The key to a successful acquisition is the careful and proficient management of the process to ensure that the transaction flows smoothly and stays on track.
An acquisition typically begins with the parties entering into appropriate documentation safeguarding their respective interests, namely confidentiality agreements, heads of terms and exclusivity agreements. Thereafter, it is in both parties' interests that the due diligence exercise is conducted effectively, deal terms are negotiated to a standard that the parties are happy with or are willing to accept and that such terms are clearly documented in the transaction documents.
Expert legal advisers should be retained to provide guidance and assistance throughout the process, to ensure that all parties remain aligned, to deal with the formalities surrounding the completion of the transaction and to provide guidance on business integration following the completion of the deal. There are however certain pitfalls both legal and operational when acquiring a business which the parties and their advisers must be alive to.
Legal Risk - Inadequate Due Diligence
One of the purposes of due diligence is the early identification of legal risks, which may impact a buyer's decision to proceed with the transaction, or justify a reduction in the purchase price. As such, it is essential that due diligence is carried out to a high standard and covers all aspects of the business of the company that the buyer is considering acquiring ("Target"). The scope of the due diligence exercise is dependent upon the context of the matter and the nature of the Target's business.
Change of control
When reviewing the Target's material contracts, there should be a focus on provisions which may hinder or delay the transaction from proceeding smoothly. An example of this type of provision is a change of control clause stipulating that the consent of a third party is required for a change of control in the shareholding of the Target, which can be present in loan agreements and supplier agreements. A failure to obtain the necessary consents can reduce the value of the Target to the buyer, particularly if the contracts or financing that are in place are beneficial or material to the Target's business. As such, it is crucial that any material third-party consents are made condition precedents in the sale and purchase agreement ("SPA").
Real estate
A critical aspect of due diligence is the identification of real estate ownership. Legal advisers need to verify that the Target holds legal title to any material properties, identify any encumbrances that may affect the buyer's ability to use or deal with the relevant property or that will need to be removed on or before completion, and assess potential liabilities and risks - for example, defects in title that may affect the buyer's ability to sell the property, or environmental liabilities arising from contaminated land or water pollution.
Additionally, it is important to determine whether the relevant property leases and operational licences are existing and are valid, otherwise there would be potential operational issues.
Apart from allowing the buyer to make informed decisions about whether to proceed with the transaction and on what terms, the identification of these risks at an early stage protects the buyer from unexpected liabilities and issues that would adversely affect the buyer's interests.
Litigation and ESG
Litigation can bring significant financial liabilities and is a burden on management time. As such, any existing or threatened litigation or disputes relating to the Target's business or its assets should be highlighted to the buyer, and the buyer should be made aware of the number and status of litigation claims, the estimate of damages, and the likelihood of success of each claim.
Any issues relating to environmental, social and governance ("ESG") compliance should also be considered, especially given its growing importance as a factor in assessing the value and reputation of a company. The buyer may also want to ascertain if the Target's ESG policies align with theirs, as the buyer may have existing ESG obligations with third parties - for example, a requirement to achieve minimum sustainability targets, or the buyer may have provided warranties relating to compliance with voluntary and/or legislative requirements regarding ESG.
The scope of ESG issues is constantly expanding and covers a vast range of factors, including environmental issues, supply chains (for example, working conditions or underpayment of staff), community and stakeholder engagement (how the Target interacts with, and their impact on, the communities in which it operates), and corporate governance. Certain types of companies may also be subject to ESG reporting requirements, which would make ESG compliance for such companies crucial.
Certain liabilities relating to ESG may be difficult to quantify, such as reputational damage, criminal prosecution and monetary penalties for environmental breaches and offences, but they may ultimately be significant. If the Target has a poor ESG profile, it may affect the buyer's decision to proceed with the acquisition because of related regulatory, strategic, reputational and litigation concerns. A poor ESG profile may also affect the creditworthiness of the company, which can make obtaining financing for the Target more difficult down the road.
Intellectual property
It needs to be determined whether the intellectual property material to the Target's business has been validly registered. Due diligence on a Target's intellectual property depends on the nature of the Target's business. For example, if the Target is an IT company, the buyer would want to verify that the Target's software is protected under copyright or is patented (where applicable) in the Target's name, and that any software that has been developed by the Target's employees has been assigned to the Target. Additionally, any marks which identify the Target's brand should have been registered – for example, the Target's logo (trade mark registration), slogans (trade mark registration), and website (domain registration). A buyer would also want to ensure that it will be granted access to the Target's social media accounts, especially if such accounts attract a large following.
A buyer would also want to know if there are any challenges or disputes relating to intellectual property rights owned by the Target, and whether there are any infringement claims brought by or against the Target. If the Target uses any intellectual property rights under a licence, it needs to be identified whether such licence can be transferred to the buyer.
If intellectual property material to the Target's business has not been validly registered, or there are infringement claims related to such intellectual property, or there is an inability to transfer a licence to the buyer, this could significantly impact the buyer's decision to proceed with the transaction due to potential operational issues post-completion.
Employment
The buyer may intend to retain certain employees, such as those involved in the management of the Target. Due diligence should focus on their employment contracts, and any findings can contribute to a buyer's decision whether to renegotiate any employment agreements to incentivise such employees to stay with the Target - particularly if there is a concern that valuable know-how, talent or expertise may be lost. The buyer may also want to consider implementing changes to the terms of the Target's employment agreements to align with the buyer's own policies and with market expectations to attract talent to the Target post-completion. Likewise, if the buyer is intending to terminate employees, the buyer needs to be made aware of its obligations as an employer under contract and under law.
Other factors that should be considered are whether there is any non-compliance with applicable employment laws, whether any employee benefits or schemes would be affected because of the transaction, and whether there are any existing or potential employment claims (such as breach of contract, unfair dismissal, or discrimination).
As a result of the due diligence exercise, the buyer can consider the potential impact any changes that will occur as a result of the transaction may have on the Target and its employees, and what the buyer can do to mitigate any issues that may arise as a result.
These are important considerations to prevent a potential failure of the intention of the transaction, as employees are a key driver of the success of a company, and as such, to the success of an acquisition.
Legal Risk – Contractual Protections
Legal advisers should also build contractual protections into the SPA, which may include the use of bespoke contractual mechanisms where necessary to allocate and manage risk.
Where there is a split exchange and completion, appropriate conditions precedent should be included in the SPA to protect the buyer, such as a condition that the relevant regulatory approvals for the transaction are obtained, and conditions in relation to the completion of the relevant formalities in order to execute the transaction documents (for example, board approval and shareholder approval) and to effect the transfer of the shares and/or assets of the Target so that legal ownership passes to the buyer.
Restrictive covenants should be imposed on the seller in the SPA. Such covenants may include restrictions on the permitted activities of the seller following completion, such as soliciting or having dealings with existing customers or suppliers of the Target, soliciting or employing existing employees of the Target, or becoming involved in a business in competition with the Target. This prevents negating the intention of the transaction.
Subject to the nature of the transaction, the parties may also consider including an earnout provision, which is a pricing mechanism which involves at least part of the purchase price being calculated by reference to the post-completion performance of the Target. In an owner managed business, an earnout provision can incentivise the existing management to continue carrying on the business of the Target profitably post-completion and mitigate the risk that the buyer has overpaid.
Warranties and indemnities
Warranties and indemnities are forms of contractual protections used to protect against known and unknown risks. The issues identified during the diligence exercise establish the scope of the seller warranties and identify the areas requiring specific indemnities.
Warranties are contractual statements typically given by the seller concerning various matters relating to the Target, and encourage the seller to disclose known issues, which gives the buyer the opportunity to consider whether to renegotiate the purchase price or to request related indemnity protections in the agreement.
Indemnities transfer the risk of a specific, identified liability to the indemnifying party (i.e., the seller), and allows the indemnified party (i.e., the buyer) to recover on a pound-for-pound basis in respect of that matter or event should it arise. They are often used where a warranty may not allow a buyer to recover, for example, when it is hard to show diminution in the value of shares.
Operational Risk - Employees and Culture
Employees are the foundation of a company, and maintaining the continuity and productivity of the workforce is an important factor to the success of the transaction. To mitigate the risk of unsettling the workforce during a transaction process, attention should also be paid to the human side of the deal. It may be important for the buyer that certain employees are retained for their know-how and expertise, and as such clear and timely communication during the transaction process and early engagement with such employees can minimise any uncertainties that the relevant employees may feel. Training for new systems and routines should be planned to minimise employee concerns and disruption to operations.
Additionally, it is important to safeguard employee morale by identifying and maintaining the Target's culture. If integration is not managed effectively after the completion of a deal, there may be issues relating to different leadership styles, cultural differences, and with different systems and processes. These issues may negatively impact the day-to-day business of the Target because employees may be more inflexible, less productive and less motivated if they feel that their concerns are not being heard, their position is not secure, or if they have lost their trust and confidence in the management.
Legal advisers can help to mitigate long-term risks by providing guidance on carrying out integration of the Target's business smoothly post-acquisition. This can include providing support relating to employee retention arrangements, recommending solutions in relation to any issues discovered during the due diligence exercise, and advising on the employer's obligations in relation to redundancies.
Conclusion
Acquisitions require a significant investment of time and resources, and a range of legal and operational risks can undermine the success of the transaction. Effective due diligence, appropriate contractual protections and careful integration planning are therefore essential. Experienced legal advisers can play a key role in identifying and managing these risks, helping transactions proceed smoothly and achieve their intended objectives.
