With a market trend towards vertical integration, it is necessary for small businesses and entrepreneurs to understand how vertical integration can be a viable option for growing a business.
Vertical integration occurs when a business performs a service for itself that it would otherwise purchase from another business. Apple is a great example of a vertically integrated company. Apple manufactures its own hardware, owns the core software, optimizes its software for the hardware, equips it with iTunes and iCloud, and sells its products almost exclusively through its own retail stores. Apple is essentially a hardware, software, services, and retail company all in one thus cutting the costs of middlemen.
There are several ways in which a business can vertically integrate. A business can enter a new market on its own, enter into a long-term contract with another business, or merge with another business or acquire another business by purchasing the other business’s assets or stocks.
As seen in the Apple example, vertical integration can lead to many economic efficiencies but. there are a number of consequences and considerations to be cognizant of.
BENEFITS
The vertical integration of a business could lead to technological and transactional efficiencies and increased investment incentives.
Depending on the industry, two companies that use similar technologies in production would benefit from vertical integration because the two businesses could maximize their use of the technologies. For example, if a television manufacturer merged with the manufacturer of the electronic components, costs would decrease because the television manufacturer would not have to purchase the electronic components and the quality of the television may increase because the electronic components would be made specifically for those televisions. Additionally, if the two businesses use similar machinery the businesses would reduce costs further because the individual businesses would share the costs of the one machine rather than taking on the costs separately.
If two businesses choose to vertically integrate by way of a merger or acquisition, the surviving entity will benefit from transactional efficiencies. Negotiating and writing up contracts costs money, dealing with other businesses involves risk, and the less information one business has about the other, the greater that risk is. Following a vertical merger, a business will be assured it is working with a reliable entity and will be aware of the available supply and financial information of the other entity. Further, in comparison to vertically integrated businesses that elect not to merge, merging businesses may also benefit from transactional efficiencies from reduced tax payments and accounting costs. Non-merging businesses may have to pay state and federal taxes on products purchased from outside businesses, and non-merging businesses will also have additional costs from internal recordkeeping and accounting.
Finally, vertically integrated businesses may benefit from increased investment. Businesses that are vertically integrated may lead to greater investments because vertical integration results in increased communication and coordination between the two businesses.
SUCCESSOR LIABILITY
If a business chooses to vertically integrate by purchasing the assets of the other business, the acquiring business must watch out for successor liability. Generally, the buyer-business in an asset acquisition is not liable for the seller-business’s debts and liabilities.
However, there are four important exceptions to this general rule: the agreement exception, the de facto merger exception, the mere continuation exception, and the fraudulent transfer exception.
The Agreement Exception
A buyer-business can take on successor liability where the asset purchase agreement expressly states the buyer-business agrees to assume the seller-business’s liabilities or where the buyer-business engages in conduct that implies it intended to assume the seller-business’s liabilities, such as where the buyer-business voluntarily pays a seller-business’s debt that was not required by the agreement. To prevent this exception from being triggered, the agreement should clearly state which liabilities, if any, the buyer-business will assume.
The De Facto Merger Exception
This exception is triggered when the asset purchase is simply a consolidation or merger between the buyer-business and seller-business. The de facto merger exception involves many factors, with no single factor being determinative, so it would be prudent to consult an attorney regarding this exception. In an effort to further persuade you to consult an attorney, this exception is the most commonly litigated among successor liability cases.
The de factor merger exceptions considers the following factors:
1. Whether the shareholders/members of the seller-business continue to be the shareholders/members of the buyer-business.
2. Whether the seller-business discontinued its operations or is dissolved soon after the asset sale.
3. Whether the buyer-business assumed the liabilities of the seller-business.
4. Whether there is a continuation of the seller-business, as evidenced by the same or similar management, employees, physical location, assets, etc.
The Mere Continuation Exception
The mere continuation exception is triggered when only one business remains after the asset purchase and the buyer-business has substantially the same or similar ownership as the seller-business. This exception typically applies when the owners of the seller-business maintain significant ownership in the buyer-business, as that would be indicative of corporate reorganization disguised as an asset purchase.
The Fraudulent Transfer Exception
The buyer-business can be liable under the fraudulent transfer exception if the court determines the asset purchase occurred in an attempt to escape the seller-business’s liabilities.
HOW TO AVOID SUCCESSOR LIABILITY
As discussed above, there are several ways in which a buyer-business can find itself on the hook for the debts of the seller-business. In order to minimize the risk, a small business should work through the following list before it purchases a business:
- Conduct a lien search at the state, local, and federal level (paying close attention to UCC and tax liens)
- Conduct a title search for titled assets
- Check in with the local tax authority
- Draft a carefully worded purchase agreement
- Take your time! Don’t be rushed!
Vertical integration can result in a myriad of efficiencies for a business, but it is crucial that a small business consult with an attorney during the process to avoid successor liability.
Sources:
Herbert Hovenkamp, Federal Antitrust Policy: The Law of Competition and its Practice 506 (5th ed. 2005).
Sullivan, Understanding Antitrust and Its Economic Implications 352 (6th ed. 2014).
Kenneth J. Arrow, Vertical Integration and Communication, 6 The Bell J. Econ. 1 (1975).
Herbert Hovenkamp, Principles of Antitrust 361 (2017).
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