This guide to buying or selling has been prepared to give an inexperienced seller or buyer a brief overview of the various stages of buying or selling a UK company.
The Beginning
The first stage that the parties to such a deal will usually go through simply involves the early negotiating for the most basic terms of the deal. Sometimes the parties will negotiate direct with each other; sometimes they will go through an agent or broker. It is unlikely that lawyers will be involved at this stage.
Once the parties have come to a basic agreement, they sometimes wish to set this out in writing by using “Heads of Terms”, sometimes also known as a “Memorandum of Understanding” or “Letter of Intent”.
Other Considerations
When purchasing shares in a company the buyer indirectly inherits all the assets and liabilities of the company. From a legal point of view, in addition to the commercial aspects, there are also considerations as to the employees and the property.
The employees will remain with the company under their existing terms and conditions. It is therefore important to know what these are and also to find out whether there are any potential problems with the employees, for example, onerous terms and conditions. Employment law is rapidly changing and the buyer will need to ensure that the seller is compliant.
Another factor that needs some consideration is the premises from which the seller trades. The buyer will need to consider and plan for the future and will need to know whether the company requires the premises. The seller will either own the freehold of the premises or have a lease of the premises. If the premises are occupied under a lease then the buyer will need to look into the lease to see the length of the remainder of the term and also the liabilities under the lease. As in normal situations when buying a property, enquiries and searches will need to be carried out.
There are many ancillary issues the lawyers will be aware of and they will be able to guide each party through the process.
Heads of Terms
Heads of Terms is a document which sets out the basic terms that the parties have agreed. It will detail the shares being purchased, how much is being paid for them and any other terms that are known at this stage, such as whether there will be deferred payments, whether the seller might continue to work in the company as a consultant or employee, whether the price is dependant on the asset value or performance of the company.
The Heads of Terms is usually stated not to be legally binding, with the exception of clauses relating to confidentiality and any “lock-out” provisions. Lock-out provisions are usually intended to stop the seller negotiating with any other prospective buyers for a fixed period, and to allow the buyer to carry out all the necessary investigations into the business. The advantage of Heads of Terms is that they help to clarify exactly what the parties understand the basis of the deal to be. They can also speed matters up when lawyers are instructed, as the lawyers will have a broad overview of what the parties are trying to achieve. Indeed, sometimes the lawyers will help to draft the Heads of Terms. In addition, Heads of Terms can be used to prevent the seller negotiating with any other prospective buyer, by the use of a lock-out clause as described above.
The disadvantage of Heads of Terms is that sometimes agreeing the Heads of Terms can itself take some time and, therefore, delay matters.
Heads of Terms can be useful if there is any later dispute when drafting the Share Sale Contract, as the parties can refer back to the Heads of Terms to show what everybody thought was agreed. However, sometimes this can be a disadvantage, as Heads of Terms might be ambiguous or unclear, or silent on certain points. It is therefore important to ensure that the Heads of Terms are properly prepared. It is common to put a provision in the Heads of Terms that the Share Sale Contract will incorporate the terms provided for in the Heads of Terms together with any other matters agreed between the parties.
Non-Disclosure Agreement
Once the Heads of Terms (if used) have been agreed, the next stage (or the first stage if Heads of Terms are not used) is for the seller to obtain a non-disclosure agreement or confidentiality undertaking from the buyer. Once that has been obtained the next stage is Due Diligence. Sometimes if the seller and buyer want to discuss matters, but do not know what the terms of the deal should be, they enter into a Non-Disclosure Agreement and then Heads of Terms.
Due Diligence
Due Diligence is the name given to the process by which the purchaser of a company discovers all the information he would like to know about the company he is buying.
Very often a purchaser will have done his basic Due Diligence and obtained various copies of accounts, contracts, marketing materials and other documents before instructing his lawyers. However, one of the first things that the purchaser’s lawyers will do is to prepare a detailed list of questions about the accounts, assets, affairs, financial and tax position of the company. This questionnaire is forwarded to the seller’s lawyers, who will often answer the more technical questions themselves, but the majority of the questions would be answered by the seller, usually with the assistance of his or the company’s accountant.
Very often, a buyer’s Due Diligence questionnaire will contain questions that the seller might think, on the face of it, to be irrelevant. However, the buyers and sellers need to remember that a lawyer is looking for detailed technical points that a layperson cannot be expected to appreciate might have a significant effect on the company, its assets or business.
The Due Diligence process is a constantly evolving one, and does not end with the sending of the first questionnaire and the receipt of the answers to it. Very often, the Due Diligence answers will raise more questions of their own. The answers themselves will usually be accompanied by large volumes of documents.
It is very important that the parties and their lawyers keep a careful record of the Due Diligence answers and documents received, as they will usually be referred to in the Disclosure Letter (see below).
The Due Diligence process referred to here is that carried out by the buyer into the affairs of the company. However, it is also wise for the seller to carry out his own Due Diligence.
Seller Due Diligence
It is important for a seller to know the exact affairs of the company he is selling and whether there are any problems associated with it that might return to haunt him later. The Share Sale Contract will contain seller warranties regarding the affairs of the company, against which the seller can be sued if the warranties prove to be wrong. Therefore, the seller will want to be sure that he is not warranting anything that is not correct.
This means that the seller should carry out his own Due Diligence process. Very often, the easiest way to do this is to use the buyer’s Due Diligence questionnaire as a guide. However, when the seller’s Due Diligence is carried out, the seller must do his best to ensure that he knows of any problems with the company or its business which might come to light after the sale. The seller must remember that the completion of the sale is not likely to be the end of his involvement with the matter.
Equally, if there is any deferred consideration, the seller should look into the financial standing of the buyer and may even want to consider requesting security for the consideration.
When the Due Diligence is completed, or more commonly while it is still going on, the buyer’s lawyer will prepare the first draft of the Share Sale Contract (the “Contract”).
The Contract
The buyer’s lawyer will usually prepare the first draft of the Contract. This will be forwarded to the seller’s lawyers as quickly as possible for review. It is extremely unlikely that the first draft will be the final draft. Indeed, it is entirely normal for a Contract to go through several drafts before a final version is agreed. The reason for this is that the first version of the draft Contract often raises new issues even where the parties have entered into Heads of Terms. The parties will wish to put in detailed provisions regarding how and when the price is to be paid, the warranties the seller is to give (see below), how the sellers liability is to be limited (see below) and possibly non-competition provisions preventing the seller from competing in the future with the company he is selling.
The basic structure of the Contract will be:
1. Definitions of words and phrases used in the Contract.
2. A summary of the shares being bought (generally these will just be the shares in one company).
3. The purchase price and how and when it is to be paid, together with any provision for variation of the price depending on, for example, the value of the assets of the company or its performance after completion.
4. The process for completion of the transaction.
5. Any non competition covenants.
6. The limitation of the seller’s liability.
7. Warranties.
8. Legal boilerplate clauses.
It is not unusual for the Contract to take several weeks from first to final draft.
The Warranties
The Warranties are usually contained in a schedule annexed to the Contract. The warranties are a detailed list of statements by the seller regarding the state of the company and its affairs. They will include warranties relating to the seller’s legal ownership of the shares and his right to sell them, the accounting and tax affairs of the company, employment terms of the company’s employees, that there are no disputes or litigation involving the company, no problems with the company’s trading, details of all land and property owned or used by the company, and the accuracy of details of intellectual property (such as copyrights, computer software, trademarks etc) used by the company, etc.
The Warranties form the basis upon which the buyer has recourse against the seller if anything goes wrong in the future. The buyer will therefore want the Warranties to be as comprehensive and detailed as possible. The seller will wish to give as few warranty promises as he can. This means that the first draft of the Contract will contain very strong and lengthy warranties. The seller can seek to reduce his exposure in several ways:
1. Amend the Warranty to something that is more acceptable.
2. Limit the scope of the Warranty by a Disclosure (see below).
3. Delete the Warranties altogether.
The negotiating of the final form of the Warranties is perhaps the most lengthy part of the contract negotiation process.
Although there are some standard Warranties, the precise form and details of the Warranties will depend largely on the result of the Due Diligence process. As the Due Diligence process is likely to be ongoing while the contract negotiating process is running, it is likely that a buyer would seek to introduce completely new Warranties at any time during the negotiating process, as information becomes available. In addition to Warranties, a buyer might seek indemnities in respect of specific matters. An Indemnity is stronger than a Warranty, in that a Warranty is a general statement by the seller that there is no particular problem, so it is therefore up to the buyer to find a problem. An Indemnity is used where the buyer has actually identified a specific or likely problem, and is seeking a promise from the seller to make good any loss arising out of that particular problem.
Alongside the Contract, there is a further document called a Disclosure Letter, which seeks to limit the scope of the Warranties.
The Disclosure Letter
The Disclosure Letter is a document usually signed by the seller (but less commonly by the seller’s lawyer) in which the seller sets out matters of which he is aware that are at odds with the Warranties. For example, if there is a Warranty that the company is involved in no litigation but, in fact, the seller knows that the company has a pending lawsuit, the Disclosure Letter will contain a provision referring to that lawsuit.
The point of the Disclosure Letter is to bring to the buyer’s attention before completion of the sale any potential problems. The buyer would then lose the right to sue the seller if any losses occurred as a result of those “disclosed” problems. The Disclosure Letter is therefore an extremely important document for the seller, because it gives the seller the opportunity to exclude or limit his liability in relation to problems that he knows exist.
From the buyer’s point of view, the Disclosure Letter is also an important document, as it causes the seller to bring the buyer’s attention to problems before he is committed to buying the company. The buyer might choose to accept a disclosure and take the risk accordingly, or he might seek an Indemnity (see above) in respect of the specific problems disclosed, as specific indemnities would not be limited by the Disclosure Letter. If a problem is serious enough, a buyer might seek to renegotiate the price or even to pull out of the deal completely.
The seller will, therefore, sometimes wish not to disclose a problem that he knows is there, (as he would not want the buyer to use this as a negotiating tool in seeking a lower price), and the seller might be willing to take the risk that the buyer would not find out about this problem after completion.
The Disclosure Letter, therefore, is one of the principal reasons for the seller Due Diligence (see above).
The seller has means other than the Disclosure Letter for limiting his liability.
Limitation of the Seller’s Liability
The Contract will contain clauses limiting the seller’s liability to the buyer if things go wrong. Claims against the seller by the buyer will usually be limited in time. In respect of most claims the time limit is likely to be sufficient to allow the company at least a complete financial year after completion. However, the usual time limit is between one and two years. This is generally long enough for the buyer to find any potential problems – indeed it is likely that the buyer will find any skeletons in the cupboard within the first few months after completion.
Tax matters are usually limited to six to seven years because the tax authorities have the right to make a claim against the company for six years after the end of the relevant financial year.
In relation to tax, sellers should be aware that a contract will usually contain a tax covenant, the effect of which is that the buyer will be responsible for tax of the company after completion, and the seller will be responsible for the tax of the company before completion notwithstanding that completion may be part way through a tax year or there may be unpaid tax.
The seller’s liability will also usually be limited in terms of the financial value. It is normal for the buyer to be able to sue the seller for the return of the purchase money only, or sometimes just a percentage of the purchase money.
The Disclosure Letter, as referred to above, is a very effective and important tool in limiting the seller’s liability.
The seller must be aware that the limitations in liability will not apply in full to claims in respect of tax (indeed, there may be no limitation whatever in respect of tax claims) and they will often only be of limited scope in relation to Indemnities (as opposed to Warranties).
Once the Contract is agreed, the matter can proceed to completion.
Completion
The completion of the sale of the shares usually takes place at the offices of the seller’s lawyers, usually immediately after signing the Contract. However, sometimes the Contract provides for a delayed completion to take place after a gap period, e.g. where the Contract is conditional upon certain matters taking place before completion can take place. All sellers and buyers, their lawyers, and sometimes their accountants as well, will attend the completion meeting at which any final few items remaining to be agreed will be finalised, final drafts of the documents prepared and the parties will then sign all the Contract and ancillary documents.
At the completion meeting, officers of the company being sold will usually resign and new ones will be appointed, board meetings will be held to deal with the various company affairs arising out of completion, and sometimes shareholders’ meetings will be required also, as it is common for the constitution documents (the Memorandum and Articles) of the company to require changing as part of the deal process.
All of the company’s records and documents will be handed over at completion, and the money will paid, usually by telegraphic transfer between the respective parties’ lawyers.
It is not uncommon for completion meetings to last long into the night!
Conclusion
This guide is intended to give an overview of the process for the purchase of shares in a company and common issues that a buyer or seller may have not come across before. It can be a protracted and stressful (not to mention expensive!) process to buy or sell a company but a buyer or seller can make life very much easier for himself and his professional advisers by ensuring that he has his own house in order at an early stage, that he knows where all relevant documents are and that he is as aware as he can be of any issues that might arise during a negotiation leading up to completion.
Further information
If you require any further information or assistance, please contact Debbie Turner or Paul Morgan of Morgan Russell on 01372 461411.
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