M&A in China: Asset Deal vs. Share Deal – Key differences and practical implications

Hydro-Wolf has therefore asked its advisors to summarize the main differences between the two transactions and compare their respective advantages and disadvantages.

Part 1 of this series article provides an overview of the key advantages and potential challenges that foreign investors should consider when engaging in M&A transactions in China. Part 2 – this article – compares Share Deals and Asset Deals and examines the respective advantages and disadvantages of each. Part 3 addresses preparatory documentation, due diligence, and tax considerations related to M&A transactions.

Subject of the acquisition

The target company must be distinguished from its property.

As in most countries, an acquisition can use two basic structures: Acquisition of all or part of the target company itself by way of an equity purchase (Share Deal), or acquisition of all or part of the target company’s property by way of purchase of assets (Asset Deal).

In case of a Share Deal, the buyer becomes the new (co-)shareholder in the target company. The buyer of the equity in the target company can be a foreign person or company, or a Chinese person or company. The target company remains as it is, including all its (potential) liabilities.

In case of an Asset Deal, the buying side uses an acquisition vehicle to buy the assets. Typically, this will be another company in China able to host and operate the acquired assets of the target company. If the buying side does not yet have a suitable acquisition vehicle, such company first needs to be established.

Potential objects of an Asset Deal can include:

• Assets owned by the target company such as immovable and movable property, intellectual property rights, etc..
• Contractual rights and obligations of the target company (contract transfers).
• Regarding employees, the old labor contract with the target company needs to be terminated and a new labor contract established with the acquisition vehicle.

Chinese characteristics

As mentioned above, Share Deal and Asset Deal are two different methods of acquiring a business, each with its own legal, financial, tax, and operational implications. The choice between Share and Asset Deal in China depends on a number of factors, including the buyer’s strategic objectives, risk appetite, regulatory considerations and the specific circumstances of the target company. Each method has its advantages and disadvantages, and the decision to use either method requires careful consideration of the implications. In our sample case:

Transaction Structure

• Share Deal: Hydro-Wolf would acquire an equity share in Hydro-Dragon to take ownership and control of it, depending on the percentage acquired. All assets, liabilities, contracts and legal obligations of Hydro-Dragon would remain in Hydro-Dragon. Hydro-Dragon continues to exist as an individual legal entity but under amended ownership. A key advantage of a Share Deal can be the continuation of all existing licenses and registrations held by Hydro-Dragon.
• Asset Deal: In this transaction, certain assets, contracts, rights, and obligations of a company would be acquired by a local acquisition vehicle owned by Hydro-Wolf. Hydro-Dragon would continue as a (shell) legal entity, but without the sold assets. Since Chinese law does not provide for an automatic transfer of liabilities in such case (as, e.g., under § 25 German HGB, § 75 AO, § 613a BGB), an Asset Deal can limit the exposure to potential historic liabilities compared to a Share Deal. For example: if Hydro-Dragon still owes taxes, this liability would remain with Hydro-Dragon after the asset deal has taken place.

Purchasing Entity

• Share Deal: Hydro-Wolf could purchase the agreed equity share directly from Mr. Wang, who is currently the sole shareholder of Hydro-Dragon.
• Asset Deal: In an Asset Deal, Hydro-Wolf needs a suitable legal entity in China which may first need to be established. The general incorporation process for this entity must be completed prior to the Asset Deal. An already existing Chinese company may firstly need to establish a branch at the target location. This entity can then acquire the selected assets of Hydro-Dragon.

Regulatory Requirements

• Share Deal: The acquisition must comply with general regulations, including the so-called “Negative List”. This type of acquisition is also likely to be subject to more rigorous scrutiny, particularly in regulated industries. Approval by government authorities may be required. In addition, antitrust reviews may be triggered.
• Asset Deal: If the acquisition vehicle already exists, Asset Deals are often subject to less stringent rules than share acquisitions. However, the transfer of certain assets may require special approvals or registrations (e.g., land use rights, intellectual property). Antitrust reviews may also be triggered. The acquisition vehicle needs a business scope covering the target business and also needs all relevant additional licenses to run it.

Due Diligence

• Share Deal: Due diligence is more comprehensive because the buyer will become either part- or sole owner of the entire target company. The target company’s liabilities (known and unknown) remain in the target company. Hydro-Wolf needs to carefully examine Hydro-Dragon’s financial and tax statements, contracts, compliance in all relevant areas including e.g. ESG, risks related to legal disputes, etc..
• Asset Deal: Due diligence typically encompasses a focused examination on the specific assets and liabilities to be acquired. This includes verifying ownership, identifying any potential encumbrances, ensuring valid permits for use and their transferability, assessing the condition of the assets, and confirming ESG compliance, etc.

Taxes

• Share Deal: Hydro-Dragon remains the taxpayer; historical tax liabilities stay with the Target. Hydro-Wolf does not take over its own ‘tax history’ but bears the economic risk via ownership. Mitigation measures include tax due diligence, warranties/indemnities, escrow/holdback, and post-closing cooperation.
• Asset Deal: The acquisition of certain assets may trigger VAT (e.g. 13% on equipment/inventory; different treatment for real estate/intellectual property). Advantage: no historic tax exposure of the target transfers; but specific transfer taxes (stamp duty, real estate tax) must be considered.

Employees

• Share Deal: Existing employees generally remain with the target company as this company does not change. This means that the new co-owner of the target company can continue to rely on the existing management team and workforce. But potential liabilities, e.g., underpaid social insurance obligations, remain in the target company.
• Asset Deal: Employees cannot be “transferred” like a fixed asset. If the local entity of Hydro-Wolf wishes to take over all or part of the employees of Hydro-Dragon: the existing labor contracts with Hydro-Dragon need to be terminated and new labor contracts set up with the acquiring entity. The key aspect here will be the recognition of previous working time by the acquiring entity if Hydro-Dragon is not willing to pay statutory severance upon exit.

Continuity

• Share Deal: All existing contracts, licenses and permits, etc. remain with Hydro-Dragon, since the company itself remains untouched. Hydro-Dragon can continue operating. Contracts remain in force, including with suppliers and customers, lease contracts, contractual relations with banks and insurers, etc. Also, official registrations as well as the business license, industry-specific, environmental and other permits and licenses will remain in force. However, some of Hydro-Dragon’s contracts (e.g., loan agreements) may contain change-of-control provisions requiring the consent of or renegotiation with the affected party.
• Asset Deal: As licenses are not automatically transferred with the assets, it may be necessary for Hydro-Wolf’s local entity to negotiate or obtain completely new contracts, licenses and permits. This can be costly and time-consuming..

Risk Allocation

• Share Deal: In a Share Deal, only the owner of the target company changes. A Share Deal has no implications for the company’s rights and obligations. By purchasing the target, Hydro-Wolf would indirectly purchase all inherent risks associated with Hydro-Dragon. This includes potential (hidden) liabilities, litigation risks and regulatory compliance issues. Hydro-Dragon could also face claims from third parties. One of the key aims of the prior due diligence is to discover major risks prior to the transaction. Carefully drafted transaction contracts and payment structures may further reduce risks.
• Asset Deal: Hydro-Wolf’s local entity would be able to strategically allocate risk by determining which assets and liabilities it is willing to buy. Due diligence can be reduced to the relevant assets. A carefully drafted asset transfer contract may further reduce risks.

Cost and Complexity

It cannot be stated in general whether a Share Deal or an Asset Deal will be the less complex / less costly alternative. This will always depend on the individual case. A share deal regarding a young company with limited risks may be as efficient as a small asset deal. On the other hand, a Share Deal regarding an older larger company may require a high level of effort, and equally, an Asset Deal in a regulated industry requiring the prior set up of the acquisition vehicle may trigger time-consuming licensing processes.

• Share Deal: Share Deals generally require extensive due diligence. Hydro-Wolf’s main focus would be to conduct a thorough due diligence of Hydro-Dragon, and ensure that the share purchase agreement, revised articles of association and other by-laws sufficiently define, reflect and protect Hydro-Wolf’s interests.
• Asset Deal: Sometimes, an Asset Deal can be simpler and cheaper because the buyer can focus on specific assets and carve out other assets and liabilities. Depending on the extent and type of the assets, the process can be cumbersome and may involve a number of different governmental regulators (e.g., real estate, intellectual property, machinery). If Hydro-Wolf does not already have a local entity in place, it will need to establish one prior to the Asset Deal. This means that it will first need to cover the costs of setting up the entity, and secondly provide it with sufficient funds for the Asset Deal and operating costs until it is self-sufficient. This entity must also have all the necessary approvals, permits and registrations to operate legally.

Integration

• Share Deal: The integration of the target company following a Share Deal can pose significant challenges for the acquirer, as the entire company with its specific culture and established working methods, operational processes and internal systems, including IT systems, is taken over. In the current case, Mr. Wang is intending to sell 50% of his equity in Hydro-Dragon to Hydro-Wolf. This means that Hydro-Dragon will be transformed into a joint venture. Integration can pose particular challenges, as Hydro-Wolf can only exert limited (indirect) influence on changes to the working culture, operational processes, etc. In order to integrate and consolidate Hydro-Dragon’s business activities, Hydro-Wolf will also have to make adjustments. Exerting decisive influence over reporting, decision-making and manufacturing processes, will be crucial. Its advisors can support Hydro-Wolf in this, ensuring that Hydro-Wolf’s interests are represented and safeguarded after the legal acquisition has taken place.
• Asset Deal: Integration may be more straightforward, as Hydro-Wolf’s local entity would only integrate specific assets, and staff of Hydro-Dragon. This would allow Hydro-Wolf to tailor its local entity to its needs and plans from the beginning, particularly with regard to working methods, operational processes, and internal systems. If employees are transferred with the assets, there may still be challenges. Cultural differences, such as working styles, communication methods and general values, require special attention, as do management methods. Unlike with a Share Deal, where these processes are taken over with the target company, various operational processes, such as supply chain management, customer service, manufacturing practices and other business operations, must be set up from scratch.

Summary & Outlook

Hydro-Wolf has thoroughly evaluated the pros and cons of both a Share and an Asset deal and concluded that Mr. Wang’s offer of a Share Deal best aligns with its intentions, expectations and plans for entering the Chinese market. This is primarily due to Hydro-Wolf’s reluctance to set up a local Chinese company for an Asset Deal, given the registration and approval processes involved, not to mention the significantly higher costs. Furthermore, operating as a standalone entity in the Chinese market would prevent Hydro-Wolf from benefiting from the advantages of cooperating with Hydro-Dragon outlined in Part 1, which are of considerable importance to them. Therefore, from Hydro-Wolf’s perspective, the advantages of Mr. Wang’s proposal to acquire 50% of Hydro-Dragon’s equity outweigh those of an Asset Deal.

Hydro-Wolf therefore intends to pursue a Share Deal.

Next in Part 3: We outline the preparatory documentation required for a China M&A transaction, including Letters of Intent and Memoranda of Understanding, followed by an overview of the due diligence process and selected tax considerations essential for structuring and executing a successful deal.