Corp 2 inherits all contracts and liabilities of Corp 1 and keeps its own old contracts and liabilities. This creates risk for each merger side that it takes on the unknown liabilities of the other. The parties mitigate the risk through pre-merger due diligence on Corps 1 and 2. The shareholders of Corp 1 also indemnify the shareholders of Corp 2 for pre-merger liabilities, and vice-versa.

The IRS treats a classic merger as a tax-free reorganization, which is good. Regarding valuable contracts (e.g. contracts with clients), Corp 2 automatically takes over the contracts without need for the consent of the other contracting party. Note: look for “buy on sale” clauses in certain contracts, e.g. leases and loan documents – you might need the landlord’s or bank’s consent for these contracts.

Newco Merger
The alternative to a classic merger is to start a new company, called Corp 3 (aka Newco). Corps 1 and 2 transfer their assets (but not their receivables or liabilities) to Corp 3. This transfer can be direct to Corp 3 or via an intermediary distribution to the shareholders, who then contribute the assets to Corp 3. The shareholders contribute cash to Corp 3 to cover its startup period until post-merger receipts come in. The shareholders divide up ownership in Corp 3.

The primary benefit of the Newco is limited liability. Corps 1 and 2 dissolve, giving Corp 3 and the shareholders an argument that old liabilities died with the old Corps. These liabilities might include, for example, bad contracts, tax audits, employment law claims, etc. If this argument holds, the shareholders of Corps 1 and 2 can feel safe that the new venture doesn’t take on old liabilities, including the liabilities of the other Corp to the merger. This limited liability benefit is not full-proof, however, and the creditors have a counter-argument. The creditors can sue Corp 3 for liabilities of Corps 1 and 2 on grounds that Corp 3 is the successor to Corps 1 and 2. The facts of the merger will tell you the strength of the creditors’ argument.

As for taxes, the IRS can characterize as a taxable sale the transfer to Corp 3 of assets out of old Corps 1 and 2. This can be painful. Corps 1 and 2 also must assign their client contracts and other valuable contracts to Corp 3, which can be painful depending on the number and nature of the contracts.

Contributions to Ownership
The hardest part of a merger is figuring out how the shareholders of Corps 1 and 2 divide up ownership of the new, merged business. In any merger, expect to spend a majority of the negotiation on this problem.

The problem is accounting for differences in value between Corp 1 and 2 so that you divide ownership of the new business in a fair way. It’s rare that Corps 1 and 2 are so equal in value that shareholdings translate directly across from the old to the new. One way to solve this dilemma is to put a dollar value on all assets to be contributed to the new business, and base new shareholder percentages directly on the dollar values. The parties can use cash to equal out the asset values / shareholder percentages.

Exit Clause
Sometimes a party to a merger wants an exit clause in case the merger isn’t working out, usually within the first year. With the exit, the party receives the return of its assets, plus customer lists, phone numbers, office leases, staff, equipment, and corporate name and entity. Note that items acquired jointly (post-merger) need a special mechanism to ensure a buy-out at fair value.

Miscellaneous Issues
Some additional issues to consider in the merger:

* How to divide corporate control, including membership on the board of directors, veto rights and super-majority votes.

* How to set the formula for compensation of the shareholders, including salary.

* Drafting a Buy-Sell Agreement for the shareholders.

* Transferring insurance from the old corps to the new business.

* Transferring licenses to the new business.

I hope this article helps you. For more on mergers and acquisitions, see Buying and Selling a Business, and Valuation Issues in Buying and Selling a Business. Remember this is complex stuff. Before you do anything, get competent legal counsel to help you.

ABOUT THE AUTHOR: Matt Dickstein, Business Attorney
Matt Dickstein, Business Attorney, provides business legal services in the San Francisco Bay Area and the Silicon Valley, California, including San Jose, Palo Alto, San Francisco, Oakland, Hayward, Fremont, Walnut Creek, Pleasanton and Sacramento.

Since 1994, I have been representing businesses of all types, big and small. I handle business transactions, corporations & LLCs, real estate ventures, professional practices, and franchises.