Share Sales - What’s the big deal?
There are two general types of structure used for selling a business, commonly referred to as a ‘share sale’ and a ‘business and asset sale’. The two are very different and whether the parties choose one or the other can depend on a number of factors.
A share sale, as it sounds, is where a business owner sells the shares in their company, which of course only applies if the business for sale is operated through a limited liability company. To understand the complexity of a share sale, it is helpful to remember how companies are structured and the nature of shares.
As most will understand, company ownership is expressed through the ownership of a company’s share capital, which can be comprised of a single share or of many shares, and where a company does have more than one share, those can be made up of a single type (share class) or of several different types (ordinary shares, preference shares, etc.). In all cases, shares are simply a bundle of rights, to which the shareholder is entitled – such as the right to share in the profits and to vote on certain company issues, coupled with the obligation to pay for the shares. What shares do not give is legal ownership of any assets of the business – which the company will own in its own right - nor responsibility for the company’s liabilities.
Nevertheless, when a buyer purchases shares in a company, they acquire the underlying business of the company ‘warts and all’ (is the popular expression). In other words, whatever the company owns, and whatever the company owes, is what the buyer gets whether they know about it or not. That is why a sale agreement is so important, to spell out exactly what the buyer can expect to get for the money they have agreed to pay.
A share sale is very different to a ‘business and asset sale’. With a business and asset sale structure, the legal ownership of assets is passed from seller to buyer, and the buyer will normally agree to take responsibility for certain specific liabilities. Whilst that sounds a far safer and simpler approach compared to a share sale, in practice there is often very good reasons (including significant tax benefits for sellers) to structure a deal as a share sale.
Not unlike buying a house, that many will be familiar with, a purchaser of shares should normally undertake a series of checks before they buy. The due diligence process is often in two parts, comprising the commercial due diligence which looks at the target’s finances including tax affairs and is undertaken by accountants, and the legal due diligence which looks at the target’s legal compliance and at its contractual relationships.
If the due diligence uncovers significant problems, the buyer has the opportunity to withdraw from the transaction and avoid making a bad investment, or instead seek to re-negotiate the terms of the sale, such as a reduction or restructuring of the price or indemnity protection for possible future liabilities.
The Sale Agreement and Disclosure Letter
The sale and purchase agreement (or ‘SPA’) is the key document in any share sale transaction. It is in this document that the parties should spell out exactly what the buyer can expect to get for their money, and the buyer’s remedies where their expectations are not met.
- The Purchase Price
Due diligence is important to gain a general picture of what the target business is like, but of course a business is usually in a constant state of flux, with its cash increasing or decreasing every day, its stock decreasing and being replenished, its debtors and creditors constantly changing, etc. We often find a common oversight between buyer and seller is that they will not have taken this into account when they agree on a basic price for a company. From a buyer’s point of view, it will normally be prudent to make any purchase price conditional upon the target company’s financial state at completion; the most common and practical one being the company’s net assets at completion. Without that ‘check and balance’ in place, a buyer can be in for a nasty surprise when they find the company’s finances bear no relation to its last accounts, which in extreme cases could mean no cash left in the bank and a pile of bills to pay!
It is relatively uncommon for companies to be purchased for a single fixed price payable on completion. More often, the purchase price will be a variable amount, dependent (as I have just mentioned) on the company’s balance sheet at completion, and sometimes dependent on the future performance of the business. Some of the price structures can become complex, and specialist solicitors are an absolute necessity to avoid costly mistakes. With recruitment businesses, particular thought should be given to issues such as the potential for fee clawbacks, and how that should impact on the purchase price.
- Warranties and Disclosure
Another key element to the SPA are the warranties. Not unlike when we buy goods as a consumer, from a toaster to a new car, we will normally expect to get a ‘warranty’ with such things; and the same will normally apply to buying a company. A ‘warranty’ is just a legal term to mean ‘promise’. And in the SPA, the seller will be expected to provide promises (or warranties) about most aspects of the target company. In broad terms, a buyer will expect the company to be in a ‘good shape’, free from any problems relating to its employees, customers, suppliers, landlord, the Revenue etc. etc. The price being paid is based on that being true, and the consequence of a warranty being untrue is that a buyer will have the right to make a claim against the seller for compensation (damages). It is therefore of huge importance to ensure the warranties are clear, unambiguous, and (from the seller point of view) do not go further than is reasonable in the circumstances. The warranties are often the focus of negotiation between the parties, with a buyer often wanting the warranties to be as broad as possible and the seller seeking the opposite.
An important part of the sale process for any seller is to inform the buyer, before completion, about any issues which effectively renders a warranty untrue. This is called ‘disclosure’, and by doing this the buyer is unable to bring a claim for breach of warranty based on the information they have been given. The due diligence process and the disclosure process is closely linked, and often the seller will want the information provided during the due diligence process to be treated as ‘disclosed’ for the purposes of the warranties.
- Tax Covenant/Indemnity
The tax covenant (or tax indemnity) deserves special mention, not least as many find it to be a complicated and puzzling document. The general idea of the tax covenant is to make the seller responsible for certain tax liabilities of the target company. As to what those tax liabilities will include will depend on how the purchase price is to be adjusted (if at all). But, for simplicity, it is best to explain that in all cases, it will cover any tax which the company should have paid but hasn’t, whether that is a known mistake or not. This will usually cover a broad range of taxes, including corporation tax, VAT, and PAYE liabilities.
The Other Bits and Bobs
If you have ever bought or sold a business, you will probably know that these transactions create a lot of paper! The SPA is certainly the key document but there is often other documents which are required and form part of the overall paperwork. These and the other important issues and aspects of a share sale will be considered in a later blog.
Michael Crook, Solicitor