete agreement. The founders initially proposed that the buyer pay a dollar amount for the noncompete agreement. The amount suggested was slightly more than each person’s annual salary. However, the buyer was unwilling to go along with this suggestion. The founders countered with a proposal in which, if they were terminated, the buyer would pay the founders 80 percent of their salary for the remaining portion of the noncompete period. The parties dickered for a while and then eventually reached an agreement along those lines.

A FEW OTHER ISSUES

Acquisition Financing

Rarely is bank financing involved in the sale of an intangible company. Either the buyer is large enough to have sufficient cash on hand; or the buyer will use its stock as the acquisition currency. Occasionally a company will go back to its venture capital backers to obtain additional funds for an acquisition.

In some cases a small buyer must raise additional equity capital to do a deal. In one example, a Canadian firm was interested in acquiring a company in the United States; however, it did not have sufficient cash on hand and the seller was unwilling to accept stock as the transaction currency. The buyer had to go back to its shareholders including one institutional investor to raise additional funds to complete the acquisition. The transaction took a little longer because of these events, however this buyer was clearly the best one and the seller was willing to wait for the financing to be put in place.

In another situation the transaction was very near closing. It was a stock transaction so no cash was required. However, the venture capital backers voiced their opposition to the deal and the transaction fell through. A venture capital firm can have a strong influence over a deal even if it does not have voting control.

Reverse Mergers and Shell Companies

One structure to be aware of, and usually to steer clear of, is a reverse merger with a shell company. This transaction is used for taking a company public (and sometimes for financing) although technically it is a merger transaction. The essence of this transaction is that a publicly traded company exists that has no business and no assets other than perhaps some cash—it is a shell company. The shell company then acquires the target company. The shell company may change its name to that of the target. After the transaction is completed the target company will have a new group of shareholders and a stock that can be publicly traded.

On the surface a reverse merger appears to be an inventive and financially clever transaction. Technically there is no reason that a deal should not work out for the target company. In actual practice however these maneuvers should be avoided. The first problem is that the shell company could have a bad history, undisclosed liabilities, irritable shareholders, and legal problems. Second, there are rarely enough shares traded in the market to provide real liquidity. (If the company’s only asset is cash, there is no reason shares would be actively trading.) And third, these transactions are sponsored by financial promoters, not strong management looking to build companies. Often their only interest is to dump their stock on the market as soon as they can. Some reverse mergers have actually worked out successfully, but the majority of the time they come with a lot of baggage and should be avoided.

Loss Carry Forwards

If a target company has experienced losses for a number of years it may have a loss carry forward. A loss carry forward or net operating loss (NOL) carry forward allows a company to offset taxable income in future years. Loss carry forwards are no longer as attractive to buyers as they were in the past. The actual rules are fairly complicated.

The net operating losses may offset taxes due on current profits; however, the loss may be carried back up to two years and carried forward for 20 years, so the amount available in any one year is only about 5 percent of the amount of the loss carry forward. This kind of takes the fun out of the loss carry forwards. (The amount of losses that the acquiring company can use each year is limited by Section 382 of the Internal Revenue Code. This section was designed to prevent a corporation acquiring another one simply to use the acquired corporation’s NOLs.) The present value of a loss carry forward that extends for 20 years is a much smaller number. The effect of this change is to make loss carry forwards considerably less attractive to buyers.

BUYER ACCOUNTING FOR THE ACQUISITION

An intangible company that is seeking to be acquired should have basic understanding of how the acquisition will be accounted for by the buyer. The purchase price includes the total of payments made plus assumed liabilities. The buyer allocates the purchase price among the acquired assets and records the fair market value of each asset on its books. The allocation of the purchase price must be the same for the buyer as for the seller according to Internal Revenue Service rules. Both parties report the allocation on the IRS form entitled the Asset Acquisition Statement.

In 2007 the Financial Accounting Standards Board (FASB) made some changes on how accounting is done for acquisitions. Acquisition costs are now expensed. Costs such as fees paid to investment bankers, attorneys, and accountants that were formerly capitalized and amortized are to be expensed immediately. Another item called in-process research and development is no longer to be written off when acquired, but capitalized and recorded on the balance sheet.

Goodwill is the amount of the purchase price that is greater than the fair market value of the assets, both tangible and intangible assets. Goodwill is recorded on the books of the buyer. It is no longer amortized as it once was. Instead, goodwill remains on the books forever as long as it does not lose its value. It must be tested annually for impairment, and, if its value has declined, the company must write down its goodwill as an impairment charge.

Intangible assets are becoming increasingly important economic resources for many companies. Not surprisingly, a large portion of an intangible company’s assets are intangible assets. An intangible asset is not physical in nature. Intangible assets include items such as distribution rights, patents, trademarks, trade names, trade secrets, customer lists, capitalized software, and other technology. Goodwill is not technically an intangible asset from an accounting point of view.

Intangible assets have real economic value and they are recorded on the buyer’s books at their estimated fair value. This value is determined by several methods: replacement cost approach, the income approach (using discounted cash flow analysis), and, to a lesser extent, the market approach.

Each intangible asset has an estimated useful life. The useful life of many intangible assets is usually about three to five years and perhaps 10 years for those with a longer life such as trademarks and patents. Each intangible asset is amortized over the period of its useful life.

Goodwill is not treated as an intangible asset; it is a separate accounting item. Remember that goodwill is the excess of the purchase price after subtracting the fair market value of the assets, including tangible and intangible assets.

WAR STORY: AN EXAMPLE OF PURCHASE PRICE ALLOCATION

Smith Micro Software, Inc. acquired Allume, Inc. Smith Micro develops and markets wireless communication and utility software products. Smith Micro is publicly traded and had revenues of $20 million and $30 million in cash, which included $21 million from a private placement financing earlier that year.

Allume develops compression software for JPEG, MPEG, and MP3 platforms. The company’s StuffIt Wireless technology compresses an already compressed JPEG file by up to 30 percent more without losing picture quality.

The purchase price was $12.8 million, consisting of $10.6 million in cash and 397,547 restricted shares of common stock worth $1.86 million. Smith Micro also spent $320,000 on acquisition costs. The common stock was valued at the average closing market price over a two-day period before and after the sale was announced. $2 million (15 percent of the purchase price) was placed in an escrow account to secure certain representations and warranties in the purchase agreement.

Smith Micro’s allocation of the purchase price is summarized as follows:

Notice that the intangible assets and goodwill account for almost the entire purchase price. This is typical in the sale of an intangible company. The allocation of purchase price to certain types of assets can have tax rate implications. Tax advisers may see opportunities to characterize the purchase price in a more favorable manner for either party (often at the expense of the other party) by allocating relatively more purchase price to categories that result in the lowest tax rates (for sellers) or highest deductions and tax bases (for buyers).

SUMMARY

In this chapter we reviewed the basic structuring alternatives for the sale of an intangible company. The acquisition currency usually includes stock or cash and sometimes a combination of both. An acquirer can purchase the stock of the selling company or it can purchase the assets of the selling company. If purchasing assets, the buyer often assumes selected liabilities of the seller.

Shareholders of the selling company have to make a decision about whether they prefer to receive cash or shares of the buyer’s stock. There are pluses and minuses to each of these alternatives. Generally, an exchange of stock is a tax-free transaction. Sometimes the shareholders opt to receive stock in a privately held buyer in the hope that the stock will increase in value and eventually become liquid.

Occasionally, a transaction will have unusual dynamics that will require creative structuring on the part of the investment banker. Keeping each side’s interest in mind is essential in trying to develop creative solutions that each side will be happy with. On small transactions, consulting contracts and noncompete agreements can be an important part of the transaction structure.

Now that we have reviewed the basic structuring alternatives, let us turn to the subject of documenting the transaction and the agreements that are employed.