For many of the individuals involved, a sale or acquisition is likely to be a one-off or rare event. This guide covers issues of interest to both buyers and sellers, including the structure of the arrangement, its process and some of the key documents involved.
Structuring the sale
Should we buy/sell the shares or the assets of the company?
A company’s business can be acquired in one of two ways:
l By buying the shares in the company that owns the business (a share sale). Here, the sellers are the shareholders of the company and they will sell their shares in the company to the buyer.
l By buying the assets of the company which comprise the business (a business or asset sale). Here, the company is the seller and it will sell some or all of its assets to the buyer.
A number of factors may impact on which structure is used; the most common are looked at briefly below. Sometimes it will be necessary to restructure the business or company before it is sold to allow it to be acquired in the most appropriate way.
Assets and Liabilities
On a share sale, the buyer acquires the company complete “warts and all”. Generally, this route offers sellers a cleaner break as after the sale takes place they will have no direct responsibility for the company – but invariably there will a continuing liability owed to the buyer under the terms of the warranties and indemnities agreed in the sale and purchase agreement.
On a business sale, only the assets and liabilities which the buyer specifically agrees to purchase are acquired and everything else stays with the company. If the buyer suspects there are unknown liabilities in the company or is troubled by any particular aspect of the business, it may prefer to structure the deal as a business sale – allowing him or her to “cherry-pick” from the company’s assets and liabilities and take on only those risks which it understands and/or finds acceptable.
One asset/liability which the buyer cannot cherry pick so easily, however, is the workforce – see employees and pensions below.
The structure of a transaction is often driven by the tax implications for both buyer and sellers an issue which can become quite complex when their interests are at odds in achieving the most beneficial tax outcome.
Taxation is a complex area when buying a business due to the potential availability of quite complex exemptions, reliefs and allowances dependent upon the buyer/seller circumstances.
As a general rule of thumb, however, where sellers are individuals they are likely to favour a share sale in order to:
l Obtain the benefits of Entrepreneur’s Tax – which, provided the seller meets HMRC base requirements, means the capital gain on sale of the shares is taxed at just 10%.
l Avoid a potential double tax charge – an initial tax charge on the company at the time of the sale of assets to the buyer and a further tax charge on the company’s shareholders when they withdraw the sale proceeds from the company.
On the other hand, the buyer in certain circumstances is likely to prefer to structure the deal as an Asset Sale, maximising potential tax reliefs available to him.
As tax is likely to be a key determining factor to the structure of a deal, both buyers and sellers should obtain tax advice at the outset to ensure that any indicative sales terms agreed between the parties will deliver the expected taxation outcomes.
Employees and pensions
On a business sale, the TUPE regulations are likely to apply. If so, the current employees will automatically transfer over to the buyer on their existing terms of engagement and the buyer becomes their employer. Buyers and sellers should be aware that they will have specific obligations to inform employees about their plans and may need to consult with employees prior to completion of the sale. Certain pensions rights may also transfer to the buyer by virtue of the TUPE regulations.
On a share sale, there is not generally speaking a change of employer and the employees simply remain employed by the target company. However, care and advice should to be taken.
Buyers and sellers should ensure they are aware of the pensions implications when buying or selling a target company or business. This is a complex area and the potential liabilities and obligations, particularly in the context of final salary schemes, can be significant.
Generally speaking, there are more practical and commercial issues to contend with on a business sale than on a share sale.
On a share sale, only the ownership of the shares in the company is transferred. Whilst the shareholders of the company will change, its assets (including its business contracts, agreements and licences) remain in the name of the company and very little will appear to have changed. However certain contracts (for example, financing contracts and other long-term agreements) may require the other party’s consent when a change of ownership of the company is planned. It is important to identify any such contracts early as quite often a change in ownership or control of the company can trigger rights to cancel such contracts.
On a business sale, the assets and contracts of the business being sold will all need to move across to the buyer and the consent of customers, suppliers, landlords, licensors and others is more likely to be required. Contracts, agreements, land and property and certain intellectual property rights will all need to be formally transferred. There is likely to be more disruption to the business than on a share sale and the buyer may need to build confidence with the customers and suppliers of the business to maintain existing trading relationships. Quite often the seller is retained by the business for a period of time to facilitate this.
What is due diligence?
When you buy goods or services as a consumer certain conditions are implied by law, the most common being that the goods will be of satisfactory quality and fit for purpose. When a buyer acquires the shares or business of a company no such conditions are implied and the general principle of “buyer beware” very much rules here. A buyer will want to gather as much information about the company or business as possible to understand what it is taking on – this is the “due diligence” process.
Due diligence is simply put a thorough appraisal of the condition of the company or business being acquired.
The information obtained will help the buyer:
l evaluate what it is buying and where the weaknesses lie;
l whether it wants to proceed;
l establish the right price;
l identify any liabilities or risk areas which may affect how the deal is structured;
l identify areas where it requires protection in the contractual documents through warranties and indemnities;
l identify any third party consents which may be required, for example, consents from customers, suppliers or landlords;
l identify areas which may need action following the acquisition.
Legal due diligence
Traditionally the buyer’s lawyers send a detailed information request to the sellers or their lawyers, designed to flush out as much useful information as possible. These enquiries usually cover all aspects of the company or business being acquired. This will include everything from its constitution to its employees, contracts, licences, property, financing arrangements, intellectual property rights and IT systems. The degree of focus on any particular area will depend on the nature of the business or company.
A due diligence report will be prepared for the buyer which will highlight issues of concern and suggest protective measures where appropriate. The focus and degree of detail in this report will vary from deal to deal depending on the buyer’s particular needs (or, where bank or other external funding is involved, the funder’s requirements).
Legal due diligence can be a lengthy and frustrating process, particularly for sellers who will invariably need to commit significant time and resources responding to the buyer’s enquiries. Whilst it is started early on in negotiations, it can often continue well into the deal process and overlap with the disclosure process.
Financial due diligence
The buyer’s accountants will analyse the financial books of the company or business and back up this paper review by talking to its accountants and management. Financial due diligence will focus on assessing the historic trading performance of the company or business to check that the assumptions the buyer is making about its future are supported.
The financial due diligence process seeks to gain confidence that post a transfer of ownership, that the new owners are likely to inherit a business subject to the same dynamics as the previous owners enjoyed. For instance, trading relationships with customers and suppliers will be examined to seek to ensure that there are no matters that might impinge upon future trading patterns. There will also be a review of any relationships between associate / linked businesses to the sellers.
The financial due diligence process is also likely to look at historic trading patterns, any forecasts prepared by the seller to ascertain their likely accuracy and also have regard to industry benchmarks to seek to investigate the stage of maturity of both the business being acquired as well as the industry itself.
The buyer’s tax accountants will review the tax history of the target and focus on identifying any issues which could be disputed by HMRC.
Commercial and other due diligence
Both the financial and legal due diligence may identify issues of a commercial or strategic nature which the buyer may want to investigate further. Sometimes a specialist consultancy may be involved to carry out a more detailed analysis of the company or business being acquired. Other specialist reports may also be required as part of the wider due diligence process, for example, property surveys, environmental audits, health and safety investigations or actuarial valuations.
What are warranties?
Warranties are contractual promises about the company or business by the seller to the buyer. To protect the buyer against liabilities which may exist in the company or business, the sellers will typically be required to give a large number of warranties covering all aspects of the company or business being acquired. If any of these assurances are untrue and as a result, the value of the company/business is less than the buyer paid for it, the sellers may be liable to pay damages to the buyer under a breach of warranty claim.
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Warranties also perform the dual function of encouraging the sellers to provide further information about the company or business in the form of disclosures, over and above the information extracted during the due diligence process.
The bulk of a sale and purchase agreement will be the schedule of warranties given by the seller. Whilst claims are relatively rare, both parties will want to be prepared for this possibility. The buyer will be keen to ensure that the warranties are as wide as possible whilst the sellers will try to limit their scope.
Certain types of sellers who have a more detached role in a company may refuse to give the usual broad range of warranties, for example, venture capitalists, receivers or trustees. In these situations, a buyer will want to be even more confident in its due diligence process.
What is the purpose of disclosure?
From the sellers’ perspective. Due to the generally comprehensive nature of warranty cover requested by the buyer, sellers will often be required to give warranties which, if left unqualified, will not be correct. To address the risk of a warranty being untrue and leading to a potential warranty claim, the sellers prepare a “disclosure letter” for the buyer. This letter acts to qualify the warranties with factual information setting out the true state of affairs. To the extent that the sellers properly qualify a warranty by a disclosure, they cannot be sued for a breach of that warranty.
From the buyer’s perspective. A buyer will gain comfort from the warranties knowing that the sellers will want to ensure they have provided all relevant information to the buyer via the disclosure process in order to avoid any claims for breach of warranty
Practically speaking, warranty claims are rarely brought before the courts and much effort is put into the disclosure process to ensure that the buyer is fully informed and disputes avoided.
How do indemnities differ from warranties?
As well as the schedule of warranties, it is normal practice for the sellers to be required to give certain indemnities (promises to repay) to the buyer. A buyer may look for indemnities to cover itself against problematic issues identified during the due diligence or disclosure processes, for example there may be a current investigation into a tax scheme that the company operated and the indemnity may be expressed to cover the payment of any unpaid tax, penalties and interest that result from that investigation.
Indemnities will be more specific in nature than warranties. The main distinction is the basis of any claim by the buyer for breach and the damages recoverable.
Breach of warranty. The rules about claiming and calculating damages on a warranty claim are complicated but in essence, damages on a warranty claim are usually based on the buyer’s loss of bargain – is the company/business acquired worth less than the buyer paid for it because the warranty was untrue? This may be less in value than the actual loss arising from the breach of warranty.
Breach of indemnity. Where an indemnity has been triggered the sellers will be required to reimburse the buyer for the particular liability that has arisen on a pound for pound basis regardless of whether it has affected the value of the company/business. Unlike warranties, indemnities are generally not qualified by the sellers’ disclosure letter.
How can sellers protect themselves from claims?
Primarily by ensuring that they have properly disclosed all relevant information to the buyer during the disclosure process. Particular areas of risk tend to be the warranties relating to accounts and financial performance.
The warranty schedule will be carefully negotiated to try and ensure that the sellers are not being asked to give unreasonable assurances to the buyer.
It is common for sellers to build certain protections into the sale and purchase agreement which limit their potential liability under the warranties (and sometimes certain indemnities). These include:
l a time limit on when claims can be brought by the buyer;
l a minimum (or de minimis) – “insignificant” claims below an agreed sum are completely excluded;
l a threshold (or basket) – claims must exceed a certain threshold before any claim can be brought. Once this threshold is reached (either by a single claim or a number of claims in aggregate) the agreement will state whether the sellers are liable for the aggregate amount of the claims or just the excess above the threshold; and
l a cap – the maximum amount the sellers can be liable for (often the total amount received on the sale).
Where there are multiple sellers they will usually be jointly and severally liable for any claims made by the buyer. This means that the buyer can claim against all or any one or more of them. To protect themselves the sellers may:
l Require a cap in the sale and purchase agreement which limits their individual liability to the amount of consideration each individual receives; and/or
l Sign up to a separate (private) agreement called a contribution agreement which regulates how liability under the sale and purchase agreement will be shared between them.
Is insurance cover available?
There is a growing market for warranty and indemnity insurance. Policies provide cover in respect of claims under the warranties (and sometimes indemnities), either generally or in respect of discrete areas of risk.
Policies can be taken out by either the buyer or sellers. The buyer may have concerns about any financial caps on liability negotiated by the sellers or have doubts about the sellers’ future financial position and their ability to pay out for warranty claims. The sellers may be concerned about the potential risk of losing their sale proceeds if the buyer makes a warranty claim, despite a thorough disclosure exercise. Or a policy may be seen as a viable alternative to tying-up money for long periods in an escrow account.
What are the key documents involved?
Confidentiality agreement. The buyer will be under a duty not to disclose any confidential information it receives concerning the target company or business during the negotiation process. This duty may be reciprocal if the information is also flowing from the buyer to the sellers or to ensure that the parties keep the proposed transaction itself confidential. Sometimes these confidentiality obligations will be combined with the exclusivity agreement or found in the heads of terms.
Exclusivity agreement. This gives the buyer a specified period of time to negotiate and complete the deal during which the sellers may not look for, provide information to, or negotiate with other possible buyers. Again, exclusivity arrangements are sometimes found in the heads of terms or combined with the confidentiality obligations.
Heads of terms. This document sets out the key commercial terms of the proposed transaction. Although not generally legally binding, it will set the tone for the transaction. Once agreed it may be harder from a negotiation perspective for either party to go back on a point contained in the heads of terms, without good reason. Specific clauses relating to confidentiality and exclusivity may be included and, if so, these will be contractually binding.
Sale and purchase agreement. This is the main contractual document and contains the detailed terms of the sale and purchase. As a rule it is drafted by the buyer’s lawyers. It is usually a very lengthy document and prescribes:
l how the purchase price is to be met and the mechanics of payment (for example, completion accounts);
l (on a business sale) the assets to be transferred;
l any consents or conditions which must be obtained or satisfied before the deal can be completed;
l any restrictive covenants imposed on the sellers;
l completion mechanics;
l warranties and indemnities/tax deed;
l detail relating to specialist areas such as real estate, pensions, employment and intellectual property;
l other matters such as limitations on the sellers’ liability, additional buyer protections or provisions dealing with how the business is to be run during any gap between an exchange of contracts and completion.
Disclosure letter. This letter, prepared on behalf of the sellers and addressed to the buyer, acts to qualify the warranties and is one of the most important deal documents. It is supported by a disclosure bundle which contains any documents referred to in the disclosure letter.
The sale and purchase agreement and disclosure letter are finalised and signed – known as exchange of contracts. The parties are now committed to completing the sale and purchase in accordance with its terms.
Whenever possible completion will occur simultaneously with exchange but occasionally this will not be possible. Certain conditions may need to be fulfilled or third party consents obtained before completion can take place and it may be commercially too sensitive to seek these consents or resolution of these conditions ahead of exchange. In that scenario, there will be a delay before completion whilst the buyer and sellers arrange for these consents and conditions to be dealt with.
Where there is a delay between exchange and completion, the sellers will give the warranties and make their disclosures at exchange. They may be required to repeat the warranties as at the completion date and if so may be permitted to make additional disclosures in respect of the period between exchange and completion.
At completion, ownership of the company or business being acquired is transferred to the buyer.
Completion, particularly of larger and more complex deals, traditionally involves a formal completion meeting attended by the buyer, sellers, their lawyers and other advisers. It can often be a lengthy meeting as the lawyers check that all the formalities are in place, the purchase monies are available and all the ancillary documents needed to finalise the sale and purchase are ready for signature. It is not unusual for negotiations between the buyer and sellers to be ongoing at the start of this meeting. Where exchange and completion are not simultaneous there may be a lengthy meeting at each stage.
Practicalities will include:
l Board meetings and sometimes shareholder meetings;
l payment of the purchase price;
l release of charges connected with the sellers’ funding arrangements and implementation of any buyer’s funding;
l resignations and appointments of directors and auditors;
l execution of any additional transfers required on a business sale (for example, transfers of real property or intellectual property assignments).
There will be a certain amount of housekeeping to deal with following completion, including:
l Announcements and notifications (for example, on a share sale, Companies House forms and filings);
l payment of stamp duty on a share sale and possibly a business sale (if the assets being purchased include shares) and stamp duty land tax on a business sale if the assets include real property;
l preparation of completion accounts where relevant;
l on a business sale, assignments/novations of supplier and customer contracts;
l other administrative or practical matters needed to integrate the target company or business into the buyer’s group or organisation.
Sean Callaghan – BTMK
Gary Raven – Barrons