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Mergers and Acquisitions: The Benefit of Legal Services in facilitating successful transactions

What is meant by ‘mergers and acquisitions’? The term refers to that category of transactions which come about where one company wants to buy, or make a significant investment in, another company’s business.

Whether you are considering selling your business, or whether you are looking to acquire an existing business, the stages through which the transaction will move are largely the same, irrespective of the form which the specific transaction may take. 

 Professional advisory services, which include legal services, are enormously beneficial for both the parties (the buyer and the seller) at the different stages of a transaction. 

Stage One: The Term Sheet Stage

At this early stage of the transaction, the parties will often record the broad terms of the proposed deal in a term sheet (sometimes referred to as a heads of agreement or letter of intent). Parties typically do not involve professional advisors at this stage, and if the term sheet is non-binding, there is strictly speaking no risk in that approach, since the parties are not legally bound to abide by the terms of the deal as set out in the term sheet.

However, a term sheet tends to set the parties’ expectations. Significant departures, at a later stage, from the broad terms agreed in a term sheet can cause dissatisfaction and even deal break-down. 

For this reason, having a commercial lawyer and possibly one’s accountant give the term sheet a once-over before signature can be very beneficial, as both are in a position to highlight problematic terms, thereby avoiding frustration and delays in Stage Three: Negotiating Final Agreements.

Stage Two: The Due Diligence Stage

Almost every buyer or investor will want to do a due diligence investigation (also referred to as a DD) into the business and affairs of the target (i.e.: what they are buying). A DD involves looking into all aspects of the target and its business to identify if there are any concerns or issues in the business. 

The concerns typically identified include non-compliance by the target with laws, regulations or contractual obligations that apply to it, significant bad debt, disputes and/or legal proceedings that the target is involved in, disputes with employees at the CCMA, significant unpaid creditors, inadequate employment agreements, and similar issues. In short, any concern which means that the target is less commercially attractive than it appeared to be. 

If the buyer identifies very serious concerns with the target, it may decide not to buy at all. Alternatively, a buyer may utilise DD findings to negotiate a lower purchase price, on the basis that the target is actually worth less than the original proposal..

In addition, a buyer may also make a list of concerns that, while not significant enough to cause the buyer to walk away or even to negotiate the price, must be remedied either before or after the deal has closed. For example, if the buyer has identified that the target’s employment agreements are inadequate, it may require that the target enter into improved employment agreements with its staff, either as a condition to the deal closing, or within a certain period after the deal has closed.

From the seller’s perspective, the role of professional advisors during the DD is minimal. The period in which professional advisors are essential for a seller is the period before the DD, as the seller strives to get the target DD-ready. 

A target whose records and affairs are in a mess, or in a condition which makes it difficult for a buyer to conduct a DD at all, is very commercially unattractive. Buyers want to be able to look into the history of a target’s affairs so as to assess the risks of getting involved with the target. 

Professional advisors are essential in getting a target DD-ready. Accountants are needed to get financial records in order. Lawyers are needed to get legal and contractual affairs in order (including employment affairs). A company secretarial service provider can be very useful in getting a company’s share register, share certificates and related records in order.

Finally, specialist advisors may be needed to ensure that appropriate business licences are in place, environmental impacts are managed, and so on depending on the nature of the target’s business. Targets which keep their affairs in order on an ongoing basis will not require much to get DD-ready, but targets which have not been well-administered over time will require a fair degree of input.

From the buyer’s perspective, professional advisors play a major role during the DD. The financial aspects of the DD are typically undertaken by an accountant, and the legal DD should be undertaken by a commercial lawyer with the help of a labour lawyer, and in some cases other specialists, depending on the nature of the target’s business – perhaps an intellectual property lawyer, a property lawyer, an environmental lawyer, or a banking and finance lawyer

The professional advisors undertaking the DD will typically prepare a DD report for the buyer, and the buyer will use the findings of this report in negotiating the comprehensive transaction agreements.

Stage Three: Negotiating Comprehensive Agreements

In order to go ahead with a legally binding transaction, the parties will need to sign comprehensive agreements, recording the binding terms of their deal.

Unlike a term sheet, comprehensive agreements are usually very detailed and contain the precise terms of the deal between the parties. It is at this stage of the transaction – the preparation and negotiation of the comprehensive agreements – that input from a commercial attorney is most essential.

The comprehensive agreements will cover the basic elements of the deal – the identities of the parties, what is being bought, the price, how and when the price will be paid (upfront, or over a period of time), and how and when delivery will take place.

They will also cover other essentials such as warranties, indemnities, limitations on seller liability, and the manner in which the business of the target should be conducted in the period leading up to closing of the transaction. 

Finally, they’ll cover deal-specific terms such as what security will be provided, where the purchase price is to be paid off over time, and whether any concerns are to be remedied before or after closing, as identified in the DD report. 

Regardless of the form that the transaction takes, aspects of the comprehensive agreements which are most heavily negotiated tend to be the following:

  • payment terms – if payment of any portion of the price is deferred, will the outstanding portion bear interest, and will security be provided? If so, what form will that security take? Options include a guarantee, a suretyship, a security cession, a pledge of moveable property, or a notarial bond of some kind;
  • earn-out payments – many deals include a portion of the price which only becomes payable if the target achieves certain performance milestones after closing of the deal. This creates risk for a seller, especially where a seller no longer has control over the target once the deal has closed. The circumstances under which an earn-out becomes payable need to be crystal clear;
  • warranties – buyers will almost always require warranties from the seller. A warranty is essentially a promise given by the seller about the state of the target as at a particular date, for example: “as at the signature date, the target is not involved in any litigation”. A buyer usually has a right to claim monetary damages from a seller if any warranty later turns out to have been untrue at the time at which it was given. Warranties are intended to protect the buyer against the risk associated with the unknowns of the target’s history. Sellers, however, dislike the idea of remaining liable to a buyer after the deal has closed. The extent and the precise wording of the warranties are usually heavily negotiated;
  • indemnities – buyers will include indemnities to cover specific known risks associated with the target of which the buyer has become aware, usually during the course of the DD. Thus if the buyer becomes aware that the target was previously the subject of an investigation by SARS, for example, the buyer may require the seller to indemnify him (in other words, make good), should the buyer suffer loss arising out of that investigation, after the deal has closed. Again, sellers dislike the idea of remaining liable to a buyer after the deal has closed, and the extent and the precise wording of indemnities are usually heavily negotiated;
  • limitations on seller liability – whilst buyers will push for the protection of warranties and indemnities, sellers will push for the extent of their liability under the warranties and the indemnities to be limited. There are a number of ways in which seller liability can be limited, and a good commercial attorney will limit seller liability to the greatest extent possible;
  • restraint of trade – buyers usually require that a seller enters into some kind of restraint of trade, which prevents the seller from competing with the target after the deal has closed. A seller who is retiring may have no problem giving extensive restraint undertakings. On the other hand, a seller who intends to remain involved in the industry in which the target operates should obtain legal advice on the specific terms of any restraint.

Stage Four: Fulfilling the Suspensive Conditions 

It is common for comprehensive agreements to contain one or more conditions which must be met, before the deal may close. Thus, although the agreement has been signed and all parties are committed to doing the deal, the deal is ‘suspended’ until all of the conditions have been fulfilled. These are referred to as suspensive conditions (or conditions precedent).

Examples of suspensive conditions include: 

  • regulatory requirements being met (such as Competition Commission approval having been granted);
  • the buyer’s funding having been approved by a bank;
  • the seller having obtained permission from the target’s creditors for a change in control of the target; and
  • each party having adopted authorising resolutions, so that they are properly authorised to close the deal.

The period between signature of the comprehensive agreements and fulfilment of the suspensive conditions can be fairly long – sometimes two to three months, or even more if the parties are battling to get the conditions fulfilled.

Parties inevitably require assistance from a commercial attorney at this stage, to assist in getting the conditions fulfilled. Assistance in obtaining regulatory approvals and preparation of authorising resolutions will be required, and a commercial attorney is best placed to help.

Stage Five: Closing the Deal

Once the suspensive conditions have been met, the deal will finally close. In other words, the buyer will pay the price and the seller will deliver the goods (whether shares, or a business as a going concern).

The comprehensive agreements will typically provide for the parties to exchange certain documents in order to effect closing. Sometimes this happens in a face-to-face meeting, but more often it happens remotely on a date agreed in the comprehensive agreements. 

The buyer will be required to pay the price (or the portion of the price payable on closing), and provide the seller with proof of payment. The seller will be required, in the case of a sale of shares, for example, to provide the buyer with a signed share transfer form, the share certificates, and other company records reflecting that the sale has taken place. The seller may also be required to provide the buyer with certain resolutions on closing, usually (in the case of a share sale) removing existing directors and appointing the buyer’s directors to the board of the target.

The assistance of a commercial attorney at this stage – ideally the same attorney that has run with the deal from the start – is invaluable. Closing can prove to be technical, and sellers and buyers are usually preoccupied with the business aspects of the change-over, so having the attorneys manage the closing mechanics is a good way to ensure that nothing slips between the cracks.

The deal is not properly completed until closing has occurred. Neither party wants to find itself in breach for having unwittingly failed to deliver on closing.

Final Remarks

Even fairly simple transactions take time. It is in the best interests of both parties for the legals to be sound – nobody wants a come-back after closing. The nature of transaction agreements is such that, without the assistance of professional advisors, and especially commercial lawyers with transactional experience, parties may find themselves subject to contractual obligations which they cannot fulfil, or conversely they may suffer loss which they have no contractual right to recover.

SARAH LAWRENCE

Sarah has a BA from Stellenbosch and a BA Hons and LLB from UCT. She was admitted as an attorney in early 2010 after having completed her articles at ENS. She worked as an associate in ENS’ corporate commercial department for two years, before leaving last year to focus on her own commercial practice.  Sarah joined Caveat Legal during April 2012.

caveat legal panel attorney sarah lawrence

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