Buying a business – the first key steps to a successful acquisition

Posted: 15/12/2022

A company may decide to acquire another business for a variety of reasons. These could include the removal of a competitor from the market, a strategic desire to obtain control over an element of its supply chain, achieving economies of scale, the expansion of a group’s existing operations into a new field or to take advantage of available tax losses in the target company.

This article is the first in a series that provides an overview of the processes and considerations involved when buying a business.

At the outset

Once a would-be buyer has decided that it wants to make an acquisition, they will need to consider the type and size of business that might be acquired, what they are prepared to pay and how the acquisition might be financed (for example, from the proceeds of a fresh issue of shares by the buyer, existing cash reserves or bank funding). Typically, an acquisition of a private company or business takes between three and six months to complete.

In some cases, potential buyers may be contacted by the seller(s) or their advisers. Alternatively, the prospective buyer may decide to approach the owners of a strategically important business not previously for sale. In a management buy-out (MBO) context, the management team may have been approached by the existing owners or were aware that the owners were considering an exit and decide to buy the company themselves.

Forming the team

Assembling a team of experienced advisers to manage the process is vital for a successful acquisition. The composition of the team (eg lawyers, accountants and corporate finance advisers) will depend on the particular deal. Advisers who have been used by the buyer for everyday matters, such as to prepare a lease or to audit accounts, may not be appropriate for the proposed transaction. Equally, with an MBO, the company’s incumbent lawyers may be representing the seller(s) so it will probably be necessary for the management team to instruct a different firm.

Buying the company or its business and assets

Business acquisitions can take the form of either:

• a share purchase - where the share capital of the target company is bought by the buyer; or
• a business and asset purchase - where the buyer acquires a bundle of rights and assets and may assume certain liabilities of the seller entity that are associated with the part of the business being acquired.

Both structures have advantages. From a buyer’s perspective, acquiring the business and assets of a company will often be preferable to the company itself because, in general, only those liabilities that the buyer agrees to assume will pass with the business whereas, on a share sale, the target company is acquired ‘warts and all’.

Employment is one area of exception to this. On a business and asset sale, the employment of individuals assigned to the business being acquired will automatically transfer to the buyer, together with certain associated liabilities and any relevant collective agreements. Anyone whose employment is terminated in connection with the transaction will be deemed automatically to have been unfairly dismissed.

If the acquisition is structured as a business and asset sale, both the buyer and the seller are legally obliged to consult with any recognised trade unions or elected employee representatives of the affected employees. It is important that the buyer’s legal advisers have the necessary employment law expertise and, crucially, experience of advising on what are known as ‘TUPE transfers’ in order to effectively guide the buyer through this process.

An advantage of a share purchase for a buyer is that it will not have to identify and transfer each asset needed for the continuation of the business or deal with the TUPE process but can acquire everything in a neat package. The buyer may also be able to benefit from available tax losses in the target business.

In practice, the transaction structure will often be dictated by external considerations. For example, a share sale may not be possible if there is a minority of shareholders who are unwilling to sell or it may be tax-driven with the most favourable tax treatment for the party with the greater bargaining strength being the deciding factor. Share sales tend to be the norm in an MBO or if the sellers are individuals rather than corporates and the owners are seeking an exit and a clean break.

Valuation

Valuing a business is an art rather than a science. How much a buyer pays for a business is a matter for negotiation between buyer and seller(s) and will be influenced by many factors. These include, for example, the buyer’s reasons for making the acquisition and future plans for the business, if the business is being sold by way of competitive tender or auction process, the seller’s motivation for selling and future plans. Sometimes, owner-managers wishing to exit will be prepared to accept a lower price in return for a faster process and clean break.

Corporate finance advisers - who may be part of an accountancy practice or a niche corporate finance specialist - can help in valuing the business. They can also help a potential buyer to source finance for an acquisition through their network of contacts.

Confidentiality

Before a potential buyer is provided with any information about the target, it will be required to sign a confidentiality agreement (also referred to as a non-disclosure agreement or NDA). This may well be the case even if the buyer is the incumbent management team because the seller(s) will be keen to avoid news of the proposed sale becoming too widely known either within the business or the wider market as this could unsettle or demoralise employees and affect relationships with customers and suppliers.

The confidentiality agreement will place the buyer under a legal obligation to only use the information it receives about the target for the purpose of assessing the target (and not for its own gain) and to keep any information and the existence of the transaction confidential.

Heads of terms

The next step is usually for the buyer and seller(s) to enter into heads of terms (HoTs) which record the main terms of the deal upfront. This could take the form of a simple letter from the would-be buyer to the seller(s) or could be a more detailed document drafted by their legal or corporate finance advisers. The purpose of heads of terms is to flush out any areas of disagreement that might otherwise stymie the deal later on when significant time and costs have been incurred.

While the provisions relating to confidentiality and exclusivity are usually legally binding, the other HoTs provisions may not be because they lack the level of detail necessary for a workable contract. The HoTs will cover all the main areas to be addressed in the acquisition documents and will inform the content of the draft acquisition agreement (known as the share purchase agreement or business purchase agreement). The HoTs will also provide the basis for the more detailed negotiations that will follow.

The first draft of the acquisition agreement is customarily prepared by the buyer’s legal advisers (except in an auction context, which is beyond the scope of this article).

Generally speaking, HoTs will cover the following points:

• The headline price and how it has been reached. While the price will often be based on a multiple of profits, asset-based valuations may be more appropriate for some businesses.
• The target will typically be debt free with no historic borrowings for the buyer to pay off; cash free with no excess cash in the business that the seller(s) would want to extract; and with a normalised level of working capital (ie enough cash, debtors, stock, etc for the business to continue to operate as a going concern without the buyer having to make a big cash injection, typically for a period of 12 months).
• How the price will be structured. For example, if it will all be paid in cash on completion (which is relatively rare), if there will be deferred payments and whether there will be any non-cash consideration such as part of the purchase price being satisfied by the buyer issuing shares to the seller(s).
• Price adjustments - in the context of share sales, completion accounts drawn up to a date following the acquisition to verify the financial position on the completion date may be used with the price being adjusted depending on whether the figure is positive or negative compared to the expected position.

Alternatively, a locked box structure may be used, where the price is calculated on the basis of a set of pre-completion accounts that the buyer will verify and the seller(s) are restricted in the value that they can extract from the business (known as ‘leakage’) between the date to which those accounts are made up and the completion of the acquisition.

• The identification of which sellers will give warranties, in what proportions they will be liable in respect of them and any limitations on their liability.
• If there will be any indemnities – depending on the outcome of the buyer’s due diligence.
• If any sellers will remain employed in the business following completion of the acquisition and for how long afterwards they will be prevented from setting up or working in a competing business.
• Exclusivity and costs – normally, the seller(s) agree to give the buyer an exclusivity period to negotiate the deal during which the seller(s) will not discuss alternative deals with third parties. From a potential buyer’s perspective, this mitigates the risk that it will spend time and money on the acquisition process only to find that the seller(s) later accept a better offer.

Having a clear strategy at the outset is key to a successful acquisition. The benefits of appointing and involving experienced legal advisers early on to manage and negotiate the deal on behalf of the prospective buyer, ensure deadlines are met and all parties on the buy-side are kept updated, should not be underestimated and may well save costs in the long run.

This article is an edited summary from Penningtons Manches Cooper’s Guide to Buying a Business. For a copy of our Guide please click the banner below or get in touch with your usual PMC contact.

Our highly regarded corporate team provides clear, pragmatic and practical advice to businesses large and small from the UK and around the globe on the corporate transactions and the legal issues they face. To find out more about our corporate team please click here.

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