How to successfully exit a business – Part 1
Helen Gerrard and Alex McPherson recently led an interesting discussion on key legal considerations for business exit planning. Here, in the first of our two blogs regarding this session we note some key highlights, focusing on the differences between assets and share sales and common types of consideration.
Asset sales vs. share sales
Terms such as “mergers”, “assets”, “business sales” and “share sales” are often bounded around and used interchangeably, which can lead to some confusion. For example, businesses sometimes refer to “mergers”, when they’re actually committing to a “share for share exchange” (which involves the exiting company becoming a distinct subsidiary within the buyer’s group of companies, rather than being subsumed into the buyer’s corporate entity). However, a business exit will ultimately take place in one of two ways: by way of an asset sale or a share sale.
An asset sale involves selling some or all of the assets of a business. From a buyer’s perspective, this ability to “cherry pick” assets can be a real positive, as it will only be paying for (and potentially taking on liabilities relating to) the assets it really wants.
A share sale involves selling some or all of the business’ shares (or exchanging some or all of its shares for shares in the buyer’s business). This can be simpler in the sense that the buyer can acquire full control. However, the buyer also takes on any potential liabilities, which can require a more complex and time consuming (and therefore more costly) due diligence exercise. Plus, if the target’s shareholders aren’t on board, a share sale may not be a viable option (although drag-along and tag-along provisions might help if a majority are in favour, provided these provisions exist in the target’s articles of association or shareholders’ agreement).
As a tip, it’s key to ensure that your capitalisation table is kept up to date from the outset, as deals can collapse if there is uncertainty as to the ownership structure of a target company.
Cash on completion
“Consideration” refers to the benefit that flows between the parties to a deal. The most straightforward consideration payable in exchange for a business is cash on completion of the acquisition. However, things are often not so simple.
Sometimes buyers seek to defer paying a portion of the consideration, meaning they pay part of the cash on completion, and part on a pre-agreed future date (this can sometimes be a year or more down the line). This is especially the case where the timeframe is tight and the buyer perhaps lacks sufficient time to carry out in-depth due diligence.
Completion accounts and locked box accounts
Completion accounts and locked box accounts are mechanisms used to agree the consideration payable on a future date, based on the target’s financial circumstances at a pre-agreed point in time.
The completion accounts mechanism bases the price on a set of accounts that are drawn up to reflect the target’s financial circumstances on the day on which the deal completes. A Sale and Purchase Agreement (“SPA”) will usually set out precisely how these accounts will be drawn up at the time (i.e. what will be included/excluded for the purposes of determining the valuation).
The locked box accounts mechanism bases the price on the company’s balance sheet on a specified date prior to completion. As this date falls before completion, it gives the parties more certainty as to the price. However, from the buyer’s perspective, there’s a risk that the seller will allow cash to “leak out of” the business after the date on which these accounts are drawn up, meaning by the time the buyer actually takes control of the target, it could be worth less (e.g. if the seller pays a series of dividends during that interim period). This risk often leads to the negotiation of various provisions designed to control how the target can spend cash between the locked box accounts date and completion.
An “earnout” is a provision that entitles the seller to additional consideration once the deal closes. The level of consideration will depend on how the target continues to perform post-completion (the level of the earnout is usually tied to specific revenue or profit targets).
Earnouts are very common in earlier stage exists, where the founders are expected to remain with the target (or the buyer’s wider business) for a period of time post-completion. This is because an earnout mechanism tends to align founders’ interests with those of the buyer (as their personal compensation will be tied to the target’s subsequent success).
This type of consideration involves the seller trading some or all of the target’s shares for shares in the buyer’s business (note that deals often involve buyers paying sellers with a combination of cash and shares as part of the consideration). If the target’s founders are exiting, but continuing to work with the newly combined business post-completion, share-for-share consideration can help to ensure that those founders’ interests are aligned with the buyer’s.
In Part 2 of this session, we cover Due Diligence, the Deal Cycle and Completion Steps.
Founding Partner Alex McPherson graduated from Oxford University in 2003, and gained many years of broad legal experience at leading law firms Freshfields Bruckhaus Deringer and Hogan Lovells, including client secondments at Tesco, ExxonMobil and Goldman Sachs.
He set up Ignition Law in 2015, now a high-growth full-service law firm, which has worked with many thousands of start-ups, scale-ups and entrepreneurial clients, to provide pragmatic and cost-effective legal services in a community-minded and ethical way.
Partner Helen Gerrard has many years’ experience working on corporate and finance transactions and restructurings.
Prior to joining Ignition in 2016, Helen worked at Magic Circle firm Freshfields Bruckhaus Deringer for many years – in both London and New York – as well as at O’Melveny & Myers LLP in New York and Linklaters in London. She has also undertaken secondments to Goldman Sachs, Alcentra, Barings, Barclays Bank PLC and The Bank of Tokyo-Mitsubishi Ltd.
Helen acts for both borrowers and lenders in various industries, advising on all aspects of corporate lending and restructuring. Her extensive experience includes syndicated and bilateral facilities, real estate and acquisition finance and shareholder/director funding, as well as many large scale restructurings (acting for companies in distress or advising the coordinating committee of lenders).
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