Buying a business can be a much faster, easier and less hazardous process than opting to start one up from scratch. Before committing to a buy, it’s crucial that you consider whether taking ownership of the company will satisfy your needs – financially, professionally and personally. In this article, Keystone’s Corporate M&A expert, Andrew Stilton shares his top tips for prospective business buyers.
1. Consider buying assets only
There are two basic structures for buying and selling and business: a sale and purchase of some or all of the assets (subject to some or all of the liabilities) of that business or, if the business is being carried on by a company, a sale and purchase of the shares in that company.
On a sale of the assets of a business, the seller will sell some or all of the assets, and the ownership of each of them will be transferred from the seller to the buyer. On the sale and purchase of the shares in a company, on the other hand, the assets and liabilities of the business will continue to belong to the company and its existing contractual relationships will be unaffected.
Sellers will normally want to sell shares because of the availability of entrepreneur relief or (for corporate sellers) the substantial shareholding exemption. However, if you are a buyer, the beauty of buying the assets, if the seller will agree, is that it enables you to leave behind liabilities which you do not want to take on. This is particularly important where there are known claims against the business or the business is such that claims are very likely to arise.
2. Agree good heads of terms
When the parties have agreed a deal in principle, they would be well advised to set them down in writing by way of “heads of terms”, which record the principal terms which they have agreed.
Those heads of terms should clearly be marked “subject to contract”, in order to make it clear that they do not amount to a legally binding commitment (but be careful when agreeing heads of terms overseas, as that hallowed phrase may not always be enough).
Although the heads of terms will not be legally binding, they help to avoid the (surprisingly common) situation where the parties shake hands on a deal and then spend the next few weeks and months (and thousands of pounds’ worth of professional time) disagreeing over what they are supposed to have agreed.
If (as is almost invariably the case) the decision to proceed is subject to due diligence, as the buyer, you should make that clear in the heads of terms. Similarly you may want to reserve the ability to revise the price (for example, if you cannot be satisfied that key customers will continue to be loyal to the business or with the value of the stock. Human nature is such that, if there are key issues of that nature, the seller will be reluctant to countenance a price renegotiation if they were not specifically “flagged up” in the heads of terms.
3. Obtain exclusivity
As you are likely to incur a significant amount of expense in progressing an acquisition, as a buyer, you should insist upon the seller giving you a reasonable period of exclusivity, in order to give you time to do your due diligence and complete the legal process.
A “lock out” agreement of that nature will, generally, be enforceable in the UK, but an agreement to negotiate (a “lock in” agreement) will not normally be enforceable.
However, be aware that if you are buying a business outside of the UK, the laws of some countries imply an obligation to negotiate in good faith which can be legally enforceable.
4. Do your due diligence and get the scope right
Carry out an appropriate level of due diligence before you complete the transaction, rather than completing in reliance upon warranties and indemnities from the seller (see below).
That way, if you find out (for example) that a major customer account has been lost or there is a significant concern over the recovery of debtors, you still have the ability to reflect your concerns in the price or, ultimately, to walk away from the deal.
Due diligence will normally be financial (looking at matters such as accounting policies and methodologies, trading results, assets and liabilities, management organisation and financial systems) and legal (covering matters such as the ownership of the business, its contracts, any claims or potential claims against it, its employees, any pension arrangements, its property and intellectual property rights and its tax position).
In some transactions, there may be other specialist due diligence which need to be carried out, such as technical, environmental, pensions and “market” due diligence.
Whatever due diligence is to be carried out, make sure that the scope of the work to be carried out is clearly agreed with each of the advisers concerned and that they speak to each other where necessary: there is no point in having an environmental report which recommends environmental warranties or indemnities in the sale and purchase unless that advice is communicated to the lawyers who are dealing with the legals.
5. Beware the perils of formulae
Wherever possible, it is preferable to satisfy yourself that the price that you have agreed to pay is the right one before you complete the transaction, rather than rely on a price-fixing formula which has to be implemented afterwards.
If that is not possible and it is necessary to have completion accounts in order to finalise the price, make sure that the sale and purchase agreement is as specific as possible about the accounting policies to be used, in order to reduce the risk of two sets of accountants arguing endlessly about what the price should be.
If part of the price is determined by reference to future performance (an earn-out) and the seller is being left to run the business after completion, make sure that you have appropriate protections to prevent the seller from artificially increasing the amount of the earn-out payment.
(Note to sellers: if you are in this position, make sure that the buyer is similarly prevented from taking steps to keep the earn-out profits artificially low.)
6. Beware warranties which are limited to matters known to the seller
If you’re buying a business, you will almost inevitably have relied upon information provided to you by or on behalf of the seller and on various assumptions in reaching your decision to go ahead and in agreeing the purchase price.
You are generally entitled, therefore, to expect the sale and purchase agreement to contain extensive warranties in relation to the business which you are buying – its assets, liabilities, customers, contracts, employees, intellectual property rights, tax position and so on.
These warranties will invariably be the subject of considerable discussion and negotiation, with the seller endeavouring to limit them as far as possible and to matters of which the seller is aware.
You need to make sure that the warranties cover all the areas which you regard as key to your decision to proceed with the transfer, and you will need to beware any attempts by the seller to ensure that they will only be liable for matters of which they were aware.
While this may seem perfectly reasonable, in practice it can be extremely difficult to prove what the seller did or did not know. You should bear in mind that, if the seller is a company, the key individuals may have left the company by the time you bring a claim while, more drastically, if the seller is an individual, they may die and take their knowledge with them to the grave.
7. Beware your own knowledge
The general principle is that warranties are given “save as disclosed”, with the seller having the ability to disclose, in a “disclosure letter”, matters known to the seller and which, if not so disclosed, could give rise to a claim under the warranties.
The disclosure process does, therefore, have the advantage, from the point of view of the buyer, of forcing the seller to disclose, in advance of completion of the transaction, issues which may be material to you and which may impact on your willingness to proceed with the transaction or the price which you are prepared to pay.
If, for example, a material claim against the business does come to light as part of the disclosure process and you are still prepared to go ahead but on the basis that the seller will compensate you for any losses which arise as a result, you should insist upon the issue in question being the subject of a specific indemnity in your favour.
An indemnity is an agreement to compensate the buyer (on a pound-for-pound basis) for any losses which the buyer suffers, and is far better protection than a warranty.
This is particularly important because the courts have held in the past that if, as a buyer, you become aware (for example) of a material claim against the business but go ahead anyway and at the original price, you have not suffered any loss as a result of doing so and should not, therefore, be entitled to any damages for breach of warranty by the seller.
8. Beware last-minute disclosures
Be very wary of the seller who tries to come up with eleventh-hour disclosures. You should either refuse to accept them or, if need be, delay the deal for a day or so in order to consider their full impact.
This is particularly the case where the late disclosures are of a very general nature.
I was recently involved in some litigation where the sellers had, apparently, breached a warranty that they had not paid any dividends since the last year-end.
As usual, the warranties were given subject to anything disclosed in a disclosure letter, and the disclosure letter contained a general disclosure of the latest available management accounts, which were handed to my clients a day or so before completion.
The sellers argued that they were not in breach of warranty, as the dividends were reflected in the management accounts. It was true that, if you had taken a magnifying glass and peered closely at the numbers, you might have worked out that there had been a payment of some description to the sellers, but you could hardly call that a fair disclosure.
The problem is that the courts have held that there is no general legal requirement for disclosure to be fair; if the buyer wants to impose that requirement, they need to do so expressly. We had, in fact, done just that, but we still ended up in an argument as to exactly what was meant by “fair disclosure”.
Before completing, therefore, make sure that you have fully reviewed all of the disclosures and are satisfied that there are no material issues. Any material issues should be addressed by a specific indemnity or a reduction in the price.
9. Beware the man of straw
Remember that, as a buyer, while you may have succeeded in negotiating the best set of warranties and indemnities imaginable, they will be of no earthly use if you are unable to enforce them: you will never get blood out of the proverbial stone.
You may well find that the sellers have taken themselves and the sale proceeds offshore, have given the money away to their nearest and dearest, used it to repay their mortgage, or simply have blown it on a life of wine, women and song.
A corporate seller may have paid the sale proceeds to its shareholders by way of dividend, may have sold its remaining assets and then liquidated itself and returned all of its cash to the shareholders, may have used the sale proceeds to repay its borrowings or may have become insolvent after the sale.
Far better, therefore, to do as much due diligence as possible, insist that the sellers conduct a full disclosure exercise and, if any material issues come to light, address them upfront via the price you are paying, rather than rely on your ability to get money back after the event.
Even so, you will be concerned not just about what you might discover through due diligence but about the real skeletons in the cupboard, which (at the risk of mixing metaphors) may crawl out of the woodwork once you have paid the money and the business is yours. You will therefore still need appropriate warranty/indemnity protection. Make sure, however, that the seller is worth suing and, if in doubt, take whatever security you can for any claims which may arise.
This could take the form of a bank guarantee from the seller, a hold-back of part of the price in order to satisfy any claims, or a payment of part of the price into a solicitors’ escrow account so that it will be available in the event that any claims arise.
As a buyer, it is of course far more preferable to make sure that you retain the amount in question under your own control, as the old legal adage that possession is nine tenths of the law remains a very sound one.
10. Remember that people can walk …
If the business that you are buying is a “people business” and dependent upon know-how which resides in the heads of key members of staff or business relationships which are with the seller or key employees, remember that the individuals concerned may walk out of the door on day one, taking all that valuable knowledge and all those valuable contacts with them.
Getting them signed up to service agreements for an appropriate length of time may give some comfort, but the reality is that, if an individual wants to leave, they will do so and the law will not force anyone to work for an employer with whom they do not want to work.
You should include restrictions in the sale and purchase agreement on the seller competing with the business and poaching customers but these will only ever be enforceable if they are no more than what is reasonable to protect your interests; in any event, such restrictions will be much harder to enforce in the case of employees who are not themselves sellers.
As a buyer, therefore, you should take whatever steps you can to satisfy yourself as to the loyalty of key staff and key customers before you do the deal, and, once you have bought the business, you need to take prompt steps to secure that loyalty and make sure that the change of ownership is as smooth and seamless as possible.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.