Acquisition of Private Companies in England and Wales

Transcription

1 Acquisition of Private Companies in England and Wales International Investor Series No. 2 AUSTRALIA BELGIUM CHINA FRANCE GERMANY HONG KONG SAR INDONESIA (ASSOCIATED OFFICE) ITALY JAPAN PAPUA NEW GUINEA SAUDI ARABIA (ASSOCIATED OFFICE) SINGAPORE SPAIN SWEDEN UNITED ARAB EMIRATES UNITED KINGDOM UNITED STATES OF AMERICA

2 Acquisition of Private Companies in England and Wales International Investor Series No. 2 Contents 1. Introduction 1 2. Investigation 2 3. Agreeing what is to be acquired 5 4. Structuring the acquisition 6 5. Financing the acquisition 8 6. Purchase price 9 7. Completion accounts Conditions Principal documents Restrictive covenants and protection of goodwill Accounting implications 14 Appendices Appendix 1 About this briefing 15

3 This publication is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions. For more information please contact us at Ashurst LLP, Broadwalk House, 5 Appold Street, London EC2A 2HA T: +44 (0) F: +44 (0) Ashurst LLP is a limited liability partnership registered in England and Wales under number OC and is part of the Ashurst Group. It is a law firm authorised and regulated by the Solicitors Regulation Authority of England and Wales under number The term "partner" is used to refer to a member of Ashurst LLP or to an employee or consultant with equivalent standing and qualifications or to an individual with equivalent status in one of Ashurst LLP's affiliates. Further details about Ashurst can be found at Ashurst LLP 2014 Ref: January 2014

4 1. Introduction As an international investor who has decided to acquire a business operating as a private company in England and Wales, you need to understand the process by which such an acquisition is made, principal potential areas of concern and the main documents that will be involved in the acquisition. This briefing deals with the acquisition of private companies only as distinct from the acquisition of businesses (which are dealt with in a separate briefing in this series). Private companies are not generally subject to the rules contained in "The City Code on Takeovers and Mergers" which regulates the takeover of public companies. An acquisition of shares of a company is an acquisition of a separate legal entity which has entered into contracts and incurred liabilities on its own account so that when a buyer buys a company it takes on all the liabilities of that company and its business (although if agreed between the parties it is possible to structure a transaction so that a guarantee or indemnity is obtained from the seller or from one of its related entities with respect to any particular concerns the buyer may have regarding specific liabilities). The first steps towards making an acquisition of shares in a private company involve carrying out a full investigation into the state of affairs of the target company, agreeing in principle exactly what is to be acquired and structuring the acquisition in order to achieve maximum tax efficiency while complying with relevant legislation and regulatory requirements. Page 1

5 2. Investigation Due diligence is the name given to the process of carrying out an investigation into and appraisal of a target company. The scope of due diligence varies from transaction to transaction. If the seller is conducting an "auction" between several potential buyers who are bidding against each other, a limited amount of information may be available in a document or data room for investigation by solicitors. (The scope of the information provided may be increased as the number of potential buyers decreases). Alternatively, if a single buyer is negotiating with a seller, more information might be made available and a legal audit undertaken as well as an accountant's investigation. Legal audit It is usual in the UK for a prospective buyer to instruct its solicitors to carry out a legal audit of the target company and its group. The legal audit may be conducted at differing levels of detail but usually takes the form of a written report (which varies in depth) and comprises a detailed examination of the underlying contractual documentation of the target group and a report as to its content and its compliance with relevant UK legislation. The legal audit will cover such areas as: the corporate structure and constitution of the target group; the loan arrangements of the target group; the real property (freehold properties, leases and licences) held by the target group; the pension schemes operated by the target group; the intellectual property rights owned or used by members of the target group; material trading agreements and other contractual documents; licences held by the target group for the purpose of conducting its business; employment matters, including terms and conditions of employment and collective agreements with unions; litigation and compliance with relevant legislation; insurances held by the target group; and environmental matters of concern to the target group. In relation to pensions, a buyer will need to investigate all present or historic participation in pension schemes by the target company. Defined benefit schemes ("DB Schemes") (also known as final salary schemes) will require the most rigorous levels of investigation because an investor may be exposed to substantial liabilities, particularly if a relevant DB Scheme is in deficit and/or the target company is leaving a DB Scheme. These pensions liabilities may exceed the value of the deal itself. Separately, legal advice may be given on the tax implications of the proposed change in ownership and the most tax-efficient manner of structuring the acquisition. Page 2

6 In order to commence the legal audit process, the buyer's solicitors will send an information package request to the seller's solicitors seeking to extract information on areas such as those highlighted above. It follows that the quality of the legal audit will largely be influenced by the quality and quantity of information made available by the seller and its advisers. Much of the information sought as part of the due diligence will be of a commercially sensitive nature and the seller will not normally be prepared to make this available without a confidentiality undertaking being given by the buyer. Buyers should also be aware that the seller may not be prepared to make some information available at all because of its sensitivity. Due diligence investigations are useful for determining the number and scope of warranties and indemnities which might be required by the buyer in the share purchase agreement. This is discussed further in the "Principal documents" section below. The report to the buyer is often in one of the following forms: a full form report in which summaries of each document are given together with an executive summary drawing out the main areas of interest and concern, a shorter form of report where only key documentation is summarised with an executive summary or a very short form report where only key issues are highlighted. On occasion, depending on the relevant time frame a verbal presentation is given in addition or as an alternative to the written report. Accountant's investigation There may be an overlap between the areas of investigation covered by the legal audit and the accountant's investigation but careful drafting of the initial information package request can avoid duplication of cost and effort. A buyer may also instruct a firm of accountants to prepare a long form report on the target in accordance with instructions contained in an engagement letter agreed by the accountants and the buyer. This report is usually a very comprehensive document and covers the following principal areas: a description of the history, business and properties of the target group; details on the corporate structure of the target group, including directors and employees; a review of the financial aspects of the target group, including analyses of relevant accounts; a review of the taxation affairs of the target group; a review of the management and IT systems of the target group; details of the accounting systems and management accounting information of the target group; a review of the target group's operations such as research and development, arrangements with suppliers and customers and production and manufacturing capacity; and a review of the markets in which the target group operates and the target group's prospects. Page 3

7 Other due diligence In addition to the investigations by solicitors and accountants, a prudent buyer may wish to appoint the following professional advisers: depending on the size and complexity of the transaction, a financial adviser to advise on the terms of the deal and assist in the negotiation and financing of the deal; a chartered surveyor to report on the state of repair and condition of the properties. It is extremely rare for a seller to give any warranties as to the state of repair and condition of properties in the share purchase agreement and, therefore, if a buyer is particularly concerned about real property (perhaps because it is integral to the company), it is advisable for further investigations to be made; an actuary to report on the valuation of any pension funds within the target group and to advise the buyer upon the setting up of any new pension schemes. If a transfer of part of any pension scheme is to take place, the buyer's actuary will need to agree the actuarial assumptions which will form the basis of calculating any amount to be transferred from one pension scheme to another; an insurance broker to advise on the adequacy of the target group's insurance policies and to assist with any new insurance arrangements upon completion; and an environmental auditor commissioned to carry out a physical inspection and testing of a particular site if it is identified as having potential environmental problems. Page 4

8 3. Agreeing what is to be acquired Either before due diligence starts or at the end of the due diligence process, the buyer and the seller may enter into "Heads of Agreement" which records the principal terms of the transaction that they have struck. It is important that the words "subject to contract" appear at the top of a Heads of Agreement. If these words do not appear, there is a danger that the document will create a binding legal contract even though the full details of the transaction have not been determined. To repeat the introduction to this guide, when a buyer buys a company in England and Wales it acquires not only the assets but also the liabilities of the target company. The due diligence process ought to highlight areas of potential liability. If the seller agrees, it may be possible to structure the transaction to carve out certain liabilities, or to obtain indemnities from the seller in respect of identifiable issues. Page 5

9 4. Structuring the acquisition The structuring of any transaction will largely be driven by the tax considerations of the seller and buyer. Therefore, it is important to agree the tax structure of the transaction at a very early stage. Seller's tax considerations Structures that can be requested by the seller to help to mitigate its tax bill can include: Share for share exchanges In some transactions, the seller will ask for consideration shares or loan notes rather than or in addition to receiving cash. This can help to defer the seller's tax liability on any gain they have made on the shares that they are selling so that the liability crystallises at a more tax efficient time for the seller. Dividends before sale Some sellers will ask for the target to pay out an amount by way of dividend prior to the sale to the buyer. This will reduce the price to be paid for the shares and, as a result, may reduce the chargeable gain made by a seller. The rates of tax and exemptions (if any) available on the dividend and any gain will need to be considered. There are complicated provisions in the Income Tax Act 2007 enabling HM Revenue and Customs to cancel tax advantages from transactions involving shares and other securities. The complexity of these rules means that it is often difficult to decide in advance whether they apply to a particular transaction. It is generally preferable to obtain capital gains tax treatment on the disposal of the shares rather than income tax treatment, therefore, the seller may wish to apply for tax clearances from HM Revenue and Customs confirming the tax treatment of the sale proceeds and will require such clearances to be obtained prior to completion of the share purchase agreement. Applications, as a rule, take up to 30 days for HM Revenue and Customs to process, although this is not guaranteed. Buyer's tax considerations As the tax liabilities of the target will remain with it following the sale, appropriate protection for the buyer should be sought. In addition, the buyer may wish to examine the trading losses (if any) of the target group. The buyer will wish to know whether or not such losses will be available to be offset against future profits of the target. The basic position is that a trading loss may be set against trading income in succeeding accounting periods. However this favourable position may be lost where there is both a change in the ownership of the company and a major change in the nature or conduct of a trade carried on by it. Because of these provisions, a buyer would only generally "pay" for such losses if and when the target company is able to use them. Page 6

10 The buyer may also need to examine whether or not the target company will be leaving a group for the purposes of its value added tax registration. If it is, a new value added tax registration will need to be obtained for the target company. Moreover, if the target company were a member of such a VAT group, it will remain jointly responsible for VAT liabilities incurred by the group whilst it was a member and appropriate protection should be sought. The buyer will be liable for stamp duty at the rate of 0.5 per cent of the consideration for the shares rounded up to the next multiple of 5. Special rules apply where the calculation of the total consideration payable for the shares in the target is based upon an "earn out" formula. Page 7

11 5. Financing the acquisition If the buyer proposes borrowing from a bank to finance the acquisition of the target, consideration will need to be given as to whether or not the target is able to give security over its assets and those of its subsidiary companies. Pre 1 October 2008 private companies were unable to give financial assistance for the acquisition of their own shares or for the shares in a holding company unless they went through the statutory "whitewash" procedure. From 1 October 2008 the prohibition was repealed and where there are only private companies involved no financial assistance analysis is necessary. If the buyer is to borrow to finance the acquisition, it will want to maximise tax relief for any interest costs. If it is intended to reduce the tax bill of the target group by these interest costs, a UK acquisition vehicle will invariably be needed (it will borrow to make the acquisition, and the interest costs can be "included" for its tax purposes to offset the target group's profits). Alternatively, if relief for the interest costs would be more valuable in the place of incorporation of the buyer (e.g. if the tax rate there is higher than in the UK), the buyer could acquire the target group directly. If a UK acquisition vehicle is used and it borrows from a related overseas entity, the level of those borrowings will need to be considered in the light of the UK transfer pricing and debt/equity ratio rules and the worldwide debt cap rules to ensure full tax relief for the interest costs in the UK. Page 8

12 6. Purchase price The purchase price for the shares can be calculated in a number of ways. It may be based upon the historic profits of the target group. If this is the case, the buyer will wish to seek protection from the seller on the correctness and methodology of the audited historic profits as well as a warranty that there has been no material adverse change in the financial and trading position of the target group since its last audited accounts date. Alternatively, it may be based upon future profits of the target group or an aggregation of profits since the last accounts date to some period after completion. These are commonly referred to as "earn outs". In such cases, payment of part of the purchase price will be deferred and will only become payable upon the relevant profits being achieved. In these circumstances, a buyer will seek warranties on the audited accounts of the target group and confirmation of no material adverse change in the financial and trading position of the target group since its last audited accounts date. However, in addition, both parties need to be sure that the accounts by reference to which the earn out will be calculated will be prepared on a basis consistent with prior years or in line with other agreed accounting principles (for example, that for the purposes of the earn out, certain line items will be ignored) and in accordance with, at a minimum, generally accepted accounting principles and practice. The seller will often wish to ensure that the buyer can do nothing after completion that might artificially reduce the profits of the target to prevent the seller from obtaining its full earn out. Accordingly, the seller will seek detailed protection in the share purchase agreement governing what the buyer can and cannot do in relation to the conduct of the target group's affairs during the earn out period. The price may also be based upon the net asset value of the target group. In this case, it will be important for the buyer to seek to include in the share purchase agreement a clause that will reduce the price by 1 for each 1 by which the net asset value falls short of an agreed amount. This will ensure that UK common law principles that might otherwise govern the amount that the buyer can recover will not operate so as to prevent the buyer from recovering its full shortfall below the net asset value of the target. Page 9

13 7. Completion accounts If the purchase price is to be calculated by reference to a particular net asset value or level of profit, the share purchase agreement will usually provide for accounts to be drawn up as at the date of completion of the acquisition in order to calculate the level of net asset value or the level of profit of the target at that time. There will need to be provisions included in the share purchase agreement to: state which party/firm of chartered accountants is responsible for preparing the completion accounts (normally each party will want its own chartered accountants to do this); set the time limits for the preparation and agreement of the completion accounts and, if there is disagreement, the terms of arbitration of any dispute; provide for the basis of preparation of the completion accounts; that is in accordance with generally accepted UK accounting principles and usually on bases consistent with the bases of preparation of previous audited accounts of the target group; and set out the precise method of calculating individual items in the profit and loss statement or balance sheet, since accounting practice invariably involves a certain degree of subjectivity and to rely solely on generally accepted accounting principles is rarely sufficient to avoid all disputes. It is not unusual for the buyer to require there to be some form of retention from the consideration which it can hold as security in case there needs to be any reduction in the price because the net asset value or profit target is not met. If the buyer is to take the benefit/burden of trading from the last accounts date an alternative approach to calculating the purchase price is what has become known as the "locked box". This approach requires the buyer to make an offer on the basis of an historic balance sheet of the company. That is then the price which would be paid for the shares. It will not be adjusted for subsequent movements in cash, debt or working capital. However, the buyer is protected against deliberate removal of cash from the target by warranties that subsequent to the balance sheet date money has not been taken out of the company by way of dividend, management charge or non-arm's length transactions. Such warranties are typically called leakage warranties. The "locked box" works best in a sellers' market where the target is a self contained business which has been accounted for on its own. Page 10

14 8. Conditions It is important to understand the distinction between pre-contract conditions (those matters that the buyer will want to know have been satisfied before it will enter into any agreement whatsoever) and a conditional agreement which is a binding agreement but which will not be completed until conditions set out in it have been fulfilled or waived by the party in whose favour the conditions have been given. Examples of "pre-contract conditions" might include the buyer completing its due diligence review, its investigation revealing nothing material and the auditors for the target group signing off on audited accounts which relate to the target companies being acquired. Until these are satisfied the parties will not usually enter into the share purchase agreement. In contrast, examples of contractual conditions might be: a foreign buyer obtaining relevant non-uk government consents and approvals in its home jurisdiction; UK competition authority clearances being obtained if required; European Union competition law clearances being obtained if required; shareholder approval of the seller if it is a company with a previous listing on the Official List of the UK Financial Conduct Authority and the size of the disposal is such as to trigger the London Stock Exchange requirements for shareholder approval; and the seller obtaining tax clearances confirming the tax treatment of the sale proceeds. The parties should consider what is to happen if, ultimately, the conditions cannot be satisfied. For example, they might agree in advance an adjustment to the purchase price if a certain consent cannot be obtained or that if all (or certain of) the conditions are not met by a specified "longstop date", the agreement will fall away. Page 11

15 9. Principal documents The legal documents usually encountered on an acquisition of shares in a private company include: The share purchase agreement This will record that the shares are being sold by the seller to the buyer, confirm that the seller has the authority to sell the shares and has title to them and set out the price to be paid and the conditions of sale. The agreement will also contain warranties to be given by the seller to the buyer which confirm that certain statements relating to the target companies are true. To the extent that any of these statements proves to be untrue (and the buyer can prove loss), the buyer should be able to sue for damages for breach of contract. The warranties are often the subject of much negotiation and will be used to protect the buyer against the risk of unknown matters relating to the target or its business. In addition, if any specific items are revealed by the due diligence process which may potentially cause loss to the target companies, the buyer may wish to seek specific indemnities from the seller which provide that the buyer will recover 1 for each 1 paid out under any particular liability if it crystallises. The disclosure letter The seller will attempt to limit its liability under the warranties contained in the share purchase agreement by disclosing to the buyer all matters which are not as warranted and, to the extent that any such matter is disclosed, the seller will not be liable for breach of that warranty. The buyer will need to ensure that the disclosures are specific and that the buyer understands both what is being disclosed and the potential implications of the matter disclosed. Particular consideration needs to be given to the disclosure letter as this can substantially undermine the value of the warranties given. The tax deed of indemnity The buyer will require a tax deed of indemnity from the seller by which the seller agrees to pay 1 for each 1 of tax paid by the buyer for which provision has not been made in the accounts of the company. This is required because the tax liabilities of the company will pass with the ownership of the shares and the buyer will wish to ensure that it is not faced with any unexpected tax bills which reduce the value of the target company. Stock transfer forms These are in standard form and are used for the purpose of enabling the transfer of legal title to the relevant shares. The stock transfer form must be stamped by the Stamp Office to show that all relevant stamp duty has been paid before legal ownership of the shares can be transferred. Page 12

16 10. Restrictive covenants and protection of goodwill When purchasing a company, the buyer will wish to make sure that the seller is not going to compete with the target group in the immediate future as this may harm the goodwill of the company which has been bought. As a result, the buyer will usually seek undertakings in the share purchase agreement from the seller that it will: not carry on any form of business which competes with the business of the target group; not solicit or entice away any customers, suppliers or employees of the target group; not use any trade names that may have previously been used by target group companies; and not use or disclose to any third party any confidential information concerning the target group. It is usual for these undertakings to be given by the seller in respect of all group companies, other companies, joint ventures and new companies etc. in which it has or may have in the future a substantial interest (and what constitutes "substantial" will be a matter of negotiation between the parties) and, if a person, in respect of his family members. To be enforceable under UK law, such undertakings must be reasonable in scope, duration and geographic extent. If the restrictions are too extensive, they could be held to be unreasonable because they are in restraint of trade and, as a result, will be invalid. Therefore, careful consideration needs to be given to the wording of the restrictive covenants to ensure that the legitimate interests of the buyer are protected in a way that will be enforceable. Page 13

17 11. Accounting implications In the UK, there are two ways of accounting for an acquisition: "Merger accounting" This method of accounting is used where the transaction is one "in which the shareholders of the [acquirer company and the target company] come together in a partnership for mutual sharing of the risks and benefits of the combined entity, and in which no party to the combination in substance obtains control over any other, or is otherwise seen to be dominant, whether by virtue of the proportion of its shareholders rights in the combined entity, the influence of its directors or otherwise". (FRS 6, paragraph 2) In merger accounting, the consolidated financial statements incorporate the combined company's results as if the companies had always been combined. The assets of the acquired company are therefore included in the consolidated accounts at written down book value, not their fair value (as is required if acquisition accounting is used) and the value of the goodwill in the target company does not need to be included in the accounts of the new group. "Acquisition accounting" This is used where merger accounting is not applicable. In acquisition accounting, the accounts of the group formed by the acquisition should attribute to the fair values of the assets and liabilities of the acquired business as at the date of the acquisition. The extent to which the fair values of such shares and any other form of consideration exceeds the fair value of the net assets of the target is attributed to goodwill. If goodwill arises on an acquisition, UK accounting practice generally requires it to be eliminated against reserves in the year in which it arises or, alternatively, to be amortised, that is written off over its useful life against the profit and loss account. If reserves are depleted, amortisation can have a detrimental effect on the company's balance sheet and may also affect its ability to pay dividends. To the extent that there are insufficient reserves, court applications can be made to overcome the problem or a negative reserve created in the consolidated balance sheet in respect of the goodwill. However, from a presentational point of view, a negative reserve is generally regarded as being unattractive. Merger relief Where the consideration for the shares in the target company is the issue of shares in the acquiring company, "merger relief" may be applicable. Usually, where one company acquires another for the issue of shares, the difference between the fair values of the assets being acquired and the nominal value of the shares issued by the acquiring company must be treated in the same way as a premium paid on the issue of shares. This restricts the ability of the company to distribute this sum as profit. This requirement can be avoided if certain requirements are met so that merger relief is available. Merger relief may apply whether merger accounting or acquisition accounting is used. Page 14

18 Appendix 1 About this briefing This briefing forms part of a series of briefings written about corporate issues by Ashurst for international investors. The briefings in this series are: No. 1 No. 2 No. 3 No. 4 No. 5 No. 6 No. 7 No. 8 Establishing a Business in the United Kingdom Acquisition of Private Companies in England and Wales Acquisition of a Business in England and Wales Why List in London? Joint Ventures in England and Wales A Brief Guide to AIM A Brief Guide to Corporate Insolvency in England and Wales Private Equity Transactions: Overview of a Buy-out If you would like further information on the matters referred to in this guide or to receive additional copies of this or any other briefing in the series, please speak to your usual contact at Ashurst or one of our partners listed below: Richard Gubbins Partner, Head of India Business Group T: +44 (0) E: richard.gubbins@ashurst.com Anthony Clare Partner T: +44 (0) E: anthony.clare@ashurst.com Nick Bryans Partner T: +44 (0) E: nick.bryans@ashurst.com Nick Williamson Partner T: +44 (0) E: nick.williamson@ashurst.com Page 15

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