Practical Law Australia Advisory Board Member, Rachel Launders, shares some insights into issues that commonly arise when negotiating and drafting share purchase agreements. These issues are worth considering when you are next working on a business purchase, asset purchase or share purchase as the principles apply for all these types of acquisitions.
Drafting a successful share purchase agreement
At its most basic, a share purchase agreement is the mechanism by which the parties agree to a transfer of shares. It needs to set out the key elements of the agreement (price, what shares are being sold, and when completion is to happen) and the mechanics for completion (who provides what documents, how money is to be paid, change of directors on completion and so on). That part of the agreement is usually straightforward.
The complexity arises from issues such as:
- warranties, which are the key protection for the buyer if the target company is not in the condition that has been represented;
- purchase price adjustments; and
- post-completion restraints on the seller’s activities.
- These issues will occupy much more of the negotiation and drafting time than the fundamental provisions about how many shares are being sold and at what price.
The information warranty may be the most important warranty
The negotiation on warranties often stems from issues that have been discovered in due diligence. However, it is very common for the buyer’s right to recover under the warranties to be limited where an issue has been fully disclosed in the disclosure material provided before signing the share purchase agreement. This means that the carefully worded warranty about an issue of concern may not lead to a right to recovery – the buyer is on notice so must take on that risk.
If there is an issue of concern that has been disclosed (for example, a specific piece of litigation against the business), it may be possible to negotiate a specific indemnity to cover any loss arising from that particular issue. In this case, the right to recover would not be limited by the disclosure that was made before completion. There may still be some limitations on the seller’s liability or a cap on their liability, but a specific indemnity gives the buyer some protection that a warranty qualified by the disclosure material will not offer.
Alternatively, the information warranty may be relied upon to give the buyer some protection. That warranty is essentially a warranty about the quality of information that has been disclosed and the process that was followed to collate the disclosure material. At its simplest, it is a warranty that the information provided to the buyer before signing is accurate and complete. If the buyer has been given enough information through due diligence to fully understand a problem with the business, they are effectively accepting that risk. But if it turns out that the problem is worse than anticipated, or different in nature to the problem described by the due diligence material, the buyer may be able to rely on the information warranty to recover their loss.
It is worth reviewing the information warranty and the exclusions to warranty claims when the due diligence process is almost complete, to seek to ensure that the buyer will be protected if issues arise that are not within anyone’s contemplation (but should have been known if the seller’s disclosure had been sufficiently thorough) or if known problems have unknown consequences.
Plan ahead for completion
Completion is typically more a paper war (still) than a legally complex part of the deal process. There can be a lot of documents that need to be provided at completion, particularly if the sale involves a large group of companies that are being sold. The banking and finance issues that need to be addressed at completion, such as releases of security interests and replacement of guarantees, and any other matters that require third party involvement, such as consents to a change of control, can complicate the completion day requirements.
If it is only discovered at completion that a completion deliverable has been overlooked, it may be too late to get additional documents prepared or signed or to have additional steps implemented. Being caught out at completion by not having everything you need is not just embarrassing. It could hold up completion, particularly if payments are being sent through the banking system (rather than an old fashioned bank cheque), as that puts a natural end to how late in the day completion can take place.
For this reason, a dry run – where the lawyers get together a day or two before completion to make sure that everything that needs to be provided is ready, in a suitable form and signed or able to be signed – is time well spent. If there are conditions precedent to completion, the dry run will prompt the parties to confirm that the evidence to be provided to show the conditions are satisfied is acceptable.
If a party does not have all of the documents that they will need to produce on completion, there is still time after the dry run for missing documents to be located (or prepared) and for signatures to be obtained. You need to check travel plans for key signatories in advance, to make sure they will be available if required after the dry run, or, if they will not be available, have in place an alternative way of signing documents, such as a power of attorney.
This is one aspect of the deal process where you cannot be over prepared. If your client likes to operate on a “just in time” basis, you need to be particularly strict about not leaving matters to the last minute. The dry run can provide a reason to require all steps to be completed a day or two in advance of the date of completion. Your client may not go out of their way to thank you if completion goes without a hitch. However, you can be sure your clients will not thank you if completion is delayed.
Working with accountants – a necessary evil
One of the complex issues in any share purchase agreement is adjustments to the purchase price. This is typically done so that the buyer has assurance that they are receiving a fixed level of working capital or a fixed value of assets of the business at completion, and the seller knows how much cash they can take out of the business before completion through dividend payments. The type of adjustment needed will depend on the period between signing and completion, and the type of business. As many businesses have seasonal cash flows and significant changes within a month, an adjustment is likely to be needed. The most simple form of adjustment can be expressed like this:
- If cash + current debtors – current creditors > target working capital amount, the buyer pays the difference to the seller.
- If cash + current debtors – current creditors < target working capital, the sellers refund the difference to the buyer.
It is rarely that simple. I worked on a transaction recently where the working capital calculation required four different calculations, one for each part of the business. This was necessary as each part of the business had quite different financial characteristics. I found it immensely helpful and interesting to work through the different businesses with the finance team and accounting advisers, to understand what needed to be counted (or discounted) to calculate the working capital for each part of the business. It made my role of capturing the principles much easier, having been a part of the conversations from the beginning of this issue being considered. This is often left to the accountants to work through but all parties will benefit from the lawyers being involved up front, rather than trying to make sense of the accountants’ workings when a dispute arises.
Depending on the likely size of the adjustment, the parties may want to make an estimate of the working capital adjustment amount shortly before completion. The estimate is factored into the amount paid by the buyer at completion and then adjusted afterwards, once actual balances at the completion date can be confirmed. Whether this is desirable will depend on factors such as:
- Does the buyer believe that the target working capital number is on the high side? If so, they may want to reduce the amount they have to pay at completion and avoid having to chase the seller for a refund after completion.
- Does the seller believe that the target number is low? If so, they will want to expedite getting part of the working capital adjustment in their favour on completion, rather than getting it some time after completion.
Having an understanding of the cash flow attributes of the business will help you advise on whether an estimate is necessary or desirable for your client.
What post-completion restraint is needed?
There are a number of considerations at play when you come to negotiate any post-completion restraints on the seller’s business activities. It is not essential for a buyer to get the benefit of a post-completion restraint – whether this is necessary or appropriate will depend on factors such as the nature of the business being sold, barriers to the seller re-entering that type of business (for example, if it requires substantial capital expenditure, it will be less likely the seller would seek to re-enter that business), and the seller’s other existing activities.
The starting point needs to be a consideration of what is really needed to protect the goodwill that the buyer is paying for as part of the purchase price. This is an enforceability question, as much as a commercial negotiation question. If the business being sold operates in Australia only, a worldwide restraint is unlikely to be enforceable. If the conduct that is restrained is far wider than the activities of the business, the restraint will also be vulnerable to challenge. An example of this: if the business being sold is an executive recruitment business, the non-compete could not also prevent the seller engaging in a manual labour hire business as those activities are too far removed from the business that the buyer is seeking to protect.
If you are acting for the seller, you need to consider what current activities might fall within the proposed restraint and what likely developments of the seller’s current activities could be constrained during the term of the restraint. Current activities should always be excluded – the buyer is on notice of the seller’s existing activities and that should have been factored into the sale price. It can be harder to exclude the seller’s possible future activities but it is worth pushing to exclude from the restraint natural and likely developments of activities that the seller is undertaking, particularly if the buyer is seeking a lengthy restraint period and the seller’s industry is dynamic.
If the business that is being sold has a number of different components to it, it may be appropriate to have different time periods for different parts of the restraint. I have used this effectively to allow protection of the key part of a business being sold for a longer period of time than the less important parts of the business.
The time period of the restraint also needs to be reasonable. If the business has few long-term relationships and all key employees will remain with the business, the seller may fairly insist on a shorter restraint period, as the seller will have no residual knowledge of the business’s activities within a short period of time and the buyer only needs a short period of time to put their mark on the business. Conversely, if the seller has been a key manager of the business and is not staying on as an employee, a longer restraint may be justified as that individual will have significant knowledge and expertise that can be used to set up a competing business. In that situation, the buyer needs longer to make the acquired business stand alone and the seller remains a “threat” to the business for longer.
Where a person associated with the seller is a key employee who will stay with the business, the terms of any post-employment restraint need to be checked and, if necessary, the employment terms should be renegotiated as a condition to completion, to ensure that there is some consistency between the two restraints.
Always check the worth of a guarantee
Some years ago, I was acting for a seller that was under some financial pressure. The seller’s accounts were publicly available and described both its financial position and the deed of cross-guarantee that had been entered into by the parent and various of its subsidiaries. The consequences of this situation could have been that if one subsidiary became insolvent, all group companies were likely to become insolvent. There had also been much media reporting on the financial position of the seller.
The buyer wanted some security for warranty claims but my client could not agree to a significant retention amount or provide a bank guarantee for the amount it expected the buyer to request. It was getting late in the process to start looking at warranty insurance (although that was a realistic but costly option).
The buyer then told us they required a parent company guarantee for potential warranty claims. My client hadn’t offered a parent company guarantee as it assumed that offer would be rejected, given the public information about the parent’s financial position. Fortunately for all concerned, the buyer never had to test the worth of the guarantee.
There are some very good lessons out of that experience – check the worth of any proposed guarantor and be alert to whether the group has a deed of cross-guarantee in place which may mean that if one company in a group becomes insolvent, the rest will too. And that means your guarantee is worth very little.
Understand the tax
There is always some aspect of a deal that is driven by tax considerations. It might be a timing issue – do the parties want to complete in this financial year or next financial year? There could be issues about the business being sold exiting from a consolidated tax group. The tax issues could relate to the structure of the deal (for example, is it a share purchase or an asset purchase) or the way in which payments will be made.
Even if you are not, and have no aspiration to be, a tax expert, you need to understand the tax issues on the deal. There are two main reasons for this. While the tax advisers will be giving tax advice and should review the tax-related drafting in the sale agreement, the lawyers need to properly reflect the issues throughout the sale agreement, and ensure that completion happens in a way that meets any specific requirements. You will not be well equipped to do that if you do not understand the issues.
The second reason for understanding the tax issues is that it is quite likely that the same or similar issues will arise in future deals. If you are alert to the tax issues that may arise, you can bring the issues to your client’s attention at an early stage, helping the deal to be done in a more considered and efficient way.
These issues are just some of the many that come up on most share purchase and business purchase deals. These common issues bear thinking about afresh with each new deal, as the commercial imperatives of each deal are different, so the approach used in your last deal or in a precedent may be a good starting point, but is unlikely to be your end point.