STRUCTURING THE DEAL

Whilst much of the detail of structuring the deal will be negotiated during the period of due diligence and drawing up of the final sales contract, some of the overall elements will need to be thrashed out in order to agree the basic price and shape of the sale. These will be incorporated into a formal offer letter from you to the seller that sets out the main terms of the proposed deal (known as heads of terms, or heads of agreement).

Negotiations at this point are therefore not simply about price, but will also be about the overall shape of the deal.

Some of the principal issues that will need to be dealt with at this stage are detailed below.

How is the sale to be structured?

Broadly speaking, if the business is operated through a limited liability company there are two alternatives. Either:

• the owner of the shares in the company can sell these to you (or a company that you form to hold them, which is usually referred to during negotiations as ‘Newco’) so that you then own the legal entity that is the target company, together with all its assets, business and liabilities; or
• the target company can sell its business and assets to you or Newco in return for cash or other consideration which then belongs to the company under the seller’s control (sometimes referred to as a ‘cash shell’).

For tax reasons (see Chapter 16), the business’s owner is likely to want to sell you their shares. However, for accounting reasons, you are more likely to want to buy the business and assets, as you then have choices as to how you account for these in bringing them into Newco’s books, which will affect the amount of goodwill you have to account for and therefore your tax liability.

Additionally and perhaps more importantly, if you only buy the business and assets you will have limited your risk in the transaction, as you will not be picking up the company’s liabilities, other than some specific ones which may carry across, such as:

• employees’ accrued employment rights which will be carried across and become rights against the new owner of the business as the new employer under the Transfer of Undertakings, Protection of Employee Regulations (TUPE)
• any liabilities arising that relate directly to specific assets (such as the new owner taking over liability of the property or plant and equipment leases).

If, however, you buy the shares, the company now under your ownership continues to have all its own old liabilities. The worry for you here is that there may be claims of which you are not aware that may arise subsequently and give you problems. For example, the company might have had some form of legal dispute which the owners quite reasonably feel can be defended or is unlikely to be pursued further by the other side. There is always the risk for you as the purchaser, however, that the complainant may decide to take it further and may be successful. Alternatively the company may have supplied goods which have a warranty attached to them and with which at the time of the sale there appeared to be no problems; however, at some point after the sale it transpires that problems have arisen that are covered by the warranty for which the company is now liable.

So if you are considering buying the business’s shares you must expect to undertake a greater level of due diligence work in respect of potential liabilities to ensure that you avoid any of the above problems as far as possible. Alternatively, if you are looking to only buy the business and assets, you may expect the seller to seek a higher price than in a share sale because of the potential adverse tax consequences they may suffer in comparison.

HOW CERTAIN IS PAYMENT GOING TO BE?

Many buyers and sellers involved in a deal become so focused on the headline price of the sale that they fail to take into account how this interacts with the terms of payment.

Leaving aside for a moment any payments made in respect of future profits above certain targets, consultancy after the sale, or interest on finance for the sale provided by the seller; the core of the deal will be a payment made by you to the seller for the business and assets or the shares in their company. This payment can either be made by way of:

• cash or cash equivalent (within which I would include shares in your company if your shares are listed and readily tradeable on a stock exchange, so that the seller can immediately convert some or all of the shares received into cash); or
• paper, by which I am referring to payment using instruments that are not immediately realisable by way of cash. Such paper instruments can include such things as:
  • loan notes, whereby the purchasing company agrees to pay consideration over some period into the future
  • options over the purchasing company’s shares which are not immediately exercisable
  • – shares where there is no immediate market through which the seller can turn them into cash (for example where the company is private and therefore not listed on any stock exchange).

Some deals will be a mixture of the two. As illustrated in the chart below, the greater the element of cash or near cash in a deal, the greater the seller’s certainty of payment. The more paper there is in the deal, the less certainty the seller will have as to the eventual cash outcome, and they will therefore generally seek a higher price to compensate them for this extra risk.

HOW MUCH IS THE SELLER FINANCING?

Aligned to the above, what degree of the financing is the seller going to have to provide?

In many business sales, such as for example, to a management team conducting an MBO, the buyers will not have sufficient cash to pay the full purchase consideration upfront as well as to run the business following sale. In these cases, as discussed in Chapter 10, the sellers have little option but to assist by financing part of the purchase price if they want to complete a sale.

Where sellers are helping to finance the sale by allowing you a period of credit they will look to take precautions to reduce their risks by:

• Treating this the way they would any other credit sale and obtaining credit references and undertaking credit searches on you and your businesses.
• Insisting on having at least some of the consideration in cash so that you have had to produce a significant down payment and have a significant investment tied up in the new business that you will not wish to see at risk by defaulting on the liability of the old owner. At its most extreme, there is a view among some sellers that they should insist on the maximum possible cash upfront and treat receipt of any deferred income as ‘a bonus’ if it comes in. However, refusing to finance does in effect to reduce the amount of money that prospective purchasers will be able to pay them for the business.
• Taking a personal guarantee from you for the outstanding payment (if you are buying for a company), which they may seek to be supported by a charge on your house. If assets such as a property are included in the sale, the old owner may also seek to take security by way of a charge over these so that if you default, they can appoint a receiver to sell them and get their money back. This may, however, give rise to problems with your ability to raise finance against their assets as commercial lenders will also want to take these as security.
• As their payment is coming from the business’s future profits, insisting on being provided with regular sets of accounts. They will also want the right to inspect the company’s books and records at any time.
• Seeking a bond, as discussed in Chapter 10.

Sellers will try to keep the period over which they are to be paid as short as possible. However, equally importantly, they will need to appreciate that they have to make the period long enough to be practical for you as a buyer. The payments must be set at a level that allows you to retain sufficient working capital out of the profits generated to trade; and enough profit to live on. Having the business fail following the sale because payments to the seller makes it run out of cash, or you call it a day because you are not making any money out of it, are both self-defeating in the long term for the seller.

And finally, if they are providing finance, you should of course expect that they will charge an appropriate rate of interest both to cover their risks and to incentivise you to pay the debt off as quickly as possible.

You should also appreciate that in some circumstances obtaining payment over a period may actually help the seller in dealing with their tax position.

HOW CERTAIN IS THE PRICE?

The price that you will be prepared to pay for any business will be largely determined by your confidence in the likely level of sustainable profits going forwards. Where there is any concern or dispute over the likely level of those profits, use of an ‘earn-out’ can be a way of bridging the gap between the price you are willing to offer and the upfront price the seller is demanding.

In an earn-out the future payment due is generally not fixed but is to be determined on the basis of future trading performance such as a percentage of profits over the next two years in excess of specific target. This can make sense if there is some real uncertainty about future performance, or you want to incentivise the old owner while they stay on for a period to hand the business over.

But be very careful about any such arrangement. However tightly the agreement is drafted it will never cater for all the changes that may happen in the business over this time and this is an area where there is always significant potential for disputes. You should only consider an earn-out if you are very confident of your relationship with the seller following the sale.

If you do decide on such a scheme there are some key points to cover in order to minimise disputes. You should agree:

• how items which will affect the level of profit, such as changes in accounting policies, new interest costs or group cross-charges, will be dealt with
• what level of control over the business the seller will have to make certain that it delivers the profits required
• how any major changes that are planned after the sale and which will affect profit levels, are to be taken into account when comparing performance against targets.

An earn-out will usually last either one or two years, and sellers will often want to include within the contract a clause stating that in the event that you are able to sell the business on during this period at a significant profit, then the seller will share in this (a non-embarrassment clause).

OTHER KEY TERMS

Price and payment are not the only issues. Other factors to consider in agreeing the deal structure are:

How much support will you need after completion?

Will you need the seller to stay on for a month or two to train you in running the business? Maybe you need them to stay on for one or two years in order to ensure a smooth handover of contacts, relationships and clients.

What restrictions will you place on the seller?

If you are buying a business you are actually buying a flow of transactions where a group of people (the customers) come to your business to buy goods or services that you in turn purchase from another group of people (your suppliers). You are therefore really buying a network of relationships. Once you’ve paid for this, the last thing that you generally want to happen is for the old owner to set up in business again immediately or in the locality, as the chances are that customers and suppliers will simply want to deal with the person they have been used to dealing with. The value of the relationships that you thought you had bought would be very quickly compromised.

Almost every sales contract is therefore likely to include some form of non-competition covenant whereby the seller undertakes not to set up a new business in competition with the one you have just sold within a specified time or area.

Obviously the seller’s circumstances and objectives in achieving the sale will have a significant impact on how strong or far-reaching a covenant they are going to want to sign. If they are simply looking to retire, for example, then the effect of such a covenant may be completely irrelevant to them. If, however, they are looking to cease trading this particular business but may be interested in doing, say, consultancy in the area in the future, then the detailed wording of the covenant may become a significant issue which you will have to factor into the price you are prepared to pay.

HEADS OF TERMS

By the end of this process you should reach the point where you have agreed the basic price and terms of the sale with the seller, and you will be in position to agree heads of terms or heads of agreement.

This usually takes the form of a formal letter from you to them confirming the general outline of your offer, which they have agreed to accept, subject to contract.

As such your letter should set out broadly:

• The price, either by way of a specific number (£Xm), or by way of some kind of formula (X% of profit over the next three years paid annually three months after the end of the year).
• The deal structure, either a sale of shares or a sale of business and assets (in which case if there are any assets which are to be specifically excluded, such as land, property or debtors, these should be noted).
• Specific description of your requirements of the seller, such as their staying on for a specified period as an employee or under a consultancy agreement, and details of any proposed non-competition covenant.
• Conditions attached to the offer such as the need for audit and due diligence, together with an indication as to the scope of work required and how the process is to be managed, particularly in respect of access to staff, papers and maintenance of confidentiality.
• Exclusivity. Having reached this point you can now expect to start to incur significant professional costs as you will need to instruct your professional advisers to undertake formal due diligence and the detailed negotiations of the sales contract. If you are going to commit to spending this cash it is not unreasonable to seek to ensure that you are not wasting your time in doing so. You should therefore demand that the seller agree to deal exclusively with you for a reasonable period of time in order to give you a fair chance of completing the transaction.

Whilst unless there are particular circumstances, sellers will usually agree to such a condition, they will want to ensure that this period is limited to a specific period sufficient to allow you to undertake your due diligence and a contract to be agreed (say 45 to 90 days).

The offer may also specify specific conditions that have to be met in order for the deal to proceed (such as the net worth remaining over a specified sum) or set out events that will cause the deal to fail (such as the loss of specified key customers).

It is important to stress that the heads of terms letter is essentially a letter of intent to complete a deal and is not the contract for sale itself. It is important, however, for a number of reasons, as:

• It marks the stage at which you have an offer that you have negotiated and agreed with the seller.
• It does have legal implications (and therefore you should take legal advice about drawing it up) in, for example, the terms surrounding any period of exclusivity.
• It provides a degree of moral commitment on the part of both you and the seller to move towards completing a deal.
• The granted period of exclusivity clears the decks for you to commit to what is the most expensive part of the process leading up to a sale.
• It provides written evidence of the structure of the deal and terms you have agreed with the seller for future reference in moving towards the sale contract.

However, it is important to remember that you have made this offer before carrying out your detailed due diligence. It is therefore an offer made based on the information you have received from the seller and on which you are relying at this stage. Once your advisers gain access to the business’s books and records to conduct their proper due diligence, if significant issues arise these will obviously have a serious impact on the price that is finally agreed for the sale.