Documentation & Process

NON-DISCLOSURE AGREEMENT/CONFIDENTIALITY AGREEMENT

Introduction

Non-disclosure agreements (also known as confidentiality agreements) are usually signed at the very start of the acquisition process. They can be one way (normally the buyer giving confirmation to the seller that disclosed information will be protected) or two way (particularly if the buyer is issuing consideration shares and the sellers are carrying out due diligence).

Reasons for usage

Quite often the buyer will be a competitor of the seller and the disclosure of confidential business information could be disastrous if the deal does not go ahead. There is therefore a need for strict undertakings to be in place about the handling of all disclosed information.

Non-disclosure agreements should also restrict any disclosure of the negotiations taking place as well as protecting the documents being disclosed.

Quite often the parties will agree a phased process of disclosure. General information on the business will be initially sent over with very sensitive information, such as customer lists and pricing, only disclosed close to completion (when both parties are comfortable that a deal will take place).

Although typically there will be confidentiality clauses in heads of terms, it is advisable to go for a full written agreement, which creates clear sets of obligation on the party receiving the information.

Contents of a typical agreement

The receiving party will confirm that all information received by it and by the professional advisers will be held on a strictly confidential basis.

There are express carve outs for information already held by the party, information in the public domain or which comes from another source without breaching the confidentiality agreement or information which is required to be disclosed by law or a recognised investment.

There will usually be a clause which states the buyer will only deal with a single point of contact with the disclosing party.

Typically the confidentiality agreement will set out a range of remedies if the confidentiality is broken. This will be an acknowledgment that damages are insufficient and that it would be appropriate to bring an injunction if there was a breach.

The confidentiality agreement can contain a duration clause. Buyers will be reluctant to sign up to too long a period as information usually loses value after a few years. At the end of a transaction, the disclosed papers will either have to be returned or destroyed.

An increasingly common sight are non-solicitation clauses which would prevent the solicitation of clients or staff members. These need to be reviewed carefully, particularly if the seller and buyer have mutual clients.

HEADS OF TERMS

Introduction

Heads of terms (also known as memorandum of understandings, term sheets, heads of agreement, letters of intent etc), set out the main points which have been agreed between the parties to an acquisition.

Reasons for using Heads

Before embarking on a complex transaction, it is important to ensure that there has been a meeting of minds with regard to the main terms. Heads of terms are typically under ten pages long and should serve to flush any fundamental disagreements on the main issues (before considerable time and effort is spent).

Although the heads of terms are expressed to be non-legally binding (except certain clauses- see below), they carry a certain "moral" commitment and it is difficult for one party to take a different negotiation stance in the main documentation if the heads are contradictory.

Heads of terms can contain confidentiality, exclusivity, cost provisions etc, which are legally binding and provide certainty for the parties until the main agreements are entered into. With regard to exclusivity, this means that the buyer is not committing valuable time and resources to a transaction, only to find that the seller is engaged in negotiations with other parties.

Another advantage of using heads, is that they provide a clear set of instructions for the professional advisers to take forward due diligence and the production of legal documents.

Disadvantages of Heads

They can cause unnecessary delays and you may end up having the negotiations twice.

Although they are non-legally binding, the parties should be careful because anything they agree in the heads will, as stated above, be considered "morally" binding when they come to the main negotiations.

Unless handled carefully, they could create legal relations so it is always advisable to make sure that they are marked subject to contract.

As heads of terms don't necessarily create legal relations, parties can be a little more relaxed about the language used. The seller, for example, may be keen to avoid adverse tax consequences of consideration payable to individuals. The use of phrases such as "earn out" in the heads, may cause problems, even if the share purchase agreement does not link consideration payable to future employment.

The following will typically be included in heads of terms for an acquisition:

• Parties
• Consideration
• Conditions to be satisfied to completion
• Timetable
• Other key terms such as security, set off, restrictive covenants etc
• Protection sought by the buyer, such as warranties and indemnities. Increasingly the heads will also specify who will be giving the warranties, whether they will be on a several or joint and several basis and the level of limitation cover for the warrantors
• Understandings as to some ancillary arrangements such as new service agreements or real estate documents
• Conduct of the business up to completion
• Certain legally binding provisions such as exclusivity, confidentiality, announcements and costs

EXCLUSIVITY

Introduction

Before a buyer starts to commit material resources to the acquisition process, it will normally want some comfort that the seller is not going to sell to a third party. Accordingly, it is common in UK acquisitions for a buyer to be offered a few months "clear run" in order to complete the acquisition. The grant of a period of exclusivity is therefore to guard against corporate gazumping. Such arrangements are also known as lock out or no shop agreements.

By using exclusivity arrangements, the seller is prevented from using the buyer's offer as an insurance policy enabling the buyer to seek higher offers elsewhere. It also allows the buyer a period in which to commit time and resources to the acquisition without the pressures that would exist if there were competing offers.

A few common questions on this process:-

Q. When will exclusivity be granted?

A. Not usually before the signing of heads of terms.

Q. Is consideration paid by the buyer for the grant of exclusivity?

A. Not as such. The buyer will often have to agree to reimburse the seller's costs if it withdraws from the transaction without cause.

Q. What are the normal terms of an exclusivity clause?

A. You would expect the following component parts:

There should be carve outs to allow the company to continue to operate in the ordinary course (e.g. a retailing business must still be able to sell its products even though there is a restriction on selling business assets).

The exclusivity period can be ended if negotiations are terminated by both parties or the buyer withdraws.

The exclusivity period may also be ended if the buyer is not progressing the transaction.

Q. Can a seller ever enforce an exclusivity agreement?

A. The House of Lords has made it clear that exclusivity agreements will be enforceable if the agreement is reasonable, for a fixed period and made for consideration.

It is also not advisable to state that the seller is prevented from negotiating with a third party for a reasonable period of time as this may be void for uncertainty. It has also been held that a provision requiring a party to negotiate in good faith during the exclusivity period is unenforceable because it lacks the necessary legal certainty. Accordingly it would appear that exclusivity agreements can prevent the seller negotiating with a third party but cannot necessarily oblige it to sit down and actively negotiate with the buyer. On the question of consideration, it would appear sensible to have any agreement executed as a deed where consideration is presumed.

Q. What can I do if the exclusivity agreement is breached?

A. Providing that the exclusivity agreement is legally binding, the two main remedies sought will be:

• an order for specific performance, normally in the form of an injunction preventing the seller from selling to a third party; and/or
• damages for breach of contract.

With regard to damages, a party may insert a clause stating that if exclusivity is breached an agreed damages payment of a specified amount is due. The buyer should ensure that any specified sum is a genuine pre-estimate of its loss or it will be void as a penalty. For example, if the sum was to reflect the professional fees incurred, it is more likely to be enforceable.

DUE DILIGENCE

Under English law, the principle of caveat emptor applies, which means it is essential that the buyer carries out a thorough investigation of the target’s business. Due diligence is, in effect, an audit of the target’s legal, business, and financial affairs. It enables the buyer to ascertain whether the target has good title to the assets or shares being purchased, and reveals the full extent of any liabilities the buyer will assume. Consequently, it will help the buyer work out whether he is paying a fair price.

The buyer will seek contractual protection from the seller in the form of representations and warranties, and this protection will usually be limited by disclosure and other contractual provisions. Due diligence assists the buyer in deciding what contractual protection it requires from the seller, and which risks it is not prepared to take on. Ultimately, the due diligence investigation could reveal that the buyer is not going to get what it wants out of the acquisition, or even that the acquisition is too risky at any price.

The due diligence investigation should establish the following:

• whether the seller has good title to the assets/shares being acquired;
• whether there are any unstated or understated liabilities;
• provide detailed information on the target business which puts the buyer in a better position to decide whether to proceed with the acquisition and at what price, to bargain with the seller, to plan the integration of the target business, to determine whether any consents are required for the acquisition, and to determine what ancillary documentation is needed; and
• enable the buyer to identify the necessary steps it will have to take in order to take effective control of the target business.

The scope of the due diligence investigation will depend on the type and purpose of acquisition. For example, if the buyer and the target are significant players in the same market, and they are looking to gain a trading advantage, competition issues will form a major focus of the investigation.

Practical issues will also influence the scope of the investigation. A tight time frame, and low budget will limit the level of due diligence that can be carried out. In such circumstances, a buyer might, for example, ask the seller to provide copies of unusual or onerous contracts, rather than all trading contracts. Such a request should be drafted carefully, to ensure that it encompasses all important contracts.

In some cases, a long investigation might not be desirable, as it will give another bidder an opportunity to outbid the buyer. The seller may also object to a long investigation which would interrupt and delay the normal running of business. If this is the situation, the buyer would be prudent to take other precautions. For example, ensuring that warranties and indemnities are sufficiently wide, considering a retention of the purchase price to cover potential warranty claims, and considering pre-completion conditions, such as obtaining consents to change of control.

ACQUISITION AGREEMENT

The acquisition agreement will take the form of either a share purchase agreement or an asset purchase agreement depending on whether the buyer is acquiring the corporate entity as a whole, or simply the business as separate from the undertaking that owns it. On a purchase of shares, the buyer acquires the shares in a company, with the intention of purchasing the whole company, "warts and all". Conversely, an asset purchase enables the buyer to cherry-pick certain assets of the seller.

Share Purchase Agreement ("SPA")

In simple terms, the SPA governs the sale of share in the target company by the incumbent shareholders to the buyer, hence the parties to the agreement are the selling shareholders and the buyer. Additional parties may also be joined perhaps as to guarantee the performance of the main seler or the buyers obligations.

A large proportion of the document will be taken up with warranties and indemnities to be given by the seller. In order for the buyer to gain some form of contractual protection concerning the acquisition of the target, the seller will make a number of warranties or statements (that a particular state of affairs exists) concerning the affairs of the target. These warranties will cover every aspect of the target and tend to be highly detailed. Further protection can be established via indemnities which promise to reimburse the buyer in the event of a designated liability arising in the future.

The seller can limit his potential exposure to liability under the warranties and indemnities by making appropriate disclosures in a disclosure letter which is handed over on completion (having first been agreed between the parties). See further under "Disclosure". It is usual for the seller to seek to limit any warranty by giving the warranty with reference to the warrantors’ knowledge information or belief and by negotiating a maximum liability under the warranties and indemnities.

As a share sale will usually represent a clean break for the seller, the buyer will seek to include restrictive covenants in the SPA with a view to limiting the seller’s ability to:

• compete with the business of the target company for a certain period after completion;
• solicit staff of the target for a certain period after completion;
• solicit customers and suppliers of the target for a certain period after completion.

The SPA will also be accompanied by a tax deed or tax covenant which will include extensive tax warranties.

The seller will usually arrange for completion accounts to be carried out by their accountants after completion and for the purchase price set out in the SPA to be adjusted following agreement of these accounts. As the buyer may have made their valuation on the basis of the most recent audited accounts or (unaudited) management accounts, completion accounts provide a means for the buyer to confirm their calculations. Therefore, the agreement would provide for the buyer’s accountant to dispute the accounts within specified period of time and for the completion accounts to be ultimately referred to an independent expert if needs be.

Asset Purchase Agreement

Parties to an asset purchase agreement will be the seller and buyer of the business, together with any warrantors or guarantors not also being the seller or the buyer.

The agreement will set out and define those assets which are to be transferred which may be intellectual property, business contracts, fixed assets, goodwill, plant and equipment or real property. These various assets must each be transferred from seller to buyer and certain assets, such as real property, will need specific consideration. For tax purposes, it is normal to apportion the purchase price attributable to particular assets being sold. Important contracts between the seller and third parties will need to be transferred to the buyer and if possible novated (agreement from the third party to release the seller from the contract and for the benefit and the burden of the contract to pass to the buyer). This will require the consent of the contracting third party which may not necessarily be given.

Particular attention is also given to the employees, as employment law provides that where there is transfer of all or part of a business, the employees are automatically transferred to the buyer on the same terms and conditions that they enjoyed prior to the transfer. So unless agreed otherwise, if the transaction involves the transfer of an identifiable economic entity, the employees assigned to that entity will automatically be transferred. (See Employment Issues)

There is not so great a need on a business acquisition for the same extent of warranties as are associated with a share purchase agreement as the buyer will be acquiring specific assets and not exposing himself to unforeseen liabilities. However, where the acquisition is for the business as a going concern, warranties may be lengthy and extend beyond the specific assets and liabilities transferred.

The agreement will also set out any specifics concerning consideration which may include an earn-out element. See Consideration/Earn Out.

DISCLOSURE

Disclosure is an important part of any private acquisition. The main function of the disclosure letter is to disclose against any warranties in the acquisition agreement which cannot be given, but it also assists the buyer with its due diligence exercise. Disclosures must be fair, otherwise the seller may find itself on the receiving end of a claim for breach of warranty. The buyer should consider the disclosures carefully in conjunction with the warranties, and decide whether to accept them, bearing in mind that if a warranty is breached, no claim will lie if the seller has made a fair disclosure against that warranty.

The disclosure letter is usually divided into two parts; general disclosures and specific disclosures. The general disclosures cover certain matters which appear in public records and/or matters of which the buyer ought to be aware on the basis of pre-contract searches and enquiries (though there is room for negotiation as to what should be included). For example, corporate information published at Companies House is usually included as a general disclosure. Before the buyer accepts the general disclosures, it should ensure that it is able to carry out the searches and enquiries necessary to obtain the information listed in the general disclosures.

The specific disclosures are those which relate to specific warranties, and are drafted with cross reference to the relevant warranty. For example, if there is a warranty that there is no current, pending, or threatened litigation, the seller should disclose the full details of all current, pending, or threatened litigation in order to avoid liability for breach of that warranty.

A disclosure bundle accompanies the disclosure letter, and can be voluminous. It contains documents which are required by the warranties, for example copies of the material contracts, as well as copies of documents which evidence the information given by the disclosures, for example correspondence relating to any current litigation.

The disclosure letter and bundle should be delivered to the buyer, in final form, before the acquisition agreement is signed. If there is a delay between exchange and completion, a second disclosure letter might be delivered at completion, as the warranties are usually expressed to be true at the completion date.