(Article from DLLC August 2023 Newsletter)
When buying or selling a business or shares in a company, there are critical steps and documents involved. Not to be confused, the company is not selling its shares or equity in Yummy Pte Ltd but a part of its business e.g. machinery, raw material, know-how to that third party. When engaging in any transaction involving the company, you must ask yourself whether you are buying shares in the company or its business, wholly or in part. Your answer would have very different considerations to think about in relation to the transaction and what to look out for.
The 3 Most Important Documents
Have these three documents in your mind at all times you are about to enquire for a business to buy or sell or when you negotiate. Do not forget that this is the pre-sale stage and for discussion purposes. The three critical documents are:
1. Non-Disclosure Agreement (NDA)
2. Term Sheet
3. Letter of Intent (LOI)
#1 The Enigmatic Non-Disclosure Agreement (NDA)
The Non-Disclosure Agreement or NDA is an agreement protecting the use of confidential information exchanged between the parties. The primary purpose is to ensure that both the disclosing and receiving party is aware of the scope of use.
The NDA sets out step-by-step what the receiving party must do after use of the confidential information. Usually, the receiving party is asked to return or destroy and show proof of destruction of such confidential information. The removal of the confidential data is expected to be from all devices received orally, physically, visually or electronically.
NDA clauses restrict use, specify timelines, and restrict who within the receiving party can access the information. Signing an NDA formalises a binding agreement ensuring protection of the disclosing party’s information to the highest standard.
In the event of a breach, the NDA sets out remedies such as injunctive reliefs and damages. Enforcing terms can be challenging, requiring strong documentary evidence that the breach occurred and that the information was indeed confidential.
#2 The Naked Term Sheet
The purpose of the Term Sheet is to disclose clearly and transparently all the commercial terms negotiated between the parties before moving forward. It usually captures the key considerations in one to two pages, allowing parties to quickly decipher the essence of the deal.
A Term Sheet is a preliminary, non-binding document (except for provisions such as confidentiality and exclusivity). It acts as a blueprint, covering purchase price, payment terms, representations and warranties, due diligence, and closing conditions.
Key Considerations
– Flexibility: Term sheets are flexible and open to negotiations until mutually agreeable terms are reached.
– Bird’s Eye View: Analyse not only from a financial perspective but also operational, strategic, and long-term objectives.
#3 The Ubiquitous Letter of Intent (LOI)
Letters of Intent are widely used in various transactions and are common in sale and purchase deals. It is a precontractual written document setting down a preliminary understanding between parties. Some writers even categorise the term sheet as part of the LOI.
The LOI can also be referred to as ‘Heads of Agreement’, ‘Memorandum of Understanding’, or ‘Letters of Understanding’. Whatever the label, it should reflect and include the negotiated term sheet.
What to Look Out For?
Clauses may be drafted unclearly, creating doubts about the true intention between parties. Without legal guidance, parties may include clauses that create unintended obligations.
Red Flags
– Binding vs Non-Binding: Courts may consider an LOI binding if it contains essential terms, even if intended otherwise.
– Good Faith Deposit: Usually paid during due diligence or pending final agreement. Negotiate refundability if the deal falls through.
– Watch out for clauses such as “not binding”, “process of negotiation”, or “have not reached agreement on all terms”.
General Red Flags in Pre-Sale Deals
– Refusal to disclose information.
– Misinformation leading to misrepresentation.
– Aggressive timelines without proper due diligence.
– Unreasonable one-sided terms.
What to Look Out For in Sale & Purchase Deals
– Valuation: Ensure alignment with true value and growth prospects.
– Earnouts & Performance Metrics: Be cautious of performance-based payments.
– Synergies: Ensure strategic fit.
– Financial Due Diligence: Verify seller’s financial statements.
– Tax Implications: Watch for outstanding liabilities and opportunities.
– Working Capital & Cash Balances: Clarify treatment of cash.
– Representations & Warranties: Expect detailed clauses.
– Indemnity: Ensure liabilities remain with the seller.
– Non-Compete & Non-Solicitation: Guard against restrictions impacting future operations.
Summary
When buying or selling a business or shares, the process should start with the NDA, Term Sheet, and Letter of Intent. Each plays a critical role in protecting parties, clarifying terms, and ensuring a smoother transaction. Ultimately, the sale and purchase agreement is the final binding document.
The NDA protects confidential information, the Term Sheet outlines commercial terms, and the Letter of Intent frames the transaction with deposits, price, and key obligations. Recognising red flags and carefully scrutinising terms such as valuation, tax, and indemnities is crucial for avoiding pitfalls.
