Understanding, executing and succeeding in M&A transactions

What is M&A?

An acquisition occurs when a buyer purchases either the share capital or assets in a target business. As the buyer will usually assume control of the business upon completion, it will ultimately hold greater bargaining power during negotiations. A seller may use an acquisition to realise some or all of the value of a particular asset or shareholding and exit the business altogether, or to reduce their involvement with a view to “going off into the sunset” at a later date.

A merger consists of the fusion of two separate businesses, usually of similar size and resources and which provide complementary goods and/or services, into a new company, or ‘NewCo’. Unlike an acquisition, the parties will want equal control rights over the NewCo once the transaction completes.

Structure

The structure of an M&A transaction can be grouped into the following stages:

1. ‍Introduction and preliminary due diligence. Introductions can come about in several ways, whether through existing contacts in the industry, corporate financiers, or even via online marketplaces. Whatever the origin, the buyer’s next step should be to request that the seller complete an initial due diligence questionnaire, which a solicitor can prepare; this acts as a fact-finding exercise to uncover more information about the target company and can be tailored to specific areas of the business. Any relevant information or documentary evidence provided by the seller is usually uploaded to an online data room managed by the buyer’s M&A team. Before any information changes hands, however, a non-disclosure agreement (or NDA) should be entered into between the parties to protect sensitive business information on both sides.
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2. ‍Heads of Terms (HOTs). HOTs serve as a letter of intent between the parties and sets out the terms and conditions of the sale. HOTs are generally not legally binding apart from exclusivity, confidentiality and cost provisions and therefore will not necessarily bind the respective parties to the deal. However, as they do evidence serious moral intent, both parties should use the opportunity to iron out as much detail as possible about the transaction at the HOTs stage to mitigate the risk of protracted negotiations arising later. Tax advice should also be obtained at this stage to ensure the proposed structure will not have any undesirable tax consequences for either party.
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3. ‍Legal Documents. Typically, the buyer’s legal representatives will prepare the first draft of the share purchase agreement (SPA) or asset purchase agreement (APA) (as applicable), which will set out key terms such as price and how the consideration will be satisfied. The agreement should be carefully reviewed to ensure the terms align with the HOTs and that any other specific requirements or expectations of the relevant party have been met. Any terms not agreed upon in the HOTs will need to be negotiated in detail at this stage.
   
   Other key legal documents may include new articles of association and/or a shareholders’ agreement to incorporate any bespoke terms. The buyer may also require that any continuing sellers enter into new service agreements to take effect from completion. A variety of other ancillary documents, including consents and approvals authorising the transaction at both board and shareholder level, will also need to be drafted as the SPA or APA is likely to include the delivery of such documents as a condition to completion.
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4. Disclosure. The sellers will be asked to give warranties, which are statements of fact about the business and the shares or assets to be purchased, usually given as at the date of completion. The starting point is usually that each seller will give all the warranties, although if the target is investment-backed, it might be that certain sellers may only be required to give limited warranties, such as in relation to their ownership of the sale shares, for example.
   
   The warranties essentially act as a further due diligence exercise by the buyer to draw out more information about the target and uncover any issues that may impact its value. If any warranties are found to be untrue, this could result in the buyer bringing a claim for damages against the seller(s) if it can prove the breach of warranty resulted in a diminution in value of the shares or assets it purchased after mitigating any loss.
   
   Sellers should ensure that the SPA or APA contain appropriate protections from liability arising from breach of warranty claims, such as caps on liability, time limits for the buyer to bring a claim and ‘de minimis’ and basket thresholds in relation to the aggregate value of any claims. Although expensive, warranty and indemnity insurance can also be obtained on both buy-side and sell-side to cover financial losses arising from a breach.
   
   In most cases, a seller’s best protection against a claim is to provide a disclosure to the extent that any warranty is untrue. Sellers are advised to take legal advice as to the level of disclosure required, as this may vary depending on the terms of the documents and getting it wrong could result in a lack of protection against any breach of warranty claim.
   
   If any information disclosed causes particular concern to the buyer, it may look to obtain an indemnity from the seller. An indemnity is a promise from the seller(s) that it will repay the buyer upon the occurrence of a specific event on a pound for pound basis in respect of a defined loss, which the buyer does not have to mitigate. Classic examples include where the target is party to historic but unsettled disputes which could later lead to costly litigation, such as past intellectual property infringement or employee tribunal claims.
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5. Exchange and completion. Once documents are agreed, legal representatives will arrange for them to be signed, following which they will be exchanged and completed. This can occur simultaneously or on separate dates if completion is conditional on the occurrence of a certain legal or commercial event. An example of this is where the target is a regulated entity under the Financial Services and Markets Act 2000. Any change of control in such an entity must first be approved by the Financial Conduct Authority, meaning documents may be exchanged but must not complete until such approval is received.

M&A motivators

Below are some examples of why a business may want to take part in M&A:

1. ‍Expansion
   
   Expanding via an acquisition or merger with a business which already has a presence in another jurisdiction or market is likely to be less costly (and therefore less risky) than expanding organically. 
   
   A buyer may want to make an acquisition either to remove a competitor from the market (to make more space for itself) or where the goods or services provided by the target are complementary to those it provides.
   
   Mergers are often motivated by the prospect of obtaining economies of scale. This will generally mean both businesses can enjoy cost synergies and a greater generation of profits than if they were to remain independent.
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2. Key talent  
   
   An M&A transaction can be a good way to access a specific pool of employees which a competing business may enjoy. This is most prevalent in the technology sector, where talent is in great demand, but perhaps more difficult for start-up businesses to attract compared to more established companies.
   
   M&A can also be used to incentivise existing employees, with it becoming increasingly common for a buyer to offer share options to key members of the seller’s management team as part of the transaction.
   
   Business owners may want to attract investment from certain key investors by way of M&A, whether for additional financial support or to improve the company’s reputation. Acquisitions by private equity firms are also becoming more common, which may be ideal for owners looking for a cash injection leading to more growth in the short term and a more lucrative exit later on.
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3. ‍Realisation of value
   
   Perhaps obviously, M&A serves as an opportunity for owners to realise some or all of the value they have invested in their business, hopefully receiving a big pay-out on completion.
   
   Earn-outs and other deferred consideration structures are also increasingly common. This is where part of the consideration is paid to the sellers at a later date, subject to the business meeting performance targets (based on, for example, EBITDA) over an agreed period of time. The deferred consideration is almost always subject to the sellers staying with the business throughout the relevant period following completion.
   
   At first glance, deferring consideration may appear to be in the buyer’s favour, whether for cash flow purposes, or to spread the risk of their investment. However, particularly in the context of earn-outs, as long as the document terms allow any remaining sellers sufficient control of the business during any such earn-out period, this could be seen as an opportunity to obtain a greater pay-out than if the consideration were paid upfront.

Preparing for an M&A transaction

It is well-known that M&A transactions can be expensive and time-consuming. Every transaction will incur professional fees, including those of legal, accounting and tax advisers, but the level of cost can depend on many other variables. For example, how complex is the deal, are the parties generally aligned and what is the state of the target and/or its assets prior to the deal? For both buyers and sellers, taking the time to consider and agree any complexities early (for example, by outlining them in the HOTs) can be helpful in minimising any undue costs or delays.

Due diligence exercises can be a particular drain on internal resources and staff for the target, as information must be collated from all parts of the business. To reduce the impact of this, sellers preparing for a sale should conduct their own due diligence regularly so that any issues relating to finance, tax, commercial contracts or regulatory aspects of the business, can be discovered and dealt with appropriately and as early as possible by their legal team.

Equally, buyers should not forgo undertaking an initial due diligence exercise prior to the HOTs stage. Although it is unlikely nothing new will come up during later due diligence, if issues can be uncovered early this could help to reduce the risk of nasty surprises later on, when time and cost to make the purchase have already been incurred.