(Article from DLLC October 2023 Newsletter)
5 Key Clauses to Look Out for in the Agreement (Even If you Don’t Understand It)
Due Diligence Exercise
The very purpose of any due diligence exercise is to verify, assess and question the target company’s organisation structure, business model, financial statements, and the representations made to you on the business.
Most importantly, the due diligence exercise is to flush out any information about the target company’s liabilities from monies owing to employees, tax authorities or third parties to any contingent liabilities that could sink a target company with a lengthy litigation.
As the acquiring company, your goal is the right questions.
It is not an exercise to critique the target company, and neither would representatives of the target company tolerate unwarranted criticism of the target company. Practically speaking, your approach to the due diligence exercise could well affect the success or failure of the acquisition.
The due diligence process is, in simple terms, to identify risks and to limit the risk to you. The risks which the acquiring company finds after the due diligence is the value of the risk which it is willing to pay. Often, after an elaborate due diligence exercise, either the target’s representations and indemnities are increased, or the deal price originally indicated is reduced in value to cater for the higher risk discovered in due diligence.
Key Areas of Due Diligence Relevant to the Purchaser
Material Contracts
Assuming you have already understood the target company’s business and the corporate structure including who owns what shares and the minutes of meetings of shareholders’ meeting and board minutes, the next important segment would be the types of contracts that the target company has signed and committed to fulfil i.e., material contracts.
Material contracts are those entered into by the target company both in the ordinary course of business and those to advance the company’s businesses.
Major Customers & Suppliers
It is common for the acquiring company to ask for copies of all licences, franchising, merchandising, marketing, manufacturing, distribution, agency and such similar agreement depending on your trade. From a practical perspective, the acquiring company would want to know your major customers accounting for the bulk of your business and your major suppliers especially if these contracts can be terminated easily. You would also be looking out for any personal guarantees or power of attorney signed by the target company.
Bank Statements & Financial Statements & Loan Documents
Equally important to the process are two key financial documents. The first is the bank accounts. From a bank account, much can be learnt from the company’s cashflow. The second is the financial statements i.e., the profit and loss, balance sheet and Adjusted cashflow statements. You would also get a good sense of the company’s assets, whether fixed or current, used in the business.
The caution is that financial statements tend to reflect the financial standing for the previous year and is historical data. Astute financial managers will ask for latest management accounts to the nearest month end to assess the actual financial position of the company.
The third category of documents is related to any loans, borrowings, security, mortgages, charges, debentures and letters of credit granted for the benefit of the target company.
Intellectual Property / Employees / Regulatory Obligations
Once the acquiring company is satisfied with the above key documents, they will then dig deeper into whether the company has any intellectual property, review its pool of key employees and carefully scrutinise any regulatory breaches. Each of these requirements would differ subject to the industry concerned.
These items are important because there are statutory requirements for employers to pay their employees their salaries and CPF on time and any dues and liabilities. One area of concern that any acquiring company should look out for is whether the target company is engaged in unethical practices in relation to employees e.g., cashback schemes or the lack of building permission for ad-hoc structures at the target company premises.
Litigation Risks
Exceedingly early in the due diligence exercise, legal professionals would be hired to conduct cause book searches and liquidation searches to determine if the target company is embroiled in legal suits. This would be a major step in the process for the acquiring company to assess the dollar value of the risk of the liability or the contingency of cashflow needed to fund a legal dispute. You would also wish to identify if there are any overseas litigation which could pose a threat to the target company.
The bottom line is that the target company is not under any obligation to point out its flaws. Why would it do so; it would become less attractive for acquisition. Therefore, it falls on an acquiring company to ask the right questions and to dig deeper with follow-up questions on key aspects of the business.
Prepare an organised list of questions on all the key areas above and ask for at least 3 years of past information for consistency. Most importantly, if you chance upon an answer that appears incomplete or unusual, to persist to investigate further. Your spider senses tingling may well have some merit in your enquiry.
How does Due D Translate to the Sale & Purchase Agreement?
In this intricate world of business transactions, the sale and purchase of shares in a company stands as a pivotal moment where fortunes change hands and legacies are reshaped. For both buyers and sellers, navigating this landscape can be a complex and daunting endeavour. At the heart of this pivotal exchange lies the Sale and Purchase Agreement (SPA), a comprehensive legal document that encapsulates the essence of the deal.
The SPA, often loaded with legal jargon, can appear intimidating at first glance. However, there are five key clauses within this document that every stakeholder, whether a seasoned investor or a novice entrepreneur, must grasp. These clauses, like guiding stars in the night sky, illuminate the path to a successful transaction and safeguard the interests of all parties involved.
In this exploration, we embark on a journey to unravel these critical clauses, shedding light on their significance especially after a due diligence exercise and the impact they bear on the sale and purchase of shares.
These clauses encompass the essence of the deal, from the determination of the purchase price to the safeguarding of representations and warranties, from the conditions that must be met before the deal can continue to the intricacies of indemnities and post-closing covenants.
5 Crucial Clauses to Look Out for:
#1 Purchase Price and Payment Terms
This clause outlines the total purchase price for the shares and the payment terms. It’s essential to understand how and when the payment will be made, whether it’s a lump sum, in instalments, or contingent on certain milestones.
After your successful due diligence exercise and risks factors that you have found, your due diligence report could be used to reduce the price. Be aware that it can be a deal-breaker if the target company is adamant on its price. In such a situation, the price could remain, but payment terms could be varied with conditions imposed.
#2 Representations and Warranties
This section contains statements made by the target company about the company’s financial health, assets, liabilities, and other important aspects. Buyers rely on these representations and warranties to assess the company’s condition. Sellers should be aware of what they are guaranteeing to the buyer.
A well investigated due-diligence exercise would reveal all the flaws in the target company. These flaws should then be converted into representations or carve-outs or stated as disclosure items of the company in a Disclosure Letter. The warranties to look out for and of significant value would relate to tax liabilities, operational matters, sighting of stock and assets of the company.
#3 Conditions Precedent
These are conditions that must be met before the transaction can proceed.
Common conditions may include regulatory approvals, third-party consents, or the absence of any material adverse changes in the company’s business. Both buyers and sellers should know what conditions need to be satisfied for the deal to close.
It has been observed that if conditions precedent have not been followed, and the other party has not waived its requirement for the conditions to be met, it will be a deal-breaker and the other party will be entitled to walk away from the deal. Therefore, it is critical that you are fully aware of the conditions, no matter how cumbersome, they are met before the closing date.
#4 Indemnities and Limitations of Liability
This clause addresses the parties’ obligations in case there is a breach of the representations, warranties, or other provisions in the agreement. Understanding the indemnity provisions and limitations on liability is crucial, as it can have a significant monetary impact on both parties in case of a dispute.
It is also important to identify how your dispute will be resolved and what is the governing law of the sale and purchase agreement. Look out for whether the agreement is to be resolved in the Courts or with an Arbitration Institution or some other form of dispute resolution.
#5 Post-Closing Covenants
This section outlines the obligations of both the acquiring and target company after the transaction has been completed.
It may cover matters such as the transition of management, employee matters, and the handling of any remaining liabilities.
Sellers should be aware of their responsibilities during the post-closing period. It is not as simple as transferring the shares of the company to the acquirer but ensuring that all devices, passwords, bank accounts, key contacts are also handed over to the acquirer. It requires the target to give effective control of the company to the acquirer.
Final Note
These clauses are fundamental in a Sale and Purchase Agreement for shares and can greatly affect the rights and obligations of both parties. It’s essential for concerned parties to fully understand and aggressively negotiate these clauses to protect their interests in the transaction.
