We explore how to structure earnouts for buyers and sellers in M&A and the use of performance metrics, earnout milestones & protection clauses in SPA.
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A purchase and sale agreement (or a sale and purchase agreement), including an asset purchase agreement (“APA”) or a share purchase agreement (“SPA”), is a key document in mergers and acquisitions (“M&A”). It sets out the terms of the deal and lays down the basis upon which the seller and the purchaser will proceed with the deal. In this article, we look at the different forms which an M&A transaction can take, examine the structure of an APA or SPA, and highlight some of the issues which a seller or a purchaser may wish to note in the negotiation and drafting process. Other articles in this multi-part series on M&A look at the role of a letter of intent ("LOI"), due diligence and representations and warranties. Readers who are contemplating an M&A deal and would like assistance in drafting or reviewing an APA, SPA or other M&A documents may contact our M&A lawyers.
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An M&A transaction can take the form of a share acquisition or an asset acquisition.
In a share acquisition, the purchaser may acquire control of the target company through purchasing the shares of the target company (or through other means, such as subscribing for new shares issued by the target company). To the extent that the purchaser owns the shares of the target, the purchaser will, in the absence of other agreed arrangements, indirectly own all the assets of the target and assume all the liabilities of the target, whether or not known to the purchaser.
In an asset acquisition, the purchaser acquires direct ownership of some or all of the assets, and directly assumes some or all of the liabilities of the target business. The purchaser has greater flexibility to decide what assets to include and what liabilities to exclude.
The decision as to whether to proceed by way of a share deal or an asset deal will depend on a number of factors including the following:
Ease of Obtaining Third Party Approvals - Transactions may be subject to approvals by third parties. For example, where a target is licensed by a regulatory authority, the license may not be capable of being transferred as part of an asset acquisition. In this case, a purchaser may have no choice but to acquire the target business by way of share acquisition, and accordingly, will have to comply with regulatory approvals which may be applicable to a change of control of the target company. Similarly, for example, in an asset acquisition, there may be substantial practical difficulties in arranging for the purchaser to assume liabilities of the target business as each creditor of the target business must consent to a change in the identity of the debtor. In contrast, in a share acquisition, consent of individual creditors is normally not required (unless specific change of control provisions have been previously agreed with an individual creditor).
Ease of Financing – A purchaser may have greater difficulty in arranging financing in a share acquisition due to company law restrictions on companies giving financial assistance for the acquisition of their shares. Asset transactions are not normally subject to statutory restrictions of this nature unless the assets comprise shares.
Tax Efficiency – The tax consequences of a share acquisition and an asset acquisition may be very different. Each of the purchaser and the seller will need to consider their own tax position and may have different preferences for whether to proceed by a share transaction or an asset transaction.
Once a deal structure has been determined, the parties will often prepare and negotiate a definitive purchase and sale agreement which, in turn, may include a number of ancillary M&A agreements and other documentation.
In an asset deal, the definitive purchase and sale agreement is normally an asset purchase agreement.
An asset purchase agreement (“APA”) is an agreement which sets out the terms and conditions upon which assets (i.e. the specific assets of a target business desired by the purchaser and in many cases, the business undertaking itself) will be sold by the seller and bought by the purchaser, and the respective rights and obligations of the parties against one another. An asset purchase agreement will often require the parties, on closing, to execute additional documents ancillary to the asset transfer. These ancillary APA documents may include:
a bill of sale to transfer ownership in tangible assets from the seller to the purchaser;
deeds of novation as well as assignment and assumption agreements to transfer contractual rights and obligations;
transition service agreements (“TSA”) or reverse transition service agreements (“reverse TSA”) to provide operational support for a specified period of time post-closing;
employment documentation to transfer employees of the target business to the purchaser as the new employer; and
non-compete agreements which normally restrict the ability of the seller to compete with the purchaser post-closing in the same line of business being sold.
In a share deal, the definitive purchase and sale agreement which the seller and the purchaser will typically enter into is the share purchase agreement (or securities purchase agreement).
A share purchase agreement (or securities purchase agreement, “SPA”) sets out the terms and conditions upon which some or all of the issued shares of a company will be transferred from the seller to the purchaser, and stipulates the rights and obligations of the seller and the purchaser respectively. A share purchase agreement will often require the parties to execute ancillary agreements and other documents either at the time of the signing of the SPA or upon completion of the transaction. These ancillary SPA documents may include:
guarantee agreements for a guarantor to guarantee the purchaser’s obligations (e.g. obligations to proceed to completion and pay the purchase price), or in some cases, for a guarantor to guarantee the seller’s obligations to provide indemnities to the purchaser post-completion;
a deed of tax indemnity for the seller to indemnify the purchaser in respect of specified tax liability of the target company arising before the completion date;
(in the case that the target is sold on a debt-free basis) a deed of release for an existing creditor of the target company (such as an affiliate of the seller) to discharge the target company from some or all of its obligations (e.g. to repay a debt) to the creditor upon completion of the transaction;
a shareholders’ agreement in the case of a transfer of part of the issued share capital of the target company; and
an instrument of transfer and, in the case of a sale and purchase of the shares of a Hong Kong company, a sold note and bought note to effect the transfer of legal and beneficial ownership of the shares of the target company.
The drafting of an asset purchase agreement or a share purchase agreement may commence during the due diligence process. The APA or the SPA will normally reflect the commercial terms set out in a letter of intent (“LOI”) and will take into account findings from the due diligence process.
The APA or the SPA will typically include:
representations and warranties from both parties, in particular from the seller concerning the target business (these are examined in our article entitled "M&A in Hong Kong: Due Diligence”)
pre-conditions to closing of the transaction;
pre and post-closing covenants by the seller and the purchaser respectively;
specific closing mechanics; and
Conditions precedent (or closing conditions) (“CPs”) in an M&A deal refer to conditions which must be fulfilled (or waived) before there is an obligation on one or more parties to complete the transaction. In other words, the non-satisfaction of a CP gives the seller or the purchaser (or both) a right to refuse to complete the deal.
CPs for Purchaser – The purchaser may, for example, wish to condition the transaction upon the financial position of the target company at the time of closing (e.g. by imposing a minimum net working capital level), or to require that all the seller’s representations and warranties as set out in the APA or the SPA remain true and accurate. On the other hand, the seller would normally wish to limit the number of CPs for the purchaser so as to limit the circumstances which would otherwise entitle the purchaser to refuse to close the deal.
CPs to Completion – Some CPs, such as regulatory consents, may apply to both the seller and the purchaser. For example, where a target company is regulated by the Securities and Futures Commission (“SFC”) (e.g. a licensed corporation), completion of the deal may be subject to obtaining substantial shareholder approval under the Securities and Futures Ordinance (“SFO”). Similarly, where a target company is regulated by the Insurance Authority (“IA”) (e.g. an insurance company, a licensed insurance agent or a licensed insurance broker), completion of the transaction may be subject to change of control or other regulatory requirements under the Insurance Ordinance (“IO”). For details, please see our financial institutions M&A practice.
Pre-completion covenants (or pre-completion undertakings) are obligations which one party undertakes to perform during the interim period between the signing of the purchase and sale agreement and the closing date.
The purchaser is often concerned about the seller’s handling of the target assets or business during the interim period, and hence may wish to restrict the manner in which the seller carries on the target business, or the types of conduct which the seller may undertake during the interim period. For example, the seller may covenant with the purchaser not to create encumbrances (e.g. not to create a charge in favour of a third party creditor) over target assets or amend any material contracts during the interim period. Or, for example, in a share deal, the purchaser may request that the seller undertake not to issue any shares or to assume any material contingent liability during the interim period. Lawyers for the purchaser will help identify areas which potentially call for action by or restrictions on the seller, with a view to ensuring that at closing, the target business will not be materially different from what the purchaser has agreed to buy at the time of the signing of the purchase and sale agreement. On the other hand, lawyers for the seller will, for example, help negotiate limitations on any proposed restrictions with a view to preserving the seller’s ability to conduct the target business in ways it sees fit pre-closing given that there may be a risk that the purchase fails to go ahead and the risk of the business thus remains with the seller.
In contrast to pre-completion covenants, post-completion covenants (or post-completion undertakings) are obligations which are to be performed after closing has taken place. Common post-closing covenants may relate to a request by the seller that the target business change its name post-completion or to a request by the purchaser that the seller not compete with the target business post-completion.
Completion mechanisms (or closing mechanisms) are methodologies used for pricing an M&A deal. The two commonly used mechanisms are the completion accounts approach and the locked box approach.
Under a completion accounts approach, the parties will agree on an initial purchase price (which will normally reflect the value of the target business and due diligence findings) which will be payable on the closing date. This initial purchase price will, following closing, be adjusted for the purpose of calculating a true-up adjustment to reflect the actual value of the target as at the closing date. For example, a target may be sold on the basis that certain financial indicators (e.g. net working capital) as at closing meet a prescribed threshold, in which case the initial purchase price may be adjusted upward if the target’s net working capital on the closing date exceeds that threshold, and vice versa. For this purpose, the purchase and sale agreement will typically stipulate the timeframe and methodology for preparing the completion accounts post-closing, the timeframe for true-up payment, and in the event that the parties are unable to agree on the completion accounts, the mechanisms for resolving differences (e.g. whether the parties wish to appoint an independent third party accountant to determine any unresolved issues, and if so, the procedures and cost arrangements for such appointment). One benefit of adopting the completion accounts approach is that it provides some comfort to the parties that the actual purchase price will aim to truly represent the financial snapshot of the target on the closing date.
Under a locked box approach, the purchase price is determined with reference to the financial position of the target as shown in the target’s balance sheet (known as “locked box accounts”) and the purchase price is “locked” at the time of deal signing, on the basis that the seller will undertake not to take actions which would otherwise result in a “leakage” of value of the target during the period between the date of the locked box accounts and the closing date. One benefit of adopting the locked box approach is that it provides a higher degree of certainty on the purchase price and reduces post-closing overhead, in that because there will be no price adjustments or true-up post-closing, the parties will not have to incur time and costs preparing or negotiating any completion accounts post-closing. Under this approach, lawyers for the purchaser will, for example, help negotiate locked box representations to ensure the accuracy of the locked box accounts and to ensure that there will be no material changes in the financial position of the target prior to closing. On the other hand, lawyers for the seller will, for example, help negotiate exceptions (known as “permitted leakages”) to any proposed prohibitions to enable the seller to conduct the target business as it sees fit and take value out of the target within acceptable parameters.
In addition to the two mechanisms above, it is also common for parties to structure post-completion payments in the form of earnouts, where the purchaser may be required to pay additional sums to the seller based on the performance of the target business.
In other cases, such as in an asset deal involving the sale and purchase of a book of business, payment of the purchase price may be staged and be determined by reference to actual business performance, such as the amount of revenue actually generated or received post-closing.
Restrictive covenants (or non-compete clauses) are provisions which restrict the ability of one party to engage in business activities in competition with the other party. In the context of an M&A transaction, restrictive covenants often restrict the ability of the seller (and its affiliates) to engage in the same business as the target, to have economic interests in similar businesses, or to solicit any employees, customers or suppliers of the target post-closing.
The enforceability of restrictive covenants will depend on specific facts to determine, for example, whether there exist legitimate business interests to protect, and whether the proposed restraint is no more than is reasonably necessary to protect those interests. Factors which will need to be considered include the nature of the target business, its operations and client base, and whether the proposed scope, duration and geographical restrictions are reasonable in the circumstance.
An APA or SPA will normally be accompanied by a disclosure letter or a disclosure schedule prepared by the seller’s lawyers. The disclosure letter will qualify representations and warranties made in the sale and purchase agreement, thereby limiting the seller’s liability for any potential breach of such representations and warranties.
Once the APA or the SPA has been executed, as alluded to above, there will normally be a period of time to satisfy the conditions precedent to closing and to provide time for the parties to prepare for closing (e.g. to enable the purchaser to arrange funding).
Typically, conditions precedent must be satisfied prior to a long-stop date agreed in the APA or the SPA. If any conditions precedent have not been satisfied by that time, the APA or the SPA may give the purchaser or the seller, as the case may be, the option to terminate the agreement.
Depending on the terms of the APA or the SPA, upon termination, the parties may be released from certain obligations (e.g. obligations relating to closing) but some provisions, such as confidentiality and guarantee provisions, may survive termination. Depending on the circumstance and the drafting of the agreement, there may be a return or forfeiture of the deposit payment upon termination.
On closing, the purchaser will normally pay the purchase price. The parties will exchange documents (often referred to as completion deliverables), including the ancillary agreements and other documents discussed above, board resolutions authorizing the transactions, and in some cases, evidence of regulatory clearances, shareholder approvals and third party consents (e.g. waiver of pre-emption rights) to evidence the satisfaction of conditions precedent.
We explore how to structure earnouts for buyers and sellers in M&A and the use of performance metrics, earnout milestones & protection clauses in SPA.
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