THE ANATOMY OF A BUSINESS SALE 3
This is the third part in our series of notes on selling a business.
The first part in the series set out the basic differences between a share sale and an asset sale (also known as a business sale).
This second part looked at the different stages to a sale.
This note (the third part) will look at some of the documents required on a share or business sale and the post completion steps.
LEGAL DOCUMENTATION AND POST COMPLETION STEPS
The next stage in the process is the negotiation of the documentation. This is often progressed at the same time as due diligence is being carried out.
In very simple terms, the legal and tax advisers to the buyer will ordinarily prepare first drafts of the main documentation comprising either a share purchase agreement or an asset purchase agreement, depending on whether it is a share purchase or an asset purchase. In addition, in relation to a share sale a separate tax covenant may be prepared (or it may be in the share purchase agreement) whereby the seller agrees to indemnify the buyer from any unforeseen tax losses which the target company may suffer in the period prior to completion of the sale which should have been paid by the company but were not. This indemnity is in effect on a pound for pound basis and covers liabilities that the seller knows about and does not know about. It is an allocation of risk that ordinarily falls to be accounted for by the seller.
The share/business purchase agreement is a detailed and lengthy document and will affect the sale of the relevant shares or assets, as the case may be, and will contain a number of other relatively common provisions, including warranties and indemnities, undertakings, confidentiality undertakings and restrictions on the ability of the seller to set up a competing business with the buyer following completion and / or to solicit customers, suppliers or employees of the business which has been sold.
The sale agreement can also contain details about deferred considerations, set off for claims, security for deferred consideration payments, earn outs/earn our protection, adjustments to the purchase price such as net asset value adjustments/profit adjustments/locked box/completion accounts provisions, and anti-embarrassment provisions (to share any upside if the buyer sells on the business/shares shortly after acquiring them for a greater price than it acquires it for).
There will be a number of ancillary documents to support the sale process, including in the share purchase process, things like voting powers of attorney to allow the buyer to vote and utilise the rights attaching to the shares following completion before their name is entered into the register of members, board minutes of the buyer, seller and the target company, various waivers of claims of the seller in favour of the target company, and resignation letters as officers and employees of the company.
This note does not consider in detail the content of the documentation that your lawyer would take you through so that you understood the relevant provisions during the course of the sale process.
Warranties and Indemnities
Whether the sale of the business is by way of a share sale or an asset sale, the proposed buyer will normally require the seller to provide certain undertakings about the business. These are known as warranties. In its simplest form, a warranty is a statement of fact which, unless it is qualified, will provide the proposed buyer with a remedy in contractual damages (as a rule of thumb) in the event that the warranty proves subsequent to the acquisition of the business to have been untrue or misleading.
These warranties can be voluminous and run into many pages. They are in effect a method by which the buyer places the risk of the business that they are acquiring not being as they thought onto the seller. The onus is then on the seller to qualify those warranties so as to provide information to the buyer of anything that is inconsistent with those warranties. This then means that the buyer can either carry on and acquire the business with the knowledge provided, can renegotiate the price or can look for some other remedy against the seller if the relevant qualification comes to fruition following completion.
The method by which the warranties are qualified is known as the disclosure exercise. This normally takes the form of preparing a document known as a disclosure letter, whereby certain specific and general disclosures are made against the relevant warranties so as to qualify them. If a disclosure has been made fairly, it will be deemed to qualify the warranty and the seller will not be liable for any claim brought by the buyer in relation to information so disclosed.
The documentation that is in the EDR is utilised to support any disclosure against the relevant warranties.
There is a considerable amount of overlap between the due diligence process and the disclosure process but it is extremely important that information which is disclosed as part of the due diligence process is, if required, repeated in relation to any disclosure against the warranties. This does appear to sellers of businesses often to be duplicitous. In many respects it is, but unless the relevant disclosure is made against the relevant warranty, there is a risk that the buyer will not be deemed to have knowledge of the relevant inconsistency with the warranty and the seller will remain liable for a claim in damages for breach of the relevant warranty.
The disclosures against the warranties must be very specific and very clear and cross-refer to any relevant documentation to support the provisions qualifying the relevant warranty. If they are not sufficiently clear, and information adequate so that the buyer can make an informed decision about the disclosure is not provided, the warranty will not be fairly qualified and as such the seller will remain liable in damages.
There are circumstances where information comes to light about the company as part of the disclosure process. If the information has been fairly disclosed (in short means with such detail as is required so the buyer understands how the warranty is being qualified) against the warranty, this will in principle mean that the buyer has no right to bring a claim against the seller for a breach of that warranty. Instead, any areas of concern that the buyer has are often covered by an indemnity. This is a standalone provision that provides the buyer with an express pound for pound remedy in relation to any loss suffered by the buyer or the company often following completion arising out of a specific set of circumstances. Under these circumstances, the knowledge of the buyer is irrelevant and it does not in any way qualify the indemnity.
The seller of a business will often look to provide within the acquisition agreement for a series of limitation on its liability such that its liability is capped to a maximum amount (often the consideration payable for the business) and there will in addition be certain materiality thresholds inserted in the agreement, where claims below a certain amount will not be capable of being brought by the proposed buyer. There will also be time limits in relation to when claims can be brought against the relevant seller. This area is often heavily contested and will boil down to the commercial strength of the relevant parties in the negotiations.
It is now possible to obtain warranty and indemnity insurance so the seller/the buyer can in effect insure against any potential liability for warranty/indemnity claims. This is not generally something that your lawyers can directly assist with, and you will need to get in touch with a suitable warranty and indemnity insurance broker. The costs of the premium are sometimes prohibitive compared to the value of the deal. It will therefore require further careful consideration as to whether it is appropriate in relation to the appropriate transaction.
Post Completion Steps
Once the business has been sold there are a number of steps which will need to be taken by both the buyer and the seller. The types of steps will depend upon whether or not it was a share sale or an asset sale. There will be fewer things to consider in relation to a share sale, as the buyer will have acquired the company, together with all its inherent assets and liabilities, which includes all relevant contracts etc. This means that as far as the outside world is concerned the company will carry on much as it did before the change of control of ownership of that business.
In an asset sale, there will be considerably more work required post completion by the buyer, who will need to attend to the transfer of the relevant contracts, notification of customers and suppliers of the new owner, the transfer of any employees into the relevant company (which will occur under the Transfer of Undertakings (Protection of Employment) Regulations 2006 (“TUPE”) at law), notification of HMRC in particular in relation to the registration for VAT, all of the headed paper, website and other related business aspects of the company will need to be reviewed and changed to provide for the new owners.
In addition notification will be required to customers and employees where relevant, and generally making announcements about the sale – these should be agreed before they are made between the parties as the sale documents often include restrictions on announcements.
The seller/buyer should diarise the various and carry out post completion requirements including claims periods, preparation and agreement to completion accounts and deferred payment/adjustment payment dates.
This note does not seek to address any of the tax or commercial implications of the sale of the business. It is important that you fully understand those issues before you embark on the proposed sale as there can be considerable tax and professional costs involved in relation to the proposed sale. In particular, it should be noted that if a proposed buyer acquires the entire issued share capital of the company, the buyer will be required to pay stamp duty in relation to the considerable payable for the sale of the shares at the rate of 0.5% of the total consideration. This will extend to the total consideration even if the consideration is not known at that date as a result of some form of earn out or similar provision whereby the price is determined by the future profitability of the company.
This briefing note is not intended to be a comprehensive guide and does not cover every aspect of the topic and is not intended to provide legal or other advice.
Chattertons Legal Services Limited
Dated May 2022