The two basic ways in which to acquire a commercial enterprise are by business (asset only) acquisition or share acquisition. The focus of this article is on share acquisition where a buyer acquires the shares in a private limited company (usually referred to as the ‘target’ company) that owns the business in which the buyer is interested.
A company is a legal entity distinct from its owners. It is the company which owns the business that it operates and its shareholders in turn, own the company. The company itself will often be the tenant of a lease of premises from which the business operates; it will be the employer of the employees and it will enter into contracts in its own name.
The buyer will acquire shares in the target company by taking a transfer of the shares from the existing shareholders. Although the ownership of the company has changed hands there is no change in the ownership of the business as the business remains within the ownership of the company.
Importantly, following the sale of the shares in the target company, all liabilities of that company continue to be enforceable against it. Because the buyer of the shares will inherit any liabilities (whether it knows about them or not), the buyer will undertake a ‘due diligence’ exercise and, in addition, seek wide protections (known as ‘warranties’ and ‘indemnities’) from the seller - and these will be contained in the Share Purchase Agreement. Therefore, if the target company does turn out to be saddled with problems the buyer has a right of redress from the seller.
Due Diligence:
One of the basic principles of English law is that of ‘let the buyer beware’. It is therefore up to the buyer to ensure that it has made all necessary enquiries regarding the condition of the target company and any factors that may affect its value. Rather like buying a house or a second hand car, it would be very unwise not to undertake a survey or look under the bonnet to find out what exactly is being purchased and what potential problems may be inherited.
This process of investigation and information-gathering can be sub-divided into ‘financial due diligence’ (focusing on the tax and financial affairs of the company), and ‘legal due diligence’ (focusing on the target company’s main commercial agreements, property, employees, intellectual property, etc). The focus of the due diligence exercise will vary depending on the nature of the company to be acquired. Generally the buyer will want to elicit information about the target company, its business, its assets and liabilities, properties, contracts, employees, and details of the seller of the shares.
It will be important to review the important contracts entered into by the target company as some will contain clauses which allow the other party (supplier, customer, etc) to terminate the contract where the shares in the company change hands.
The knowledge that the buyer learns through the due diligence process will help the buyer to decide whether it wants to continue with the acquisition or revise its offer for the shares in the company.
Main Documents:
Heads of Agreement At the end of the initial negotiations most buyers and sellers set out the main terms on which they have agreed the sale in a brief written document, which both parties sign. The bulk of this document will be non-binding (such as price, level of stock, etc) although, often, provisions relating to confidentiality, exclusivity (where the seller agrees not to deal with anyone other than the buyer for a period of time) and liability for costs if the acquisition does not complete, will usually be legally binding.
Confidentiality AgreementThe seller will be very keen to prevent the target company’s employees, competitors, suppliers and customers from finding out about the sale. The seller will therefore be understandably reluctant to pass on sensitive information to the buyer prior to entering into a legally binding Confidentiality Agreement, especially where the buyer is a competitor. Unless the buyer enters into an enforceable undertaking of confidentiality there is a risk that the buyer will not be under a duty of confidentiality.
Pre-contract enquiries and replies Pre-contract enquiries are prepared by the buyer’s solicitors and sent to the seller’s solicitors in the form of a detailed questionnaire tailored to the particular target company. The replies will enable the buyer to obtain an up to date and accurate picture of the company, its business, its liabilities and assets, employees, properties, intellectual property, contracts, and the seller’s shares, amongst other things.
Share Purchase Agreement This document tends to be fairly lengthy, but forms the body of the transaction and contains most of the important legal business. Within it the seller agrees to transfer its title to the shares to the buyer and the buyer agrees to pay the purchase price (which may be in tax efficient forms other than cash). There will be numerous other provisions setting out the fine details of the deal negotiated between the buyer and seller. These would include, for example, provisions dealing with property, pensions, intellectual property, the warranties, indemnities and completion arrangements. The Share Purchase Agreement will also include the usual restrictions to prevent the seller from competing with the target company and also from soliciting customers, suppliers and employees after completion – which the buyer will insist upon in order to protect the goodwill of the business.
A large chunk of the agreement will comprise warranties. Warranties are assurances or promises given by the seller in relation to condition of the company. If they turn out to be untrue or the seller does not disclose information that it holds in order to correct them, then the buyer will be able to claim for damages for breach of the warranties. Therefore, the warranties are often the most eagerly fought over section of the Share Purchase Agreement.
One way that the buyer may seek to protect itself is to ensure that a percentage of the price payable for the shares is retained by the seller in a separate bank account for a certain period after completion. The logic is to make sure that there is a pot of cash easily accessible to the buyer in the event that it wants to make a claim for a breach of warranty or indemnity. Such retained money is usually put into a separate deposit account in the joint names of the solicitors for each of the buyer and the seller.
Disclosure Letter The purpose of the Disclosure Letter is to tell the buyer about any information of which the seller is aware which makes any of the warranties untrue. For example, if the target company owns vehicles that are subject to a hire purchase agreement then the seller would tell the buyer this in the Disclosure Letter to ‘correct’ the warranty that holds that “the target company owns all of its assets outright”. It is important for the seller to take steps early on in the transaction to reveal as much as possible in relation to such disclosures, as this prevents the buyer from being surprised by new information at the eleventh hour, which can often lead to cold feet.
Conclusion:
Selling or buying shares in a company is one of the most challenging projects that any shareholder, entrepreneur or investor can become involved in. It will typically involve a substantial amount of energy on all sides, but can also be among the most financially rewarding events for either a company owner looking to ‘sell up’ or for a company’s board of directors looking to expand the business quickly. The process needn’t be a headache:
Take professional advice early on as to whether a share acquisition is suitable. The choice may be tax driven or it may be that the buyer wishes to ‘cherry pick’ the assets that it wants, and only assume certain liabilities.
Do not underestimate the importance of due diligence. It is always preferable to discover a problem and deal with it before completion of the acquisition than to have to rely on the warranties afterwards.
Instruct professional advisers who are experienced in share acquisitions, and preferably instruct them before the substance of the deal has been negotiated (as a good adviser will be able to assist with the commercial as well as the legal aspects of the transaction).
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