A client recently asked me for some advice about a business opportunity which would involve stepping into an existing business to try to turn it profitable. His proposal was to work for several months in an attempt to turn around the business, in exchange for a certain percentage of equity in the company. After some questioning, I found out that the business had been operated by someone who left the company and may or may not have taken the employees and the client list as well. It also sounded like the company could become involved in one or more potential lawsuits in the future (both as plaintiff and defendant). I quickly explained to the client that by taking shares of the company, he is effectively buying (or investing his sweat equity) into an entity with lots of potential future liability. Buying into the company is buying into the potential of future lawsuits.
If you are considering buying a business, you must understand the conceptual difference between a purchase of the assets of that company/business and a purchase of the shares of that company. I was once in a meeting with a client and a lawyer I used to work for. The lawyer used the following analogy: a company is like a box. The assets of the company are everything inside the box. If you buy the company, you buy everything inside the box. If you buy the assets, you buy what is inside the box.
In other words, buying the box means that you get the box itself, including all the history that attaches to the box. For a company, this means that you get the tax history of the company (subject to certain rules that may prevent trading in tax losses), and you get the litigation history – i.e., the potential for future litigation. Furthermore, you can’t pick and choose which items inside the box you get, because you are taking the whole box with everything in it. This is in obvious contrast to buying the assets where, subject to negotiations, you may be able to exclude certain things from the list of items you are purchasing, and you are not buying the box itself along with its history.
Many factors must be considered when deciding whether to buy shares or to buy assets, so proper advice should be sought. However, it is crucial to at least understand the basic conceptual difference between the two, and the box analogy is a simple explanation of the difference.