A Practical Guide to Private Equity Transactions
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67
The deal documents
any leases, licences or similar documentation that may be required concern-•
ing any properties;
any relevant consents, authorisations, powers of attorney or similar docu-•
ments; and
all appropriate board minutes, resolutions of shareholders, and letters of •
appointment or resignation from ofce as director, secretary or auditors,
together with relevant Companies House forms.
4.2 The equity documents
The documents which are entered into between the investors, the managers
and the relevant Newcos are usually referred to as the equity documents. These
will include:
the investment agreement setting out the terms on which the investors •
agree to invest, and various obligations on the Newco companies and the
managers;
the articles of association of Topco, which set out the different rights attached •
to the shares held by the managers and the investors;
a disclosure letter from the managers (and often Topco) to the investors, set-•
ting out matters qualifying the separate warranties given to the investors by
those parties in the investment agreement;
the loan note instrument(s) to be entered into constituting the loan notes to •
be issued to the investor(s), and any relevant managers or sellers as may be
applicable;
the service agreements to be entered into by each of the managers and Topco •
(or the relevant company in the group employing such managers);
declarations given by the managers to the investors as to their personal cir-•
cumstances, employment history and similar matters;
resolutions, board minutes and Companies House forms dealing with the •
incorporation of each relevant Newco, including the appropriate structuring
of the share capital of Topco and adoption by Topco of the relevant articles
of association; and
any ‘ip up’ documentation that may be necessary, as referred to in • section
3.5 above.
4.3 The debt documents
The debt documents (also often referred to as the banking documents) set out
the terms on which any debt funding is to be provided to the acquiring Newco
group, for example:
the facilities agreement(s) with the relevant bank funder(s) setting out the •
terms of any term loan, working capital and other facilities;
where applicable, a mezzanine facilities agreement together with any accom-•
panying share warrant instrument and certicate(s);
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Transaction structures and deal documents
the intercreditor agreement and/or deed(s) of priority, setting out the appro-•
priate subordination of the various debt instruments;
debentures and related cross-guarantees giving all secured lenders the rele-•
vant security;
such documentation as may be necessary for the capitalisation of any intra-•
group debt, together with an appropriate intra-group loan agreement to gov-
ern the ongoing loan accounts between members of the Newco group;
fees letters setting out the various fees payable to the bank lenders;•
any accession documents or side letters as may be necessary to deal with any •
syndication of debt; and
board minutes and shareholder resolutions of each member of the Newco •
group approving the entering into of the various banking documents.
Chapters 4, 5 and 6 outline the nature and content, and key points for nego-
tiation, on each category of documents in turn.
5 Conclusion
Whilst there may be particular issues on any transaction necessitating a spe-
cic structuring requirement, there are equally some common considerations
which are relatively simple for a legal practitioner to follow once the basic
principles and objectives of the parties are understood. As we have seen, the
instruments held by each party are derived from a particular perspective on
risk and return.
More complex structures involving the incorporation of a number of new
companies are also fairly commonplace. Ideally, the exercise of nalising the
deal structure should be undertaken, comprehensively, at the outset of a trans-
action. It can be particularly frustrating, in the pressured environment leading
to a legal completion, to nd that the full suite of deal documentation requires
amendment to accommodate one or more additional companies within a struc-
ture, especially where this is to address a requirement that could have been
identied at an early stage. Signicantly, this will also often need to be settled
as quickly as possible in order to ensure that any relevant tax clearance appli-
cations are sufciently accurate to be reliable.
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4
Acquisition issues
1 Introduction
In this chapter, we will examine the issues that typically arise in relation
to the acquisition documentation on a UK management buyout. As has
already been explained, there is more to a management buyout than simply
the acquisition. The whole exercise requires considerable project manage-
ment, combining the acquisition process with the funding elements of the
transaction, both equity and banking, which are explored in the chapters
that follow. The issue is further complicated in a secondary transaction (see
chapter 12), where some of the sellers are also part of the buyer team.
We will concentrate on the issues that arise on the acquisition of a pri-
vate limited company in the UK. Whilst buyouts may be structured such that
the assets of Target are acquired rather than the share capital, such instances
are relatively rare (other than in distressed or insolvency situations, which are
outside the scope of this book), so a share acquisition is assumed. The key
contractual document that regulates the terms for the sale and purchase of
Target is the acquisition agreement, and much of this chapter highlights the
issues arising in the drafting and negotiation of that document which are dif-
ferent as a result of the transaction being a buyout rather than a sale from one
trading company to another. This chapter is not intended to be a complete
or exhaustive manual on the issues that arise on the acquisition of a private
company; whilst it does set out some of the features of a typical deal, the focus
is very much on those specic considerations which arise in a private-equity-
backed transaction.
In addition to the acquisition agreement, this chapter will examine the
important role of the tax covenant in share purchase transactions, and the
competition law issues that can arise with a private-equity-backed buyer.
The particular issues that arise on the acquisition of a publicly traded
company via a public-to-private transaction are considered separately in
chapter 10.
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Acquisition issues
2 The acquisition agreement
2.1 Parties
The parties to the acquisition agreement will usually be limited to the seller(s)
and the buyer. In the context of a private-equity-backed transaction, the buyer
will invariably be a new company incorporated specically for the purpose,
and, where a group of new companies is established for structural reasons, the
buyer will typically be the lowest in the hierarchy in that structure.
1
In certain situations, other parties may also join in to the acquisition agree-
ment. These situations may include:
(a) Guarantors. If the seller is, for example, an intermediate holding com-
pany in a group of companies, it is likely that the ultimate parent company
may also be asked to enter into the acquisition agreement as a guarantor
of the seller’s obligations (or, at least, of certain key obligations) in the
document. Similarly, the beneciaries of any trust selling shares may be
required to act as guarantors. It is possible that a guarantor may also be
required to enter into other contractual provisions directly in addition to
guaranteeing the obligations of the relevant seller (for example, a parent
company in relation to restrictive covenants
2
).
(b) Target itself. Although rare, there are sometimes situations in which it is
appropriate for the Target to join into the transaction. This is often sug-
gested so that Target may be contractually obliged to satisfy particular
obligations. Examples include the discharge by Target of existing debt
on completion, whether to the seller or to external funders.
Traditionally, Target, being a party to the agreement, or otherwise entering
into contractual obligations on its own behalf at the time of the acquisition
of its shares, tended to raise alarm bells (at least for lawyers) due to the pro-
hibition on Target giving nancial assistance in respect of the acquisition of
its own shares under what was then the regime set out in sections 151–158 of
the Companies Act 1985. Since 1 October 2008, the prohibitions on nancial
assistance (now found in section 678 of the Companies Act 2006) relate only
to public limited companies. Accordingly, in many transactions, the risks of
nancial assistance no longer arise. It is important, however, to bear in mind
that there can be other legal issues arising as a result of Target being a party to
the acquisition agreement or otherwise undertaking certain actions at the time
of the sale. For example, it is important to consider whether there is a corporate
benet to Target itself of entering into the arrangements, or whether the dis-
charge of any such obligation or the making of payments for the benet of its
shareholders might be interpreted as a distribution that may be unlawful. As
a result, most practitioners still avoid Target being a party to such obligations
1 For further details on the structuring of transactions, see chapter 3.
2 For restrictive covenants, see section 2.10 below.
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The acquisition agreement
where possible, instead relying on the respective obligations of the buyer and
the seller(s) to procure that Target will perform the relevant action.
It should also be noted that every public limited company is subject to the
continuing nancial assistance regime – not just a public company which is the
ultimate parent company in a particular group, or whose shares are traded in
the public markets. Where the Target is such a ‘vanity’ public company (i.e. a
public company whose shares are not publicly traded, and which does not have
any other legal justication for being a plc), the Takeover Code will neverthe-
less still apply on the acquisition of its shares. Accordingly, there may well
be situations in which there is a desire to re-register such a public company
Target as a private company as part of the transaction, with the resultant need
(after discussion with the Takeover Panel) to obtain a waiver from the relevant
shareholders to recognise that the provisions of the Takeover Code will not
apply once it is no longer a plc.
2.2 Price and price adjustment
The price payable will be debated in some detail during the initial negotiation
of any offer letter or heads of terms. This debate not only concerns the amount
of the consideration, but also will usually extend to the form of the considera-
tion (i.e. whether the price is to be satised entirely in cash, or whether all or
part of the consideration will be in non-cash form), and any mechanism for
adjusting the price. Part of the price may be satised by the issuing of loan
notes in the buyer (usually bank guaranteed) or, in some cases, shares in the
buyer, for example.
3
In this section, we will consider some of the pricing issues that are regu-
larly encountered on private equity deals.
(a) Completion accounts
Buyers will regularly state that any offer made is on an assumption that Target
is cash and debt free, and has a normalised level of working capital. Completion
accounts are often used to test the level of cash and debt, working capital or
net assets (or such other key balance sheet measure as may be relevant for
the business concerned) as at completion of the transaction. This is a mecha-
nism which allows buyers to check the actual state of the business at the time
of purchase by carrying out an accounting exercise in a brief period of time
following completion, and to adjust the price (usually on a pound-for-pound
basis) if the level of net assets (or such other measure as is relevant) delivered
at completion is found to be below the specied target level, or to be more than
an agreed tolerance below that level. Sometimes, the mechanism will be an
either-way mechanism, with the price also increasing if the net assets (or other
relevant measure) transpires to be higher than expected.
3 In these cases, certain of the issues outlined in chapter 12 for a secondary buyout may be
equally relevant to a non-manager seller taking an ongoing stake in the buyer.
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Acquisition issues
Completion accounts mechanisms can be complex in their drafting – par-
ticularly where the mechanism seeks to spell out in detail the precise practices,
policies and principles to be used, and the procedure to be followed in the
event of any dispute. The starting-point is usually the practices, policies and
principles adopted by the Target in its last statutory accounts, but this may
be challenged by the buyer, for example if there has been a change in law or
accounting practice since then, or if the buyer has identied an issue from due
diligence which suggests another treatment is appropriate. A common com-
promise is to include the detail of the policies in a schedule (in so far as they
can be agreed and documented), and then provide that last accounting policies
may be followed (where no express provision is stated) so long as these are
compliant with generally accepted accounting practice. This can remove the
scope for doubt or disagreement after the event, although it requires a com-
prehensive and co-ordinated approach by the legal and accounting advisers on
both sides, to ensure that the mechanism does not produce an outcome adverse
to their respective client’s expectations.
In the event that there is more than one seller, the question of how any
reduction to the price arising from the completion accounts mechanism should
be apportioned between them may arise. In many cases, this will simply be
a reduction in proportion to their entitlement to receive the headline consid-
eration – which is usually the more equitable approach. However, there may
be sensitivities for some sellers – as noted in chapter 13, this is particularly
the case where one or more of the sellers are private equity investors without
a detailed knowledge of the business and its affairs on a day-to-day basis.
4
Similarly, it is worth noting that some sellers can be particularly sensitive to
agreeing to a completion accounts mechanism in a management buyout, on the
basis that the managers may well be better placed to know that there are issues
which may ultimately favour the buyer by leading to a reduction in the head-
line price agreed. As the management team for the seller(s) before completion
will become the management team for the buyer after completion, the seller(s)
may be less able actively to participate in and oversee the exercise of prepar-
ing the completion accounts (although a completion accounts mechanism will
invariably give the seller(s) an opportunity to review and object to the buyer’s
draft accounts, with any issues that cannot be resolved directly between them
being referred to an independent accountant).
The questions of whether there should be any cap on the potential price
adjustment pursuant to the completion accounts exercise, whether the adjust-
ment should operate on an either-way basis or a downwards-only basis, and
whether there should be any tolerance (in the form of an agreed de minimis)
around the relevant accounting target before any price adjustment is triggered
will all be subject to negotiation on a deal-by-deal basis. Generally, this will
depend on the relevant bargaining strengths of the parties in negotiation,
4 See chapter 13, section 3.4.
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The acquisition agreement
although the underlying business and commercial drivers for the exercise will
also be relevant. For example, where a completion accounts mechanism is sug-
gested because the seller(s) have expressed extreme condence in delivering
the proposed balance sheet target, and the buyer is only prepared to pay an
agreed price on that basis, this is far more likely to lead to a downward-only
adjustment; in contrast, where both parties are of the view that the uctuations
in working capital are such that they are difcult to measure on a day-to-day
basis, so that an adjustment mechanism is needed to protect both parties, then
an either-way mechanism is more reasonable.
As the completion accounts mechanism is expected to lead to an adjust-
ment to the price in a reasonably short timescale (usually between one and
three months), this is often supported by a retention from the purchase price
(see further section 2.4 below).
(b) Locked box mechanism
A locked box mechanism is sometimes used as an alternative to completion
accounts. Here, the buyer investigates the nancial affairs of Target and is per-
suaded to be comfortable on the net asset position (or other nancial yardstick)
as at a date before completion of the acquisition, and the sellers effectively prom-
ise that they have not received any payment or otherwise extracted value from
Target since that date except for permitted payments (such as salary in the case
of managers, or interest on loan notes in the case of investors). This exposes the
buyer to the general risks of trading since the agreed earlier date (as no comple-
tion accounts are prepared), but protects it against value extraction by the sellers.
Sellers normally give a several commitment, so that each is only liable for the
value which that particular seller has received that was not a permitted payment.
A locked box mechanism is, generally speaking, more attractive than com-
pletion accounts to the sellers because each seller knows that, provided it has
not had any payment except for a permitted payment (as dened in the agree-
ment), there will be no adjustment to the price. This gives certainty, saves cost
and delay, and maximises the ability of any investor seller(s) to return proceeds
promptly and fully to clients. As noted above, however, a completion accounts
process may still be preferred by the sellers if the net asset or working capital
uctuations are such that there may be additional value generated for which
the sellers would not be compensated under a locked box arrangement.
Locked box mechanisms were particularly common in the auction and
other seller-led processes which typied the seller-friendly markets of 2006
and 2007 in the UK. The shift in bargaining power towards buyers since then,
and a greater caution on the part of buyers as a result of general market uncer-
tainty, may well lead to a return to more traditional completion accounts.
(c) Earnouts and similar arrangements
Deals sometimes include an earnout mechanism, where part of the price is to
be determined by a future event (for example, the prots achieved by Target
74
Acquisition issues
in a future period, or the gain on the disposal of some asset within Target).
Earnouts can be complex, especially in a sale to a private-equity-backed busi-
ness given the different roles of the management team in the deal. If the trans-
action is a secondary buyout for example, management have an interest in the
outcome of the earnout as sellers, as ofcers of Target going forward, and
potentially as shareholders in the buyer.
Where a seller agrees to an earnout, such seller will usually want some con-
tractual protection in relation to how Target is to be run, and how the outcome
of the earnout is to be measured and paid. This often extends to a detailed
schedule of matters that cannot be implemented by the Target group without
the consent of the seller(s) for fear that this might distort the amount of the ear-
nout payment, for example by entering into contracts or incurring signicant
expenditure outside the ordinary course of business. The extensive controls
which the funders of a buyout will require under the equity and senior debt
documents, as outlined in chapters 5 and 6 respectively, can conict with the
earnout protections that a seller requires. The gearing and other costs resulting
from the buyout itself can also complicate the measuring of the earnout pay-
ment, necessitating detailed accounting advice in order to agree the relevant
earnout formula.
The additional amount payable under an earnout mechanism will generally
be capped on a private equity transaction, as the buyer’s funders will want to
know that the funding they are arranging for the buyer will be sufcient to dis-
charge that liability if it matures. Also, the time period for the earnout would
normally be no longer than, say, two or three years. This is because the ulti-
mate exit of the investment will be easier if the earnout is resolved before that
exit. A seller should also consider how best to protect itself if the exit happens
sooner, and what effect (if any) this should have on the earnout itself.
One key issue for a seller would be security for the payment of any earnout
consideration, especially if the buyer will be highly geared. The protections
typically sought by a buyer in order to address security for any unexpected lia-
bilities in the other direction (such as a retention: see section 2.4 below) would
be rare here – the funders to the buyer would not normally be able to tie up
their cash resources by funding such retention. However, guarantees from a
bank or even security over Target (or the shares in Target) ranking behind that
of the secured bank funder(s) could be considered. Practice varies, however,
and in many situations the earnout consideration is simply left as an unsecured
liability payable by Newco. Similar situations can sometimes arise when a price
adjustment is ‘unwound’ – for example, if the seller has agreed a price adjust-
ment because of a particular issue (for example, a suspected tax liability in
the Target not provided for), and subsequent events show that the issue did not
materialise or resulted in a lower cost to Target than that which was expected.
Often, a seller will have negotiated to recover part of the adjustment in these
circumstances. Security is less of an issue here, however, as it is more likely that
a retention will be used to secure the monies funded by the price adjustment.
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The acquisition agreement
2.3 Other risk allocation during negotiation
As was highlighted in chapter 2, the price set out in the original heads of
agreement or offer letter is often revisited during the transaction process, most
usually as a result of adverse ndings from the extensive due diligence proc-
esses.
5
It is not uncommon for due diligence to identify areas of difculty or
concern in the Target or its business (for example, potential litigation, pensions
or tax issues, or material capital or other expenditure required to satisfy par-
ticular regulatory requirements). Generally, when these matters can be clearly
quantied, they will lead to a price negotiation.
The extent to which the parties will agree a price reduction depends, among
other factors, on their relative bargaining power. In a more buyer-friendly mar-
ket (such as has prevailed in the UK as a consequence of the credit crunch and
the resulting difcult economic climate), a buyer is likely to be in a stronger
position to agree a price reduction in its favour to reect any issues identied
during due diligence. In contrast, in a seller-friendly market with signicant
competitive tension for an asset (as was typical in the two years leading up to
the credit crunch), a seller might be in a position to resist any reduction to the
initial headline offer. Some sellers can become emotionally attached to the
headline price stated in the heads of terms or offer letter, and in their own
minds may feel that they are already entitled to it. Where there are potentially
many competing buyers, this emotion can sometimes be justied. However,
in a market where buyers are few and funding is tight, too much addiction to
the headline price can prove to be counter-productive. This is particularly the
case where the problem identied is something real and material of which the
seller was not already aware. If the reality of the situation is that the seller must
either agree a price reduction or walk away from the sale, the seller should
remember that a decision not to sell does not solve the problem. If there is a
genuine issue in Target, then the seller will face the issue of addressing that
problem in any event, even if the particular sale does not proceed at that time.
Accordingly, in some situations, a seller can often be persuaded to accept a
price reduction for an identied and quantiable problem.
Sometimes, the issue cannot be quantied in a way which allows the impli-
cations to be fully or accurately reected in the price. For example, in the event
that Target is subject to actual or threatened litigation, there will be a risk that
a particular claim will succeed, but it is often not practicable to measure the
extent of that risk, or to identify the monetary amount involved. In other situ-
ations (for example, the risk of a pension shortfall), the matter may well be
ascertainable and quantiable in theory, but the timescale for calculation of
the relevant monetary amounts before signature would protract the sale nego-
tiation for many months (and cause the gure to be out of date even when it
has been determined). In these situations, the parties may agree a compromise
5 See further chapter 2, section 4.
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Acquisition issues
price adjustment such that there is a one-off reduction in the price to reect any
agreed quantication of the risk. If such an agreement can be reached, then
the simplicity is attractive, although it is important that the seller(s) review
the acquisition agreement carefully to ensure that such adjustment is not ‘dou-
ble counted’ as a result of any warranties, indemnities or price-adjustment
mechanism. In many situations, such an agreement cannot be reached due
to the uncertainty of the particular situation, and in that case some form of
wait-and-see approach, or risk allocation, will be agreed. For example, the
seller(s) may agree to indemnify the buyer for any liabilities arising as a result
of the issue, but only once the liabilities have been incurred and are quantied.
Alternatively, the parties may agree each to make a contribution towards such
liabilities, or to pay only within certain cost bands, such that the seller under-
writes only part of the exposure.
The precise solution will depend on the nature of the issue concerned.
The question of how any relevant litigation or disputes will be conducted also
arises; as a party agreeing to indemnify the other for losses suffered will wish
to ensure that appropriate steps are taken to mitigate such losses.
6
2.4 Retention accounts
Where any of these price adjustment mechanisms require a party to make a
payment to the other after completion, there is credit and security risk for the
recipient party. The same point arises for claims under the warranties and
tax covenant, or claims under any indemnity or other specic risk-allocation
mechanism. The fact that there may well be a valid contractual claim against
a seller some months (or possibly years) later is of little comfort if by then
such seller cannot be found, or the consideration received has been spent.
Accordingly, where there is a signicant likelihood that the sellers could be
required to make a monetary payment at a later date, the buyer will usually
require some form of security.
One possible solution would be for the buyer to defer part of the price, such
that it becomes payable only on the occurrence of a specied later event (or the
date when it is clear that the liability concerned will have passed), and subject
to an adjustment to take into account any liability suffered as a result of the
matter concerned. However, this, in turn, exposes the seller(s) to the risk that
the buyer may not be good for the balance once it is nally due and payable.
A typical compromise, therefore, is that some of the purchase price is placed
into a blocked retention or escrow account held between the respective lawyers
to the parties, or by an independent escrow agent service. This is designed to
protect either party against any insolvency or similar risk on the part of the
other once the mechanism unwinds and the monies become payable.
6 For limitations generally, see section 2.9 below.