Whether a firm is looking to expand its existing operations, find a struggling business to turn around or stepping into the corporate world for the first time, acquiring a company is one of the most common and effective ways to launch and/or grow any business. The process does, however, carry an element of risk and first-time buyers, in common with more experienced purchasers, should be careful to keep a number of considerations in mind.
Here then, are the top 10 issues that could trip up would-be buyers.
1. Assets or shares?
While we’re assuming the acquisition of 100% of a company’s share capital, the alternative, an asset purchase, should always be considered.
While a share purchase may be the simplest route from a commercial standpoint it does mean that the business will be acquired “warts and all”. If the target is a company with a lengthy trading history and/or is susceptible to hidden liabilities, an asset purchase allows the ability to cherry-pick the best assets and leave behind the liabilities. This can be highly attractive even if the legal practicalities of transferring each individual asset can be quite cumbersome. In addition, both acquisition structures carry potential tax implications and getting the right advice will be key.
2. The “A Team” of advisers
It is never too soon to get specialist advisers involved. They can guide buyers on the first approach to the target company and flag up showstopping pitfalls before too much time and money has been spent.
Good legal and financial advice throughout the transaction will pay dividends. A missed liability or overoptimistic financials could be far costlier than any adviser’s fees.
Before incurring substantial due diligence costs, buyers should make sure they have legally enforceable rights of exclusivity. These should lock out other bidders during negotiations (and ideally for a time period afterwards if the deal collapses).
Depending on respective bargaining power, it may even be possible to obtain an indemnity from the seller to cover the costs in the event the seller pulls out without valid reason. This will keep the seller focused on the transaction as they are certainly more likely to be committed to the deal if there is a risk of losing money.
4. Due diligence – the devil is in the detail
It will be vital to know what is being bought.
Properly executed due diligence should give a full picture of how the company is performing now and how it is likely to perform in the future. Legal due diligence can uncover issues regarding employment matters, intellectual property rights and compliance with relevant legislation. Financial due diligence will focus on the quality of historical earnings and maintainable profits, future prospects of the business and balance sheet black holes. The buyer should obviously have also carried out its own commercial due diligence.
The results of any due diligence gives the purchaser the opportunity to renegotiate the purchase price and demand warranties to cover any potential liabilities.
5. The warranties
Having completed the due diligence and discovered what there is in the company (and more importantly what is not there), a good set of warranties will be needed to protect the buyer in respect of the risks and liabilities being purchased.
In valuing the company the buyer will have made some key assumptions (for example, that the company is not subject to any litigation and that the accounts have been properly prepared) and it is vital that they are protected in the event that these are not true. By the buyer’s insistance on a comprehensive set of warranties the seller will be motivated to disclose all possible problems.
Only by giving a certain level of disclosure can a seller protect itself from a warranty claim. Without negotiating a set of warranties the buyer risks forming an incomplete and inaccurate view of the company. It also denies itself the right of recourse to the seller in the event of an undisclosed liability.
6. The warrantors
Where there is a single seller, there is usually just one single warrantor. If there are several shareholders all selling their interests in the company, agreeing the identity of the warrantors can be more difficult.
Where shareholders have been one step removed from the day-to-day management of the company (such as institutional investors), they will be reluctant to give any warranties on matters in which they have not been actively involved. In such circumstances, where they do give such warranties, it is likely that they would seek to limit their liability to their actual knowledge on an individual (rather than a joint and several) basis.
Purchasers would be strongly advised to resist liability for warranties on an individual basis and ensure liability is given on a joint and several basis. This means that it will be possible to pursue any one or more of the warrantors for the whole liability in the event of a breach. It is then up to the shareholders to determine how they contribute to and share any such liability.
7. Holding back the money
It is important to remember that, regardless of the level of protection procured through due diligence and warranties, protection is only as good as the seller’s creditworthiness or financial position. If the seller does not have the money to pay out on a claim, the buyer will be left carrying the can.
Those buying from a large corporate structure, may want to ask for a parent company guarantee to back up the warranties. For all transactions some part of the purchase price should be held back. If it is intended that any of the sellers are remaining with the business after completion, discuss the possibility of an earn-out structure or deferred consideration whereby part of the purchase price is paid upfront and the remainder held back until certain conditions have been satisfied. Similarly, the parties could agree to ring-fence part of the price. This is then held in an escrow or retention account for an agreed period of time during which the buyer has the benefit of a secured pool of money to which it can have recourse in the event that any issues are discovered after completion.
8. How much to pay?
No issue will be more commercially and emotionally charged than the purchase price. There is no hard-and fast rule on the best way to value a company and the method chosen will have as much to do with future plans as it does with the current status of the company. Multipliers of gross sales or after-tax profits, book value, return on investment and capitalised earnings can each form a good basis for valuing a company, but ultimately the key drivers may be as simple as how badly the seller wants to sell and how determined the buyer is to buy.
9. Protecting the value of the Company
Even before conducting due diligence on the company, it is likely that the buyer will have a good idea as to where the value of the company ultimately lies.
Every company will have its key assets and any sensible buyer will work hard to ensure that the acquisition has as little impact on those assets as possible. It may be that the company’s business is focused on a small number of vital customers. Legal due diligence should uncover whether there are any change of control clauses in the relevant contracts which could trigger termination rights for the customers on completion of the transaction. Even if no termination rights are triggered, ensuring customers are fully informed and happy with the new ownership could pay dividends in the future.
Perhaps even more important than the customers is the quality of the management team. Legal due diligence should reveal whether there are any potential change of control or golden parachute provisions in the employment contracts. Consideration should also be given to whether the management/ workforce are to be incentivised as part of the transaction to safeguard the value of the company going forward. If the sellers play an important role in the day-to-day running of the business (and will be exiting as part of the sale), make sure sufficient handover arrangements have been put in place prior to completion to ensure a smooth transition and minimise the loss of knowledge and impact on the value of the company.
10. Where’s the money coming from?
It is rare to find a purchaser who can comfortably finance an acquisition out of its own resources.
Careful thought will need to be given as to where the funds are coming from. A purchaser may need to approach its bank for an extension of overdraft facilities or to secure a long-term loan – a far harder task in these difficult economic times.
Alternatively, an investment partner may offer up the additional cash, but regardless of whether this is another individual or a venture capitalist/ institutional outfit, it is likely that such a partner will be pursuing its own agenda and want sufficient control and protections over management decisions and cash flows.
Institutional investors will be particularly concerned about their exit route as this is how they recoup their investment. Be sure the buyer understands any investment partners’ expectations and be aware that such funding gives rise to a new round of negotiations and legal documentation quite separate from the intended acquisition.
With funding still hard to source and all parties taking a far more cautious approach to any potential deal, it has never been more important to ensure that buyers have a basic level of protection when looking to buy a company. By surrounding themselves with good advisers, establishing exclusivity and putting in the ground work early on they will ensure that they are well placed to secure the best deal going and avoid potential pitfalls further down the line during negotiations and/or after completion.
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