In our first guide on agreeing terms, we discussed the process of initially engaging with a potential buyer of your business and the key issues to consider when agreeing the commercial terms of your deal.
In this guide, we talk you through what happens after you’ve signed the letter of intent – the steps and issues you are likely to face on the path to completing the sale of your business.
Like the first guide, this guide focusses on an asset sale process and is written from a seller’s point of view.
giving them a look under the hood
Before any buyer acquires your business it will carry out a thorough due diligence review of the assets and business.
The purpose of due diligence is to allow the buyer to confirm what it has been told about the business, to identify any issue that could affect the value of the business, to test the validity of the business model, and to understand any problem in the business. If any issue is uncovered, the buyer can reflect that issue in the commercial terms (e.g. a price adjustment or additional warranty), or, in a worst case scenario, can walk away from the sale.
Buyers usually unleash a posse of specialist advisors to go through all aspects of the business with a fine tooth comb. These include accountants, lawyers, technical specialists, and sometimes other commercial or insurance specialists, each of whom will produce a report to the buyer summarising the results of their review. Because their role is to uncover any issue in the business, the advisors will ask a large number of questions, and seek further documents and information. While this process can be frustrating, the best way to approach due diligence is to be as helpful, responsive and open as possible.
If your prospective buyer is a competitor and you are concerned about releasing sensitive commercial information or highly confidential intellectual property, a stepped approach to due diligence may be best. A stepped approach involves initially providing high level information and providing more detail as the process progresses and the buyer becomes more committed to the acquisition.
The buyer will need to review agreements so that it understands the commitments it is taking on, but a review of legal risks and obligations can be carried out without necessarily seeing identifying customer/supplier information. Agreements can therefore be provided with key information blacked out (redacted). The information redacted is usually customer names and other identifying information, pricing information, and any other commercially sensitive terms.
Where there is hyper-sensitivity over some information or intellectual property, those documents may be held back altogether until after the sale and purchase agreement is signed. The held back information can then be provided for review once the sale and purchase agreement is otherwise unconditional. Under this approach, the buyer has the right to walk away if that information has adversely and materially affected its understanding of the business.
While you should consider carefully how best to present issues, don’t be scared to disclose any serious issues in your business. We think it is best to front-foot difficult matters as early in the process as possible. The later in the process issues are uncovered, the more likely they are to lead to a price reduction. While in an ideal world, you would have identified and fixed any concern before you start a sale process, the reality is that every business has issues and it is better for you to present those issues, with your take on them, than for the buyer to uncover them at the eleventh hour. At that point, you have lost the moral high ground and may appear to be trying to do a cover-up.
Also, as you move further through the process, your commitment to the sale will increase. Because you have dedicated so much time, energy and money, and the end is in sight, you become more susceptible to being ground down on price and other key terms – addressing issues up front may avoid this.
We have a template due diligence checklist listing the categories of information a buyer will want to review. It will make the process faster and easier if you already have this information prepared and organised.
The sale and purchase agreement (SPA) is normally negotiated at the same time as the due diligence review.
SPA negotiations can be hard work and adversarial, often because:
- the parties usually are not concerned about preserving an ongoing relationship (unlike an investment transaction)
- the negotiations are primarily about the allocation of risk between the buyer and the seller.
While it is easy to get emotionally committed to the sale (particularly if you’ve mentally started spending the money), it’s best not to commit emotionally or practically to the sale. Be prepared to walk away from the deal, so that you can do so if you reach a point where you really are not comfortable with the terms as a whole (although remember that being a grumpy but still willing seller is ok – you are unlikely to have all of the terms go your way).
As with any legal document, the party preparing the first draft generally has an advantage as the document will be more friendly to the drafting party. Generally in an auction or multi-bidder situation, the seller will prepare the first draft of the SPA but where there is only one buyer, the buyer will prepare it.
There are a number of provisions in the SPA that sellers will want to focus on.
If you have agreed to an earn-out, you are more likely to achieve your earn-out targets if the earn-out period is short and the targets are simple, clearly defined and relate to areas of the business where you are the person best placed to ensure those targets are met. These matters should be clearly set out in the SPA, together with a clear description of what you need on an operational level to achieve the targets. Ideally, the business would be ring-fenced, so that it continues to be operated in the same way as before the business was sold. But often that isn’t possible. Instead, the SPA should include restrictions on the buyer in respect of the business, e.g. restrictions on making redundancies, moving staff, relocating the business, and changing the nature of the products or services of the business. Also, the buyer may be required to provide agreed levels of support to the business. Of course, the details of these provisions will vary, depending on the nature of your business and your earn-out.
The SPA should also set out any specific accounting policy or treatment to be used in calculating the earn-out and any assumption to be used, e.g. the SPA may provide that any corporate overhead must be stripped out, any restructuring or rebranding cost is to be disregarded, and any internal sale is to be on arms’ length terms.
purchase price adjustments
It is common to have a purchase price adjustment based on the finances of the business as at the completion date. This adjustment involves a lot of technical detail concerning the accounts of the business and the determination of what is to be included and excluded from those accounts. Sellers should work closely with an experienced accountant to ensure these provisions operate correctly.
Warranties are promises that the seller makes about the affairs of the business. If any of these promises are incorrect, the buyer has a specified period (generally between 1 and 2 years) to bring a claim against the seller. For that reason, the warranties are very important and generally run for pages. The negotiation of the warranties can be amongst the most contentious points in the SPA.
Our example SPA mark-up shows some typical warranties requested by a buyer, and a seller’s response to those warranties. For a tech company, key warranties to focus on are the information warranty (and whether forecasts should be warranted) and the intellectual property warranties.
If the buyer discovers that a warranty is untrue in the period following completion, it may be able to bring a claim for breach of warranty. Your best defence against this type of claim is disclosure. The buyer will not be able to bring a claim for breach of warranty if it has been told, in a disclosure letter or disclosure schedule, that a warranty was untrue or incorrect and was provided with full details (and relevant documents) as to why the warranty is not correct. You will need to go through a very careful process of considering each SPA warranty and setting out in the disclosure letter or disclosure schedule any matter which make a warranty untrue or incorrect.
Disclosure can appear to be another boring and repetitious process, but it is hugely important for a seller. Because it is your best defence against potential claims from the buyer, you should ensure that it is carried out thoroughly and with input from directors, senior management, and any other key personnel.
limits on claims
If a successful claim is made under a warranty, the seller may be required to repay part, or even worse, all of the purchase price. As protection against claims brought by the buyer, a seller can include in the SPA limits on the buyer’s ability to bring claims.
The SPA should provide that warranty claims must be brought within a stated period after completion. This will generally be between 12 and 24 months, and is often calculated by reference to the provision of the first set of annual financial statements after completion. The theory is that, if an issue that might lead to a claim is not unearthed during the process of preparing the financial statements, it is unlikely to arise.
The SPA should also provide for a financial limit on the amount a buyer can claim from a seller for breach of warranty. This limit can range from 100% of the purchase price down to a lower percentage (although certain warranties will often fall outside the cap, e.g. relating to title to the assets, solvency, and due execution). In some cases, e.g. the sale of a distressed business or where the seller is a financial investor, the seller will accept no liability for warranty breaches.
There is no science to this area of risk allocation – the liability cap is very much a matter for negotiation between the parties. The relative strength of the parties, and general m&a market conditions, all come into play.
While the best risk mitigation strategy is disclosure, there are a range of other claim limitation provisions which assist the seller limit its risk in the sale process. See our example SPA mark-up for examples of these provisions.
who is responsible for claims?
Who will be liable if the buyer wants to bring a claim under a warranty? A buyer will not want to negotiate extensive and well considered warranties if there is no-one of any substance to bring a claim against if those warranties are incorrect. You, and your fellow shareholders, will need to find a way to stand behind the warranties and other commitments you are making in the SPA.
If the transaction is structured as an asset sale, the seller will most likely be a company. A buyer will be concerned that the selling company will distribute the purchase price to the shareholders and be left as a shell with no financial resources to meet any claim, or be wound up (and so disappear for the purposes of bringing a claim). This concern is often addressed by:
- hold-back – where some of the purchase price is held back (in escrow or as a retention – usually in a solicitor’s trust account) for a set period. If there is any claim under the SPA, the buyer can use the funds in that escrow account to meet the claim. At the end of the claims period, the funds held in escrow, plus interest, are released to the seller (less any amount required to meet a claim). While a hold-back is not ideal, the amount held back is usually a portion of the purchase price (generally less than 30%), and can be a useful mechanism where the seller has multiple shareholders. Because there is a pot of gold to meet any claim, the burden of meeting any potential claim will not fall to one key shareholder (unless, of course, the claim exceeds the hold-back). If you have agreed to an earn-out, that will, in practice, provide the pot of gold to meet any claim and there should be no need to agree both a hold back and an earn-out
- earn out payment. If an earn-out has been agreed, a buyer will usually seek the right to deduct from any earn-out payment an amount equal to any claim made against the seller. Even if this right is not specifically agreed, in practice, a buyer will withhold payment of any earn-out payment if it has brought a claim against the seller. So, in effect, the earn-out will also operate like a hold-back for these purposes
- shareholder guarantees or undertakings. The buyer may also seek guarantees from the shareholders of the seller or require those shareholders to personally give the warranties and other important undertakings in the SPA. The question then becomes whether each shareholder should be jointly and severally liable for any claim, or whether any liability should be several, not joint. Under joint liability each shareholder is individually liable to the buyer for 100% of any claim. If the liability is several, each shareholder pays only for that shareholder’s relative proportion of the claim. As a shareholder of the seller, you should avoid joint liability if possible, because the buyer will pursue the shareholder with the deepest pockets. Buyers will often accept several liability in proportion to the shareholdings in the selling company. Where a buyer is not prepared to accept that position, you could enter into a behind the scenes agreement with the other shareholders of the selling company, setting out the proportionate liability of each shareholder to meet claims. These types of agreement aren’t ideal because it normally means one or two selling shareholders are likely to bear the brunt of any claim and must try to enforce the agreement against the other shareholders. Where these solutions won’t work, a hold back, set-off against an earn-out, or warranty insurance may be better options. Also bear in mind that this area can be trickier where there are financial investors seeking a clean exit. Traditionally, VC and private equity investors refuse to be responsible for claims in any way. If that is the case, warranty insurance can be a useful way forward.
material adverse change clause
Once the SPA is signed, there is often a gap until completion, to allow for satisfaction of the conditions. In this period, buyers often want to cancel the deal if something happens that adversely affects the business. This is known as a material adverse change (MAC) clause. As a seller, you will want to avoid including such a clause or, if that cannot be done, limit its scope so the buyer remains as legally committed as possible to the sale.
As a minimum, you should seek to limit the MAC clause to an issue directly related to the business (broadly drafted MAC clauses can include a change to the world economy or a change in the market in which the business operates).
MAC clauses are risky but, ultimately, where that risk falls very much depends on the commercial dynamics between the parties and their relative negotiating strengths. It also depends on how long the gap is between signing the SPA and completion – a MAC clause is not such a big risk if the deal is not conditional on obtaining regulatory approvals (which can take many weeks or months to come through).
A non-compete can impact the value of the deal for you. If you or your fellow shareholders need to work or continue to operate a business after completion, you need to ensure that you can continue to do that or that the sale price compensates you sufficiently for not being able to continue to operate a business.
Agreeing that a non-compete should be included is easy, agreeing the detail of that non-compete, less so, particularly if the seller’s shareholders need to continue to work or operate a business after completion. Also, non-competes can cause some divisions between shareholders (e.g. founder shareholders working in the business will want to limit the non-compete whereas financial investors will not be so concerned).
Non-competes have 4 parameters:
- geographic area – the territory in which the seller (and other persons the subject of the non-compete, e.g. founders) can’t compete. This should describe the territories in which the business is currently conducted
- period – the time during which the seller can’t compete – generally in NZ this will be 2 or 3 years – anything longer may be difficult to enforce
- capacity – the capacity in which the seller can’t compete. These are usually drafted very broadly and can on occasion spread beyond the seller to entities owned or controlled by a spouse or other family member of the seller
- activity – a description of the business with which the seller can’t compete.
Tweaking one or more of the above parameters can help the parties reach common ground when it comes to the non-compete. E.g. a software development business operating in the banking sector shouldn’t care if a founding shareholder of the seller develops software in the education sector.
going all the way
Once due diligence has been completed and the terms of the SPA have been agreed, the SPA will be signed. At this point you are obliged to sell and your buyer is obliged to buy the business, unless something unexpected happens that gives a specific right to terminate.
You need to ensure that, before the SPA is signed, you have obtained all necessary approvals to enter into the SPA, or that the agreement is conditional on obtaining those approvals. In the case of an asset sale, this will require a major transaction approval by special resolution of the shareholders of the selling company under s 129 of the Companies Act 1993. Obtaining these shareholder approvals can be a hassle – it can take time and in the worst case scenario, if you have problems getting the approvals, it can derail a transaction. So make sure you keep shareholders informed of progress.
preparing for the big day
Although everyone breathes a big sigh of relief when they finally get signing day, this is not the end of the hard work. Between signing and completing the sale, a lot of time and effort goes in to satisfying the conditions and to ensuring the business can be transferred smoothly on completion. There is quite a lot of detail to work through, and the parties should get onto this immediately after the SPA is signed.
Common conditions which need to be satisfied after signing include approvals to the transfer of the business from key customers, suppliers, the landlord and, sometimes, regulators (e.g. from the Commerce Commission or Overseas Investment Office). The business cannot be sold until these conditions have been satisfied. Depending on the types of conditions, the time it may take to satisfy these can vary from a couple of weeks to 2 months or more.
In this period, if the transaction is structured as the sale of assets and the employees are to be offered employment with the buyer, employees will be advised of the transaction and that their employment with the seller will terminate on completion. At the same time they will be offered employment with the buyer, with effect from completion. In New Zealand, there is no compulsory transfer, by law, of employees to a business purchaser so the arrangements in respect of employees must be set out in the SPA. From your perspective, the best position is for the buyer to offer employment to all employees otherwise you are left with having to terminate the employment of the employees who do not transfer. Bear in mind that employee costs (e.g. accrued leave balances) will usually be deducted from the purchase price as a purchase price adjustment, and that if an employee does not accept the buyer’s offer of employment, the seller retains the liability to make these payments to those employees.
and you’ve made it
Completion (or closing) is the point when ownership of the assets transfers to the buyer. At completion, each party signs the (often many) legal documents required to transfer ownership (e.g. IP and lease assignments), the assets of the business are delivered to the buyer, and the purchase price (subject to any hold-back, earn-out, etc.) is paid to the seller.
At that point the business is sold.
Now you can buy the Ferrari. Or the Vespa.