Mergers and acquisitions : law and finance [Second edition.] 9781925672909, 1925672905

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Preface Mergers and Acquisitions is a plain English reference guide for mergers and acquisitions and buyouts with step-by-step advice on the key legal, tax and structuring issues when implementing transactions. It is a comprehensive guide intended to assist professionals, investors, management teams and advisers and it gives detailed and up-to-date information on each stage of the deal and related areas. There are chapters on term sheets, shareholder arrangements, debt financing and due diligence. The book also considers the best approach to ensuring success in various specific deal types, including initial public offerings, employee share option plans, investing in rollups and distressed acquisitions. In each case the benefits and risks are considered and industry statistics included. The book is primarily focused on acquisitions and sales of private companies but also includes a chapter on public company takeovers. The useful checklists, definitions, case studies and examples all contribute to making this an essential addition to the bookshelves of all those involved in acquisitions, divestments and private equity. Thoroughly researched and extensively verified, Mergers and Acquisitions has been reviewed by a panel of industry experts, including some of Australia’s best-known lawyers, investors, bankers and corporate advisers.

Nick Humphrey August 2018

Wolters Kluwer Acknowledgments Wolters Kluwer wishes to thank the following who contributed to and supported this publication: Regional Director, Commercial Markets: Lauren Ma Head of Legal Content: Carol Louw Content Coordinator: Nathan Grice Editor: Dr Keith Lupton Cover Designer: Jessica Crocker

About the Author and Contributors About the Author Nick Humphrey is the Managing Partner of Hamilton Locke, a corporate law firm specialising in complex corporate finance transactions, including mergers and acquisitions, private equity, distressed investing and special situations, capital markets and alternative financing. Nick has worked in leading corporate groups throughout his distinguished career, including Mallesons Stephen Jaques and Norton Rose in Sydney, and the private equity group at Clifford Chance in London. He was also Global Co-Head of M&A at K&L Gates. He is the Chairman of Emerson Corporate Legal Operations, which provides company secretarial and compliance services. He works with some of Australia’s leading private equity investors, including Macquarie Bank, Mercury Capital, Pemba Capital, The Growth Fund, Quadrant Private Equity and CHAMP Ventures, as well as advising on a broad range of complex corporate transactions. Nick focuses on partnering with institutions and private equity funds

(and their portfolios) and is very experienced in negotiating large and complex acquisitions, divestments and investments, including structuring share sales, negotiating shareholder and subscription agreements and conducting due diligence investigations. He has acted on some significant mid-market deals including the sale of Gloria Jeans, Macquarie Bank’s investment into 3P Learning (Mathletics), the buyout of Mac Pac, the sale of Diona Engineering and CHAMP Ventures buyout of Lorna Jane. Nick is also the chairman of the Australian Growth Company Awards, a program launched in 2012 to recognise innovation, sustainability and integrity. The Awards are run in partnership with Deloitte, NAB Health, Macquarie Bank, GlobalX, Intralinks and 2020 Exchange. Nick is also the author of a number of best-selling books on business, law and leadership including Maverick Executive: Strategies for Driving Clarity, Effectiveness and Focus; Penguin Small Business Guide and The Business Startup Guide. He has published numerous articles on private equity and M&A in the Australian Private Equity and Venture Capital Journal (AVCJ). He is regularly asked to provide commentary on private equity to the media, including the Australian Financial Review, Sydney Morning Herald, Financial Times and Wall Street Journal. He attended the strategy and Leadership Programme at Harvard Law School. Nick is a member of the Institute of Company Directors (fellow), American Bar Association (Private Equity Committee) and Financial Services Institute of Australasia (FINSIA). He has been recognised by several influential awards and surveys as one of Australia’s leading corporate lawyers. Among these are Chambers Asia – Private Equity, Best Lawyer – Private Equity, Best Lawyer – Venture Capital, Doyles – recommended for M&A, Legal500 – ranked for M&A, Dealmaker of the Year and ACQ Australian M&A Team of year. Contributors Chapter 15: Structuring Issues when Exiting Through an IPO,

Hal Lloyd is the co-founder and a partner at Hamilton Locke with

Chapter 16: Structuring issues in takeovers and schemes, Chapter 20: Distressed Mergers and Acquisitions

focus on complex transactions that span M&A, buy-outs, capital markets and distressed or restructuring transactions. In addition to his expertise in traditional M&A and private equity transactions, Hal is one of the few corporate transactional lawyers in Australia with extensive experience structuring and executing distressed transactions. Hal has also practised in New York with a US based global law firm and is admitted to the New York Bar.

Chapter 9: Debt Finance, Chapter 20: Distressed Mergers and Acquisitions

Zina Edwards is a Partner at Hamilton Locke. Zina has extensive experience advising major trading and investment banks, syndicates, funds and public companies in relation to various high profile and complex financial turnarounds, restructurings and special situations. Zina has worked on a large number of distressed portfolio sale transactions in Australia and across Asia, acting for both purchasers and sellers. She also specialises in debt trading and alternative finance transactions and has acted for a wide range of funds and alternative capital providers. Zina previously worked in the restructuring, turnaround and insolvency team of Herbert Smith

Freehills in Sydney and has also worked in the London and Moscow office of Allen & Overy as part of the global restructuring group. Chapter 17: ESOP

Cristin McCoy is a Senior Associate at Hamilton Locke specialising in mergers and acquisitions and corporate transactions. Cristin has experience advising across a broad range of industries including retail, mining services, technology, manufacturing and financial services. Cristin works on a range of matters including acquisition and disposal of shares and assets, private equity transactions, venture capital investments and general corporate advisory work.

Chapter 14: Key Issues with Using W&I Insurance

Gordon McCann is a corporate transactional partner at Hamilton Locke, primarily involved in private treaty mergers and acquisitions in the Australian mid-market. Gordon has a broad practice ranging from private equity funds (Quadrant Private Equity and Mercury Capital) to blue chip corporates or founders. Gordon also has specific industry expertise in warranty and indemnity insurance having advised global insurance companies on hundreds of

insured M&A transactions. Chapter 1: Preliminary issues in M&A, Chapter 5: Due Diligence, Chapter 8: Equity Funding

Janelle Watts is the Corporate Development Manager at Hamilton Locke. Janelle is an experienced corporate and commercial lawyer, specialising in private M&A and venture capital. She has worked within large national and global firms, and prior to joining Hamilton Locke, worked in-house at Telstra, looking after the Telstra Ventures portfolio and muru-D (Telstra’s start up accelerator).

Chapter 18: Tax Issues, Chapter 15: Structuring Issues When Exiting Through an IPO, Chapter 17: ESOP

Betsy-Ann is a corporate and transactional tax partner at K&L Gates with deep experience in taxation issues associated with mergers and acquisitions, inbound and outbound investment, asset financing, cross border leasing and corporate and international tax.

Chapter 22: Competition Law: Merger Clearance in Australia

Ayman is a partner at K&L Gates advising clients on all aspects of antitrust/competition law as well as consumer law. He regularly advises on regulatory investigations by the Australian Competition & Consumer Commission (ACCC) and on all aspects of the Australian Consumer Law.

Chapter 9: Debt Finance,

Monty Loughlin, Lawyer,

Chapter 20: Distressed Mergers and Acquisitions

Hamilton Locke

Chapter 6: Introduction to Private Case study by Jeremy Samuel, Equity Managing Director, Anacacia Capital Chapter 14: Key Issues with Using W&I Insurance

Reviewed by Guy Miller, Director, Risk Capital Advisors.

Chapter 19: Establishing a PE Fund

Leo Quintana, Chief Legal Officer, Magellan Financial Group Limited

Chapter 19: Establishing a PE Fund

Liz Hastilow, Chief Legal Officer at Colonial First State Global Asset Management

Glossary

Based on the AVCAL glossary.

Thanks also to Renae DeVito, Executive Assistant to the Managing Partner at Hamilton Locke, Brent Delaney, Partner at Hamilton Locke, Gerald Seeto, Lawyer at Hamilton Locke, and Jessica Tang, Lawyer at Hamilton Locke, and Tara Gazzard, Lawyer at Hamilton Locke.

PART A — M&A PRELIMINARY ISSUES IN M&A Deciding on shares versus business purchase ¶1-010 Negotiating confidentiality undertakings

¶1-020

General issues in negotiating term sheets

¶1-030

Acquisition term sheet

¶1-040

Editorial information This chapter considers some of the issues to be resolved by the parties early in the transaction.

¶1-010 Deciding on shares versus business purchase Buyers will need to decide whether to acquire the shares in the company or to acquire the underlying assets and business. Buying the shares in a company involves not only buying the business of the company but also taking on all its debts and liabilities. The main factors to consider when deciding between buying the shares and buying the business are: • How much stamp duty or goods and services tax (GST) is payable? • Is warranty coverage adequate? • Will financial assistance issues be manageable? • What external consents are required?

• Will the process of offering new roles to employees be manageable? • Who are the existing shareholders, and what complexities may arise during a share sale? How much stamp duty or GST is payable? Buying shares generally incurs less stamp duty than buying assets. In general, shares can be transferred free of stamp duty in all states of Australia whereas the sale of assets may incur stamp duty of between 0.4% and 5.5% (depending on the state where the assets are located and the value of the assets). Note that purchases of shares in a company which owns land may be subject to a higher rate of duty. It is important to understand that the asset sale could also be subject to GST, unless the business is being sold as a “going concern”, and speaking to a qualified tax adviser about the potential stamp duty or GST payable in each transaction is recommended. Is warranty coverage adequate? The buyer will need to consider whether the warranty coverage provided by the seller is adequate. If the buyer is concerned about coverage, it should consider whether to buy the assets rather than the shares. In buying the shares, the buyer inherits all the liabilities in the company (such as unpaid taxes, contingent liabilities, unsettled litigation, environmental degradation claims, etc). A thorough due diligence will be useful in assessing the likelihood of undisclosed liabilities. However, where the risk of a claim is high (eg where the company has done some “creative” tax management or has been involved in high-risk activities such as asbestos disposal) the buyer may wish to err on the side of caution and buy assets rather than shares. It is worth noting that not all liabilities can be avoided by simply buying the assets (eg environmental liabilities can accrue to the occupier of the premises, not just the owner). Another option for obtaining stronger warranty coverage is to procure warranty and indemnity insurance. This is where an insurer provides a policy which covers any loss or claim arising from a breach of the

warranties or indemnities in the sale agreement. The premium will usually cost approximately 1% to 2% of the insured amount. This is covered in detail in Chapter 14 (Key Issues with Using W&I Insurance). Will financial assistance issues be manageable? A company is prohibited from providing financial assistance to a buyer of shares in itself or shares in its parent company. Financial assistance can be given in a variety of ways, not just simply the lending of money to the buyer, but also guaranteeing loans to the buyer’s financiers or granting the buyer’s financiers security, such as a fixed and floating charge. It could also be the payment of dividends at the time of sale (even if retained by the existing shareholders). The assistance can be provided before, during or even after the sale. The main exemption from this prohibition is where the majority of shareholders in the company (and any upstream Australian parent company) provide their consent to the assistance. The Australian Securities and Investment Commission (ASIC) must be notified at least 14 days before the assistance is to be provided. In deals where time is of the essence, the parties may not be able to wait for this pre-approval process (eg if the sale is highly confidential and a leak could be damaging to goodwill or if the target is in distress and needs urgent refinancing). Shareholder approval also may not be easily forthcoming if, for example: • the shareholders of the target are concerned about the high level of debt being used to acquire the company • the shareholders in the upstream parent company are widely spread, overseas or disgruntled, or • the ultimate parent is listed. In these circumstances, where the financial assistance approval process, known as a “whitewash”, proves to be too time-consuming or

difficult to obtain, the buyer might be forced to make an asset purchase. Alternatively, the financiers may have to wait until after completion to implement their security package. What external consents will be required? In a business purchase, it is important to review each of the key contracts between the target and third parties such as its contracts with its landlords, customers and suppliers. These contracts will typically require that the counterparty to the contract provide its consent before the contract is assigned to the new buyer. In particular: • Leases: These commonly require the prior written consent of the landlord before the lease can be assigned. In some businesses (such as retail chains) there may be a large number of leases. Some leases will require the new tenant to provide security for the lease in the form of bank guarantees, security deposits or a parent guarantee. This process will need to be managed efficiently in order to keep the deal timetable on track and minimise legal costs. • Government grants: Buyers should be careful to check any grants, permits, licences and subsidies to confirm whether there are any assignment restrictions. For example, a government grant may be repayable if there is a business sale. Similarly, a permit or licence may require notice or prior consent before the sale. If there are a large number of key contracts, the task of obtaining consent to assign the contracts to the new buyer might be prohibitively expensive and time-consuming. On the other hand, when buying shares, counterparty consents may not be required (as there is no actual change in the contracting party). During due diligence, care will need to be taken to confirm the material contracts do not have change of control provisions (which would still require consent). Will the process of offering new roles to employees be manageable? As with third party contracts, buying the business will require entering

into new contracts with all employees and any contractors. In contrast, when buying the company, those contracts remain in place (it is unusual to have a change of control in a service agreement, known as a golden parachute, but this should be verified in due diligence). Managing the process of drafting offers for a large workforce can be quite time-consuming and can also make it hard to keep the deal confidential (while waiting for the employees to consider, sign and return). Who are the existing shareholders, and what complexities may arise during a share sale? Buying shares requires all of the existing shareholders to agree to the terms of the sale, or otherwise be obliged to sell their shares pursuant to some other kind of contractual mechanism (such as a drag-along in the company’s shareholders agreement). If an appropriate contractual mechanism isn’t in place, and there are unsupportive, or a large number of shareholders whose agreement may be difficult to obtain, a share sale may be more difficult to complete.

¶1-020 Negotiating confidentiality undertakings It is common for a seller to require a buyer to enter into a confidentiality agreement or non-disclosure agreement (NDA). This will need to be signed and negotiated at an early stage of the deal and governs the use of confidential information made available to the buyer (which in the case of a private equity (PE) deal, is usually a new company formed to make the bid in the buyout (Newco) and the investor). Advisers (such as lawyers and accountants) tend to resist entering into direct confidentiality undertakings and, as such, the onus will be on management, the buyers and the Newco to ensure their advisers observe the confidentiality undertakings. Advisers will, of course, have professional liability to their clients for any loss arising from a breach on their part. The management team members are not usually asked to sign an NDA, as they are typically already bound by confidentiality covenants

in their service agreements. Some of the common features of NDAs follow. Disclosure: This prohibits the recipient from disclosing confidential information or using such information other than for the purpose of determining whether to proceed with the proposed deal and to facilitate transaction negotiations. It may also prohibit disclosure of the existence of discussions or negotiations between the parties. Recipients should consider negotiating some important exceptions to the general prohibition, including for information: • given to the recipient by a third party (that is not itself bound by a duty of confidentiality) • which comes into the “public domain” (other than due to a breach by the recipient) • that is developed by the recipient independently (without any use of the information supplied by the target) • that the recipient can demonstrate was already in its possession • which is otherwise required to be disclosed by law (eg Australian Securities Exchange (ASX) listing rules). Return or destruction: Most sellers require all confidential information to be returned if the deal does not proceed. The recipient should consider requesting permission to destroy the materials rather than return them. The seller may ask for a signed certificate to confirm that the information has been destroyed. Many recipients will request exceptions to this requirement, to allow information to be retained for legal compliance, or in respect of computer back-ups. Permitted disclosures: The recipients should check that they are allowed to provide copies of the confidential information to their legal, accounting or other advisers. In some cases, the NDA may also restrict which employees are allowed to access the information. Poaching: The recipient is restricted from poaching any of the target’s employees. These provisions are common where the recipient is a

trade buyer, but where the recipient is a PE house the risk is diminished. Consider negotiating exceptions: • where the recruitment occurs after a person has left the employ of the target (without enticement or encouragement from the recipient) and at least six or 12 months have expired, or • for employees who accept an offer of employment via a bona fide advertisement (such as in a newspaper or online). Indemnity: The agreement may include an indemnity in favour of the seller from any loss or claims arising as a result of a breach of the NDA. Many PE and other large corporate recipients will resist providing indemnities in an NDA. Associates: It may be drafted on the basis that the relevant parties ensure that their employees, advisers and other representatives observe the undertakings. Consequential loss: Recipients should consider including a clause which excludes consequential loss or indirect losses (such as loss of profit or opportunity) from its liability. Sunset: Another issue is whether any or all of the covenants in the agreement should terminate after a certain period of time. For example, the non-poach covenant could have a 12-month sunset provision or alternatively all the covenants could lapse after a reasonable period (eg two or three years). Sellers are less likely to give sunset provisions to trade buyers or where the information contains highly sensitive materials such as secret recipes or processes. Disclaimer: The NDA may also contain other provisions such as a disclaimer about the accuracy of information provided or a prohibition on contacting staff, customers or other stakeholders directly.

¶1-030 General issues in negotiating term sheets This section considers the key issues in negotiating term sheets. Once agreed, the term sheet governs the proposed transaction until such

time as the parties have negotiated the long-form legal agreements. The commentary on acquisition term sheets does not apply to listed public companies or companies with more than 50 shareholders. Buyers are strongly advised to seek appropriate legal advice on the implications of Chapter 6 of the Corporations Act on such proposals. Some issues which are common to all term sheets whether an acquisition term sheet discussed below or an equity investment term sheet discussed in Chapter 7 (Preliminary Issues in Private Equity Transactions), include: • What is a term sheet? • Short form versus long form? • Binding or non-binding? What is a term sheet? Term sheets are: • relatively short form documents in which the parties summarise the key terms of their proposed relationship • documents which, once signed, allow the parties to negotiate a formal legal agreement that sets out the detailed provisions of the deal • known by various names including heads of agreement, memorandums of understanding, letters of intent or non-binding indicative offers, and • useful for focusing the energy of the parties on the major issues early in the process, saving time and expense in drafting the formal agreements later. Advice from suitably qualified lawyers is important to ensure that all the relevant areas are covered, and no inadvertent concessions are made which could frustrate future negotiations. Short form versus long form?

The term sheet is intended to summarise the principal terms only and not set out every term and condition. A short-form term sheet is designed to establish the common intention of the parties to proceed with the transaction on several agreed metrics. It is important to ensure that negotiation of the term sheet does not become protracted or drawn-out. There is always the risk that the term sheet negotiation becomes a “dress rehearsal” for the main negotiation, thereby increasing costs and delaying the timetable (often at a time when due diligence has yet to be performed). On the other hand, a long-form document provides an opportunity to put forward some of the potentially more contentious issues (eg in the equity term sheet the good/bad leaver provisions or in the acquisition term sheet the warranty and indemnity limitation regime). By raising these issues at the outset, it minimises the risk that the other side feels ambushed later in negotiations. It may also allow for a streamlining of the negotiation and documentation process at the formal agreement stage. The key to the successful conclusion of a transaction starts with ensuring that the factors that might influence price or payment related terms are identified in the term sheet. For example, cash v shares, post-closing adjustment mechanisms, warranty and retention reserves, earn-outs and deferred payment. Binding or non-binding? In most cases, term sheets are stated to be “non-binding” or indicative and “subject to formal legal contracts”, the general intention being that the parties can walk away from the negotiations at any point. It is important to note that even if the term sheet is not legally binding, it will be considered a “gentleman’s agreement” and it will be difficult for a party to backtrack or raise significant new issues. It is worth considering whether certain parts of the term sheet should be legally binding (in particular, covenants with respect to costs, confidentiality, break fees, obligations to negotiate in good faith and exclusivity). In some deals, term sheets are expressed to be legally binding. This

would be the case where the parties need certainty that the deal is to proceed at an early stage (eg to avoid risk of leakage to staff or a key customer). To be binding however, the term sheet will need to contain a high degree of detail and certainty across almost all aspects of the transaction. The courts have sometimes held a term sheet or offer letter to be legally binding, and have forced the parties to proceed to consummate the deal (even where the deal has been disadvantageous to one of the parties). To minimise the risk of the term sheet being held binding, include words such as: “The parties have not entered into any agreement to negotiate definitive documents pursuant to this term sheet. Either party may at any time prior to execution of definitive documents propose different terms to those contained in this term sheet or terminate negotiations pursuant to this term sheet without any liability to the other party.” The term sheet may also form a binding “contract to negotiate” if it includes a provision requiring the parties to “negotiate legally binding contracts in good faith”. This does not mean the parties actually have to enter into definitive contracts but that a party could be in breach if it refuses to negotiate or fails to negotiate in good faith (eg raises uncommercial, onerous or non-customary terms).

¶1-040 Acquisition term sheet This term sheet sets out the key terms of the acquisition. It may be prepared by the buyer or the seller. If a seller is running a competitive sale process, it will usually prepare the term sheet. If a buyer wishes to make an unsolicited offer, then it will usually prepare the term sheet. It is preferable in PE deals for investors to use their own template, as they get the “power of the pen” and that way, there will be consistency in the terms of the acquisitions across their portfolio. Some of the key terms: Parties

The key parties to the transaction will usually be

the sellers of the target, the buyer (in a PE deal this will include the investor and potentially also the management team). It is important to consider carefully who should be a party to the term sheet: • If the sale is to be a purchase of shares, it is important to note that the target cannot bind the shareholders to sell their shares, so the buyer should ensure that the actual holders of all the shares are also parties to the term sheet. • In a PE deal, the Newco will not usually be a party to the term sheet as it will probably not yet be formed at this early stage. Obviously, Newco would be the buyer and a party to any definitive sale agreement. • If either the buyer or the seller is not an entity of substance (eg it is a nominee or merely a subsidiary of another holding company), then the upstream company or holding company may also be required to be a signatory. This may be to simply procure obligations on behalf of the buyer/seller or to guarantee the performance of the buyer/seller. • It is also important to consider who will be giving the warranties and other covenants (particularly the restraint of trade covenants). It may not just be the entity which holds the shares, it could be the individuals who control the relevant entity. Consider also whether directors of the target (who may not hold shares) should give covenants. Price

The price and any payment terms should be clearly set out, including: • the currency payments will be made in, if it is a cross-border deal

• whether any of the consideration will be paid in shares • details of any deferred consideration or earn-out • details of any purchase price adjustment mechanisms, such as completion accounts, and • whether any amounts are being paid into escrow, or otherwise being retained, and the proposed terms of their release. Assumptions

The underlying financial assumptions on which the price was prepared must be included. This typically refers to working capital levels, minimum revenues or earnings, whether it is cash or debtfree and the level of net assets.

Conditions precedent

Buyers will typically require a number of conditions precedent to be satisfied before the purchase will proceed, including: • finalisation of satisfactory due diligence • receipt of internal approvals and third party consents (such as those from landlords and material customers and suppliers) • regulatory approval (Foreign Investment Review Board (FIRB), Australian Competition and Consumer Commission (ACCC)) • no material adverse change (MAC). Sellers should consider what exclusions and carve-outs should be made to the MAC, and • consider industry specific requirements for industries such as alcohol and gaming, pharmaceuticals, mining, banking and financial services, healthcare, and aviation. Sellers will typically seek to have as few

conditions as possible, other than to reluctantly accept due diligence and regulatory approval. Timetable

The timetable to negotiate and conclude the transaction needs to be set out. This should take into account the timetable set out in the equity term sheet and also the exclusivity period, if any (see below). It will set milestones by which key activities need to be completed (such as finalising due diligence, signing legal documents, etc). The parties should try and agree a realistic timetable to avoid needing to seek an extension at a later date.

Exclusivity

Buyers will be keen to have an exclusivity period, during which time the sellers agree to deal solely with that buyer and not negotiate with any third parties. Some issues to note: • Exclusivity may not always be granted as part of the initial term sheet, particularly if there has been a high level of interest in the target from other bidders. Buyers should revisit the issue once the deal has progressed further, as sellers may be willing to grant exclusivity once they are satisfied as to the bona fides of the offer. • Until exclusivity is granted, buyers are unlikely to spend money on advisers’ fees or invest their own time into thorough due diligence. • The term sheet should also consider what happens if the sellers receive approaches from third parties. Buyers may insist that they are informed of such approaches during the period of exclusivity. • It may be prudent to regulate how the business is run during the exclusivity period, to ensure the business is conducted in the ordinary and usual

course (eg to avoid the risk of creditors being strung out or debtors being unduly harassed) and that no dividends or other distributions are made to shareholders. Legal status

As discussed above, it should be clear whether it is intended for the term sheet to be binding or not. If not, ensure there is a provision that states it is not intended to be legally binding (other than exclusivity, confidentiality undertakings, break fees or any costs indemnity).

Warranties and Term sheets rarely include specific warranties, indemnification other than to refer to “customary warranties for a transaction of this nature”. However, as a seller, it is important to try and include “customary limitations” to the warranties, such as disclosure, caps and baskets, time limits and so on. Restraint

The buyer should think carefully about who it may wish to impose a non-compete obligation on: should it be the seller, or should it extend to the shareholders of the seller.

Costs underwrite

Costs underwrites, also known as abort fees or break fees, are where one side agrees to pay the other side’s costs and expenses if the deal does not proceed. Either side may ask for an abort fee and, whether it is given, will depend on each party’s bargaining position. It may be that the parties agree to give mutual cost underwrites. The potential arguments that may arise are:

Seller

Buyer

The seller will argue that by giving

The buyer will argue it is incurring

exclusivity to one bidder (particularly, in a competitive tender), it is losing the opportunity to sell to another third party. If the chosen buyer does not then complete the transaction, the seller will have incurred costs but not completed the sale and should therefore have its costs reimbursed.

significant costs, especially in relation to due diligence, in reliance on the assumption that the seller will proceed. If the seller withdraws from the deal, is unable to obtain approval from its board of shareholders, or breaches the exclusivity undertaking (by selling to a third party), then the buyer will want to recover its costs.

It is important to note that even if the term sheet does not include a break fee, a claim for costs can be brought for breach of the exclusivity undertaking if either side can prove it suffered a loss. The events which trigger the break fee should be carefully set out, for example: • the seller or Newco withdrawing from negotiations during the period of exclusivity • the target’s shareholders failing to approve the terms of the sale • Newco reducing the offer price (other than as a result of material adverse due diligence findings).

The break fee provisions should cover adviser fees incurred on a contingency basis. In management buyouts (MBO), there is always a difficult issue as to who will actually bear the cost of a break fee payable to the sellers. The Newco will not actually have any assets and the managers will not wish to take on the significant personal liability for the seller’s costs. Buyers will also be reluctant to pay the seller’s costs as they will have already incurred their own costs. A potential compromise is that costs are limited to reasonable third party costs up to a pre-agreed cap. Other

It will usually include other provisions such as confidentiality undertakings, disclosure exceptions, governing law, etc.

Sources Australian Venture Capital and Private Equity Association Limited “Confidentiality Agreement” (2012) AVCAL . Charles Beelaerts “The Ins and Outs of Management Buy-outs” (November 2006) Company Director Journal 22. Justin Ryan and Nick Wormald “Buying Trouble: How to Manage Conflicts in MBOs” (Summer 1999) Issue 4 JASSA 7. Nicholas Humphrey “Negotiating Terms Sheets” (March 2012) Australian Private Equity and Venture Capital Journal 17. Peter Martin “Preliminary Issues” (2003) PLC Private Equity Practice Manual 2.85.

ACQUISITIONS AND BUYOUTS SPAs

¶2-010

Strategies for tender sales

¶2-020

BPAs

¶2-030

Editorial information This chapter looks at the acquisition process and focuses primarily on providing an overview of share purchase agreements (SPAs) with strategies for tender sales covered as well. However, key issues arising in a business purchase agreements (BPAs) are also considered.

¶2-010 SPAs This section provides an overview of SPAs, including: • parties • conditions precedent • pre-completion covenants • calculating the purchase price • warranties, disclosure and limitations, and • restraints of trade. Parties The parties to the SPA will be the shareholders of the target (as sellers) and the buyer. In a buyout scenario, the buyer will be Newco (being the company formed to act as the buyer, the shareholders of which will be the post-acquisition management team and the private equity (PE) investor — see Chapter 8 (Equity Funding)). When on the buy-side, an investor will not usually be a party to the SPA as it will not want to have any direct liability. As Newco is unlikely

to be an entity of substance prior to completion, sellers may well push for the investor to act as a guarantor of the Newco. This will depend on the investor’s internal practices for giving guarantees but is generally resisted. In a share sale, the target company is not usually a party, as the contract is one between the sellers and the Newco (who is buying the sellers’ shares). Care needs to be taken where the target is a party as it cannot bind the shareholders to sell their shares and there may also be a prohibition on the company giving covenants under the SPA (which could amount to financial assistance). If a seller is a nominee or a subsidiary of another holding company, then a buyer may insist that the upstream appointer or holding company also be a signatory to stand behind the warranties and other covenants given by the seller. Where the deal is structured as a partial exit for the founders, or management are selling part or all of their existing shareholding, special issues arise. The buyer should seek warranties from those founders/managers that are selling but the value of those warranties is questionable. How realistic is it for an investor to pursue its own managers? To do so would disincentivise them and distract them from pushing the business forward. Buyers should also consider who should give restraint of trade covenants. It may be prudent to not just get the entity which holds the shares but the individual who controls the relevant entity, associates of that individual and perhaps also key executives or directors of the target (who may not actually hold shares) to also give covenants. It might be hard to get these additional covenantors to sign up if they are not receiving share sale consideration or an ongoing participation post-completion and an additional payment may be required. From a legal perspective, where there is a concern that no “consideration” is given for the relevant covenants they should be included in separate deeds of restraint to overcome enforceability concerns. Conditions precedent The SPA will set out the conditions precedent to be satisfied before

the purchase will proceed. These will mirror the term sheet plus additional matters which have arisen during due diligence including: • Regulatory approval: Approval from competition or other authorities (such as the Australian Competition and Consumer Commission (ACCC) or the Foreign Investment Review Board (FIRB)) may be a requirement. If a regulatory condition needs to be satisfied prior to completion that condition will be incorporated in the SPA. • Due diligence: Usually sellers will require the buyer to complete their due diligence before signing the SPA. If the timetable has not permitted this review then the buyer should ensure that the SPA is conditional upon finalisation of due diligence to their satisfaction. • Internal approvals: Either side may have internal approvals which must be satisfied before the deal can be consummated, including in the case of Newco, the investment committee approval of the investor and in the case of the sellers, approval from its ultimate shareholders (which may be a requirement of listing rules if the seller is a listed company). • Third-party consent: The material contracts of the target may require certain third-party consents (such as from landlords, suppliers and customers) to a change of control. Where those contracts are material to the target’s business a buyer is likely to insist that obtaining those consents is a condition precedent to completion of the SPA. • Material adverse change: Particularly where the period between exchange and completion may be long or external debt is used to finance the acquisition buyers will look to include a provision that there has been no “material adverse change” (MAC) as a condition precedent to completion. Some of the key issues to consider are: – MAC provisions are usually drafted to cover a change in the financial position of the target prior to completion.

– A “broad-based” MAC provision will be drafted to include a forward-looking element (such as no material adverse change in the “prospects” of the target or no occurrence of an event which “could reasonably be expected to” diminish the financial position of the target). – Broad-based MAC provisions are often required in those deals where external debt financing has been obtained to finance the acquisition. Buyers need to ensure they can back-to-back their “out” under the MAC in the sale agreement with that of the bank under its debt facility with the buyer (so in the event of a MAC they are not obliged to buy if the bank is not obliged to fund). – In strong seller markets or on competitive tender sales, buyers might expect to be required to take “financing” risk because sellers will expect not to have to accept any execution risk arising from the buyer’s inability to finance the transaction. – It is worth bearing in mind that recent case law suggests that the “occurrence” of an event is not regarded as sufficient in itself; the buyer must factually establish that it had (or depending on the drafting of the MAC) is likely to have a material adverse effect on the target and possibly that such an event could not reasonably have been foreseen. If any of the conditions precedent are still outstanding at exchange, then the SPA should provide for a period between exchange and completion to allow these conditions to be satisfied. There should be a “sunset” date beyond which the SPA will terminate if the conditions have not been satisfied (or waived). Clearly the longer this period is, the greater the risk that the proposed sale will be leaked to customers, staff or the media (and the parties should be prepared to deal with questions from these stakeholders if there is a leak). From the perspective of the buyer, it is important to minimise the number of conditions precedent (CPs) which are in favour of the

sellers. It may be prudent to try and defer execution of the SPA until as many sell-side CPs as possible are satisfied. If this is not possible, because the seller must obtain a regulatory approval or the approval of shareholders (eg if it is a listed company selling its main operating subsidiary) then the buyer should consider strategies for minimising the risk that this approval is not obtained or the impact of it not being obtained (consider a break fee or cost underwrite for example). From the perspective of the seller, it will also be important to minimise any CPs as the Newco will have no financial capacity until it is funded by the investor and debt provider. Pre-completion covenants If completion is not simultaneous with exchange of contracts (usually to give the parties time to satisfy the conditions precedent), a buyer will be keen to guard against reductions in value of the target during that gap period over which it has little or no control of the target but at the end of which it may be obliged to acquire it. In particular, during this gap period, there is a risk that sellers may neglect the business as they are distracted by the sale process (eg omit to renew a lease or roll over an insurance policy) or seek to strip out value (by deferring creditors, accelerating debtors, paying management fees or dividends). The sellers could also bind the target to onerous new contracts (such as new supply or customer arrangements on uncommercial terms). The nature of this risk will depend on a multitude of factors including the length of the pre-completion period, the macro-economic environment and whether the gap period straddles key dates in the target’s annual business cycle (eg bonus time for a professional services target or December/January for a retailer). Usually, the longer the period of delay the greater the risk the target business’s value will be diminished. Typically, the buyer will seek to mitigate this risk by keeping the gap period to a minimum and by incorporating the following gap provisions into the sale agreement:

• Warranties: The buyer may be able to obtain protection through the repetition of warranties given on exchange at completion (or all times down to completion). As with the warranties given on exchange, there are limitations to the protections such warranties provide: sellers may resist future claims by relying on the various limitations on warranties (eg arguing that in the case of a management buyout (MBO), the management team already had knowledge of the relevant event or circumstance). The de minimis regime might also mean that the value of any claim is too small to justify recovery. • Purchase price adjustment mechanisms: If there is a completion account mechanism (discussed below), this will usually give the buyer additional protections against changes in value of the target prior to completion based on accounts drawn up as at the completion date after completion. If a locked box mechanism is employed (discussed below), the target is typically priced as at the date of the last accounts prior to exchange. Although the “no leakage” covenants will extend from the date of those accounts to completion, there will not be a true up based on the value of the target at completion. • Management team: The investor may take comfort that in an MBO, the management team is already running the business on a day-to-day basis. The seller may refuse to give the precompletion covenants in an MBO situation, on the basis that the managers will confer with the investor about operational issues. However, this should be done in a transparent manner (not simply pursuant to a side letter between the managers and the investor). • Covenants and undertakings: The buyer will require the seller to give certain covenants and undertakings about how the target business will be conducted between exchange and completion. Generally, these provisions aim to ensure the value of the target and its assets is preserved and that the target business is run by the sellers as it would have been if no buyer was in the picture. Specific covenants will proscribe specific non-ordinary course

activities (eg paying bonuses, dividends or altering the target’s capital structure) or require that they may only be carried out with buyer consent. If a completion accounts price adjustment is used, the covenants may also be crafted so as to prevent the sellers from artificially inflating the target’s value as at completion (eg prevent a manufacturing business from increasing its working capital by “stuffing the channels” of its suppliers). Typical covenants and undertakings include obligations on the seller to ensure: • the target’s business will be carried on in the ordinary and usual course of business • the target will not issue new securities, vary the rights attaching to securities, declare or pay dividends or other distributions • the target will maintain insurance and otherwise protect assets • the sellers will ensure that the target will not, without the consent of the buyer: – enter into, vary or terminate material contracts (including employment contracts) – hire or fire key staff – commence material litigation – incur material capex. Calculating the purchase price The SPA should clearly set out the component parts of the purchase price for the sale securities, including the price per share and also the aggregate purchase price. If there are different classes of shares (such as ordinary shares and preference shares) or different classes of securities (such as options or loan notes), then the SPA should show the differential mechanics and prices for those classes. Consider (ultimately this will depend on the terms of the actual securities and

the tax position of both sides) whether: • preference shares in the issued capital of the targets are redeemed, converted into ordinary shares or transferred as are • options are transferred for cash, swapped for options in Newco, exercised and the shares issued then sold, or cancelled (for a cash payment by the target) • loan notes or subordinated shareholder loans are assigned or repaid (be careful here as the monies are owed by the target to the note holder and as such the repayment would need to be by the target). The payment mechanics should be specified, including whether by telegraphic transfer or bank cheque. If the purchase price is specified in a foreign currency, the SPA needs to manage carefully the timing and basis of any conversions (eg the calculation back into A$ will be done as at 5.00 pm on the business day prior to completion, using the rate published on Bloomberg or in Australian Financial Review). Note in relation to cross-border transactions — if the bidder is paying in a foreign currency, then the bidder should consider hedging the purchase price, and if the seller is receiving foreign currency consideration, then the seller should consider hedging the sale proceeds. This should be considered initially from when the contracts are exchanged until the transaction settlement date to lock in the purchase/sale price, and thereafter as appropriate for the business’s ongoing foreign currency cash-flows. Warranties, limitations and disclosure What are warranties? The SPA will contain a number of “warranties” from the sellers. Warranties are statements of fact that the seller makes and upon which the buyer relies. They serve a dual purpose: first they force disclosure of information that a buyer needs to inform its appraisal of the value of the target and second, if they are proven to be incorrect after the target is purchased, the buyer may be able to sue the seller

to recover part, or all, of the purchase price. Warranties will cover a broad range of issues, such as: • that the financial statements are properly prepared in accordance with accounting standards and represent a true and fair depiction of the business as at the reference accounts date (these will be the locked box accounts if a locked box mechanism is employed, see Chapter 3 (Purchase Price Adjustments)) • material or non-ordinary course events since the reference accounts date • that the target owns all the business assets, free of any third-party interests (eg the computers are owned outright and are not subject to a hire purchase arrangement) • that no litigation has been commenced or is pending against the business. Warranty limitations The sellers will seek to minimise their exposure under the warranties by including “limitations” in the SPA (which will ultimately depend on the respective bargaining power of the parties) such as: • Claim periods: The SPA will usually specify a time limit for bringing a claim under the warranties: – for tax-related claims, this period is ordinarily between five and seven years from completion – for non-tax warranties, it is customary to allow the buyer at least one or preferably two audit cycles. In general, this equates to 12–24 months from completion – for core warranties (like title, power and authority), there may be a longer period of, say, 36 months – it is worth noting that in competitive deals, the sellers may insist on shorter claim periods (in some cases as short as six

to nine months). • Threshold: The sellers will not be liable for a warranty claim unless the liability exceeds a threshold, both for individual claims and/or for claims in aggregate (known as the “basket”). Some of the key issues with baskets follow: – Size of basket: This will vary from deal to deal. Typically 1% of the purchase price but can often be as high as 2% (particularly in large deals or where there was a competitive tender sale). Usually, the basket is more likely to be in the range of 0.5% to 1.5%. – Per claim basket: The per claim threshold will also vary from deal to deal, usually it is 10% of the aggregate basket but from a buyer’s perspective the per claim threshold should be as low as possible to ensure there is not an artificial hurdle to bringing a claim (as long as the per claim threshold is not so low that the buyers can “nickel and dime” the sellers over very small amounts). – Tipping point or first dollar: The question here is what happens to the claims up to the threshold amount, if the buyer recovers the entire claim (this will be a “first dollar” threshold), whereas if they can only recover the excess, this is known as a tipping point (so the buyer will have to be at risk for claims up to the aggregate amount, similar to, say the excess in an insurance policy). – Exclusions: The buyer should seek to exclude from these baskets certain types of claims including those arising from the fraud or wilful non-disclosure of the sellers’ claims relating to tax or other “core” warranties (title to the sale shares or authority to sell). • Cap on claims: The seller will seek to cap its liability to the buyer for a breach of warranties. Points to be taken into consideration are:

– Typically, the cap agreed can vary from as low as 10% to 100% of the purchase price. – In Australia, it is reasonably common for the cap to be set at the purchase price, unless it is a competitive deal where tax and other core warranties might be set at, say, 80% to 100% of the purchase price but with other warranties at 20% to 50%. – There should be a provision which states that these caps do not apply where the claim relates to fraud or wilful nondisclosure by the sellers. – It should be considered whether the cap should be increased to account for any debt assumed or repaid as part of the deal. – Increasingly, sellers are making use of warranty and indemnity (W&I) insurance as a way of minimising or absolving themselves entirely of the risk of claims under the warranties. As a market, Australia was an early adopter of such policies and still has one of the world’s more developed W&I insurance markets, see Chapter 14 (Key Issues with Using W&I Insurance). • Change to accounting practices: The sellers may ask for a limitation to exclude claims which would not have arisen “but for” a change in the accounting practices adopted by the buyer postcompletion. Before agreeing to this limitation the buyer should consider whether there should be exceptions where it needs to make changes to: – comply with existing laws, International Financial Reporting Standards (IFRS) or generally accepted accounting principles (GAAP), or – the accounts to reflect that it is now a stand-alone entity and not part of a group (eg what was immaterial in the context of

a large group may be important to a smaller entity). • Provisions in the accounts: The sellers may also seek a limitation for claims to the extent that there has been provision or reserve in either the audited accounts or the completion accounts. The standard of such provision is important; the buyer should ensure it was specific and express, to minimise the risk of the sellers seeking an unintended shield. • Knowledge of the buyer: The sellers may also seek to exclude claims for a breach of warranties where the buyer has knowledge of the relevant fact or matter of circumstance giving rise to the claim. In an MBO, this will be complicated by the fact that the management team has been involved in the operations of the target. Some sellers may go further and seek a limitation based on what management “ought reasonably to know”. It is preferable to restrict such provisions to the actual knowledge of the management team and expressly exclude implied knowledge. • Knowledge of the seller: It is common for the sellers to seek to qualify some of the warranties to the extent of their knowledge, usually by adding the words “so far as the seller is aware” to the relevant warranty. A corollary to the issue discussed above with respect to the buyer’s knowledge is whether the seller’s knowledge is actual or deemed (eg the knowledge they ought to have had if they made reasonable enquiries or due and careful enquiry). The buyer should resist an overarching provision that all warranties are subject to knowledge — generally if a liability arose while the sellers owned the business, it should be to their account (it happened on “their watch” and they should not be able to avoid the risk because they were not aware of it). In an MBO situation, the sellers will probably argue that there are areas which they cannot warrant absolutely. In an MBO, the sellers are likely to offer limited warranty cover on the basis that the management team has a far better knowledge of potential liabilities and other matters facing the business. They might argue that the managers will have built these factors into the purchase

price already and Newco should not be able to seek further protection for risks it has already priced in through a warranty claim. From the perspective of the buyers, they should still seek warranties to cover those areas with which management has had little or no involvement. In particular, they may have had limited involvement in group-level activities, such as preparing the accounts, the tax, insurance, intellectual property or superannuation aspects of the business. Also, what is the risk that the sellers, on behalf of the target business, entered into any binding contracts without management’s knowledge? Lastly, the buyers should ensure and include a requirement in the SPA that any entity providing warranties is of substance and will have sufficient funding available for the duration of the claim period to meet any warranty claims that may arise. Again, W&I insurance may help bridge any funding gap, see Chapter 14 (Key Issues with Using W&I Insurance). Disclosure Disclosure is the procedure by which sellers qualify the warranties where the factual circumstances do not accord with any one or more of the warranted statements made. The scope and terms of the disclosure clause are negotiated between the seller and the buyer. The buyer will be keen to ensure that the warranties given in the acquisition agreement are not completely negated by general disclosures made whereas the seller will seek to include as many disclosures, as broadly as possible. The SPA will usually specify the level of disclosure required, such as “full, fair and accurate” disclosure or “fair” disclosure. In practice, what constitutes adequate or fair disclosure will depend on the circumstances of the transaction, including the nature and materiality of the matter disclosed and the manner in which the information was provided to the buyer. It is not enough simply to refer to the source of information. The seller may need to make a specific disclosure with some detail of the relevant matter before it can constitute a “fair” disclosure and draw attention to the relevant document (preferably the

relevant clauses) in the drafting of the specific disclosure. The buyer should be asking the seller to quantify matters which are disclosed in the disclosure letter including an estimate of the potential liability which might arise from the relevant matter. In an MBO, not only will Newco normally be expected to accept wider limitations but also it will often be under pressure to accept disclosure on a broader basis than in a trade sale. Not only will the sellers be reluctant to warrant matters within the management team’s knowledge, but also will be wary of putting themselves in a situation where the qualification of a warranty is by disclosure based on information provided by the new management of the buyer. Restraints of trade In general, these covenants in an SPA can be more restrictive than restraints in an executive service contract. The parties should seek advice from a qualified lawyer on the terms of these provisions to ensure they are not held by a court as being unenforceable (eg are the provisions reasonably necessary to protect the legitimate interests of the buyer/target? Are they void for being too uncertain?). The courts are generally reluctant to prevent an employee from making a living using the skills they have gained through experience or study. That said, they recognise that it is unfair for an employee or director to gain a springboard from using a company’s client lists or secret information. Non-compete: The SPA will include a provision which restricts the sellers and their associates from competing against the target business in a specific region for a specified period (say three years) after completion. Non-solicitation: Newco should prevent the seller from soliciting key employees, customers, distributors and suppliers. To maximise the enforceability of this provision, careful consideration needs to be given when extending the protection beyond one to those employees and customers with whom the seller/target has had contact during the period of the seller’s ownership. Confidential information: Newco should clearly and adequately

identify all confidential information to be restricted from disclosure. The restriction does not need to be for a specific period but should no longer apply if the information becomes available to the public (other than by reason of a breach of the confidentiality undertaking given by the seller).

¶2-020 Strategies for tender sales Competitive bids are now commonplace as a means of selling a business, particularly when the seller has engaged an adviser to run the process (which is over 40% of the time in US mid-cap deals). A private treaty sale where a buyout fund has an exclusive mandate from the outset is becoming less common. With a growing focus on corporate governance and director’s duties, vendors are keen to ensure they secure the best price and terms for the business and an auction is a demonstrable means of doing so. The process outlined above (particularly the fact that exclusivity is not granted until late in the process) causes significant problems for most PE funds: • Cost tolerance: There are significant costs for any bidder inherent in participating in an auction process. Given the PE funding model, these costs are more difficult for investors to tolerate than their trade buyer competitors. Not only are there tax, accounting and legal costs (including negotiating an SPA or BPA and conducting due diligence) but there is also the internal executive time required. PE funds are simply not as cost and time tolerant as a trade buyer — in part because their performance fees are return-on-investment (ROI) driven but also because funds are significantly more active than a corporate. A trade buyer can bury the costs of one failed bid every year or two and may also have more internal resources to throw at due diligence. It is harder for a fund which is doing them every few months and has a small inhouse team. • Access to management: Competitive bids are time intensive for the management team at the seller. If the fund is running an

MBO, the board of the seller may restrict interaction between the fund and its new management team. This makes it harder for the fund not only to form a bond with that team but also to get the time to negotiate the internal structures with management. • Conforming bid: It may be difficult for a fund to lodge a conforming bid. The bid will often have to be conditional on closing the external debt funding and also on finalising the bid company structure with management. Another important issue to note is that while PE funds may be tough negotiators, there are ancillary benefits from including an MBO option. For many vendors (especially foreign companies) it is important to have a “walk-in/walk-out” sale (with minimal risk of warranty claims or workplace tensions). This is more likely to happen with a sale to a PEbacked management team given its existing knowledge of the business and existing relationships with staff. A potential way of minimising these tensions for a PE fund is for sellers to grant a break fee. The seller can run the process with two preferred bidders up to or as close as possible to an unconditional SPA having agreed to reimburse the loser with its reasonable costs incurred. This maximises competitive tension but minimises the costs to bidders of an unsuccessful bid. What is a break fee? A “break fee” is a fee promised by the seller to a bidder which becomes payable if the bidder does not succeed in the deal. The break fee payable is generally equivalent to the costs incurred by the bidder. In the US, however, break fees on bids involving unlisted entities can be as high as 3% or 4%. As a general rule, the further into the due diligence process bidders are asked to go without exclusivity, the more reasonable it is to request compensation in the form of break fees in the event of being the unsuccessful bidder. By leveraging exclusivity against risk coverage in this way, bidders gain some protection. For a detailed discussion of break fees, including their regulation by the Australian

Takeovers Panel, see Chapter 13 (Selling the Portfolio Company). Managing the auction process • Focused and staged due diligence: In the auction process, it is critical for buyers to carefully scope the due diligence to be undertaken. It is also important to set realistic materiality levels before due diligence is commenced (if they are set too low, the team can get distracted and costs may blow out). In most cases, it is also possible to stage due diligence. Early on, due diligence must be focused on investigating any high strategic risks of the company (in that way buyers can pull out of the bidding process if they come across any major problems). • Process: It is important that the bidder clarifies with the seller the process early in the transaction. Part of the “poker game” is to understand how flexible the seller really is in terms of the meaning of “final bid”. For example, can the bid be conditional on debt finance? Does the bidder really have to lodge a marked-up version of the SPA and so on? • Lodgement of SPA: As discussed above some sellers state that a conforming bid must include a marked-up version of the SPA. Bidders should consider, however, whether they simply lodge an issues paper with their bid in an effort to minimise legal expenses if they are unsuccessful but, more importantly, to keep their options open on the terms of the SPA if they are successful. • Exclusivity: The key will be to negotiate exclusivity as soon as possible in the process. Sellers will be reluctant to do this, as once a bidder is exclusive the power balance swings in its favour and it will try and reopen the price and claw back some of the terms. • Cost sharing: In addition to negotiating a break fee, bidders may be able to convince the seller to produce, at their own cost, vendor due diligence reports (eg engaging a third party to perform a phase one environmental report, or seller’s legal, tax and accounting advisers to prepare legal, tax and accounting reports).

It is generally considered that the competitive tension generated by an auction maximises the potential sales price and secures the most favourable terms for sellers. However, PE funds may simply refuse to participate in an auction process (due to cost intolerance) or be unable to participate (the complexities of an MBO mean that the fund cannot lodge a conforming bid in the specified timetable). As such sellers are narrowing their pool of potential bidders by running a strict “final binding bid” process. The granting of break fees would appear to be a win/win for both sellers and PE funds. It gives the seller competitive tension throughout the whole process (as they do not need to grant exclusivity) but gives the fund some downside protection.

¶2-030 BPAs This section discusses key issues in BPAs including: • preliminary matters • identifying assets • specifying liabilities • novating and assigning contracts, and • employees. Preliminary matters Why purchase a business? Some reasons buyers prefer business purchase transactions include: • Cherry pick: a desire to pick which assets to buy and which to leave behind • Liabilities: being reluctant to buy a company “as is” with all of its debts and liabilities (including unknown liabilities) • Buying a division: deciding to only invest in part of an existing business (eg the distributor in a supply chain), leaving the seller

to own and run the rest of the business • Step-up: wanting the ability to “step-up” the value of assets for tax purposes, namely to value the asset at a higher market value upon purchase instead of at its original value • Tax reasons: reluctance to buy a company with partially or fully depreciated assets (the seller may have already depreciated the assets as an expense on the company’s previous income tax returns, leaving little or no depreciation for the buyer in the future) • Concessions: a desire to be eligible for the full tax or government programme benefits by purchasing only the assets of the business (a company may have already taken advantage of all tax benefits or government programmes). Parties The sale is usually set out in a business or asset purchase agreement (BPA). It is important to clearly identify the seller of the assets, and the legal entity buying those assets. It is important to identify who will be providing the warranties and indemnities. If a seller company is liquidated or deregistered after the sale, it may be necessary to seek warranties from key individuals or related bodies corporate with the resources to remedy a warranty claim. Identifying assets It is crucial to properly identify the assets to be acquired. Only assets and liabilities which are specifically identified in the BPA are transferred to the buyer. Assets not specified are not transferred. Below are typical categories that make up the going concern of the business. Categories of assets comprising the going concern Plant and equipment Property (lease)

Stock-in-trade Work-in-progress Goodwill Intellectual property (trademarks, designs, patents, copyright) Business name Know-how and customer lists Employees Trade debtors Plant and equipment: This refers to fixed assets whether attached to property (fixtures) or not (chattels). Equipment is tangible property (which is not land or buildings) used in the business and refers to, for example, vehicles, machinery, devices and tools. A buyer should clearly itemise all the plant and equipment it wants to purchase and consider how value is apportioned for income tax, capital gains, stamp duty and other liabilities. If the seller leases equipment then these leases should be assigned to the buyer. During due diligence, the buyer should review the leases and check whether they require the financier’s consent. A buyer should also ask for warranties that plant and equipment are in good repair and working condition at the date of signing and that this will be maintained by the seller until completion. A buyer could consider confirming whether existing warranties and guarantees are attached to certain plant and equipment (eg vehicles) and whether the buyer can rely on such warranties and guarantees. If so, the buyer may ask for the existing warranties and guarantees to be expressly assigned to it. Property: The considerations relating to freehold and leasehold property in a business purchase will be similar to those in a share purchase. The buyer will want secure tenure and will want to confirm that there are no defects in the lease, that any options to renew are enforceable and that leases are binding on mortgagees. A buyer

should not assume a lease without the mortgagee’s consent. Failing to obtain consent is a breach of the mortgage, entitling the mortgagee to exercise its powers under the default provisions and recover possession of the property from the lessee as the lease is not binding on the mortgagee. Typically, the seller pays the lessor and mortgagee’s legal costs when assigning the lease and the buyer pays for registering the lease and for stamp duty. If a new lease is entered into, the buyer usually pays all the costs, however, some sellers may pay if the buyer insists on obtaining secure tenure before sale. Stock-in-trade: This is the product of the business and can include raw materials, work-in-progress and fully manufactured goods for sale. The parties should be as clear as possible when calculating or agreeing the method of valuing stock and work-in-progress. Doing this poorly could render the valuation method uncertain, incorrect or unenforceable. To avoid this outcome, the parties may wish to get a professional to value the stock. Goodwill: Goodwill is essential to a purchaser wishing to maintain the business’s past profits and grow profits in the future. Goodwill can be attributed to intangible personal property and can be characterised as local or personal goodwill. Goodwill is sometimes described as the value of business minus the value of net tangible assets. Fundamental to the sale of goodwill is that the buyer obtains the benefit of existing and prospective customers and clients of the business. The buyer will also want an introduction to customers and to be assigned the customer list and records and ensure that the seller maintains trading and goodwill between signing and completion. The buyer should identify the specific rights to vest in the buyer to adequately get the benefit of customers and maintain turnover and profit (eg by assigning the rights, assets and business name to the buyer and by preventing the seller from depreciating these rights (perhaps by restraining the seller from trading in a specified area for a specified time, for example)). As discussed, the buyer will then want to restrain the seller from competing with it and also restrain directors, key employees and certain shareholders. Intellectual property: Trademarks, designs, patents and copyright

should also be assigned to the buyer as goodwill can be attached to these items. A buyer should consider whether they want to use the seller’s business name going forward. The parties will want to consider how much goodwill to apportion to intellectual property as, depending on the situation, this could lead to a favourable tax outcome. Trade debtors: Parties should consider whether they also want to assign trade debtors and must consider the stamp duty implications of doing this. Another option is to allow the seller to retain the debtors pre-completion (however, a process for allocating any debts which are collected post-completion would also need to be agreed to minimise any disputes). The buyer may also want to prevent the seller from demanding, claiming or litigating against old clients for non-payment to avoid aggravating the buyer’s new client and compromising the buyer’s goodwill with them. Purchase price apportionment Setting the purchase price is important and the parties will have competing interests in how it is allocated to reduce that party’s tax liabilities on the transfer. The specific amounts apportioned to goodwill, plant, equipment, stock, etc, will be negotiated depending on the interests of the buyer and seller. Although stamp duty on goodwill and trading stock has been abolished in most states, parties should confirm whether this applies in the jurisdiction of the transfer. Some buyers may seek to apportion some goodwill to intellectual property to reduce stamp duty, however buyers should note that they have to be able to justify that the apportionment is reasonable. If the taxation authorities choose to scrutinise the apportionment and calculate a greater dutiable portion, a party may be liable to pay duty on the higher calculation. The price apportioned to plant on which a seller claims depreciation is important, as is the value of equipment for which the seller claims depreciation and capital gains tax. Specifying liabilities The buyer may assume responsibility for some seller creditors and

liabilities as part of the transaction. For example, the buyer may assume the seller’s debts to its suppliers, employees and to certain clients for performance of goods under warranties, pending litigation, or liabilities to service providers. Typically, however, a buyer will want to exclude all liabilities which relate to the period before completion. If a liability becomes known after completion, the seller may in some cases be able to recover from the buyer. A seller may want to have comfort that this will not happen by persuading creditors to release the seller and consent to the buyer assuming the seller’s place by, for example, a novation or assignment. Novating or assigning contracts Business contracts to which the seller is a party do not continue automatically after the acquisition. It is critical that key contracts can be assigned or novated so the buyer has the benefit of these after completion. Buyers may have to enter into a new contract in some cases and whether they do this, assign or novate will depend on the business needs of the buyer. The buyer has to decide whether they want to accept the seller’s liability from the start of the contract by way of a novation or if they will be assuming liabilities from completion. All parties will need to consent to the novation. Seeking consent can lead to significant work, cost and risk for the buyer. Buyers should confirm that the rights attached to assets they are buying are not personal to the seller, as these cannot be assigned. Some examples of contracts that may be novated or assigned include contracts involving business relationships, including software or intellectual property (IP) licenses, supplier, transport, advertising, distributor and plant- and equipment-lease contracts. If rights and obligations cannot be assigned or novated, then a new contract may have to be entered into by the parties. Regulatory licences and permits should also be transferred, otherwise the buyer may have to re-apply for, and pay further registration fees in respect of, the same licence. Some permits have to be newly obtained as they are not transferrable.

Customer contracts are the business’s main asset and a cautious buyer would test major customers’ reactions to dealing with a new company before purchasing the business. Key customers must agree to deal with the buyer if the business hopes to maintain existing profits and achieve its growth targets. Employees Offers to staff The BPA usually provides that the buyer must make an offer of employment to each existing employee that it will employ, effective from completion. Most buyers will want to keep existing talent as some of the goodwill of the business will be attributable to its people. The offer of employment must be on the same or better terms as employers cannot unilaterally alter employee rights. The employee’s employment with the seller is terminated when the employee accepts the buyer’s employment offer. Buyers should check existing employment contracts, industrial agreements and awards for any termination or unusual clauses, to see which of those the buyer will be assuming after completion. Ideally, buyers should obtain key executive restraints and confidential information undertakings before completion and this should be set out in their new contract. If employees are discharged after completion, restraints may not be imposed without express contractual stipulation. Deemed continuity of business Generally, continuity of the business is deemed upon a sale of business. The workplace legislation imposes an obligation on the buyer to recognise the transferring employee’s period of service with the seller for the purpose of entitlements like annual leave, carer’s leave, long service leave, notice, redundancy payments and unfair dismissal. There are some exceptions where the buyer may not need to recognise an employee’s service with the seller. Additionally, the buyer may, in the BPA, require the employee’s period of service to start again for the purposes of the unfair dismissal provisions of the Act. This means the transferring employees would need to serve

another minimum period of employment (probation), offering buyers the opportunity to evaluate the employees of the business after completion. Redundancy considerations The parties should consider the consequences of an employee not accepting an offer of employment with the buyer on identical terms to their seller employment contract. This could give rise to potential redundancy issues and the issue of who is liable to pay. Whether this is a termination or redundancy may be set out in the relevant award or contract. Pitfalls after completion Sellers should be wary of an agreement requiring the discharge of employees on completion as they may be subject to these liabilities. Buyers should be aware that in some circumstances, they may be liable for a redundancy payment if they employ the seller’s staff and then discharge them soon after completion. Buyers should also note unpaid commissions or bonuses. Sources Jill Gauntlett “A Reflection on Deal Trends in Cross-border M&A — the Asia-Pacific Perspective” (February 2010) Norton Rose . Nicholas Humphrey “Trends in Structuring Private Equity Deals Coming Out of the GFC” (June 2010) Australian Private Equity and Venture Capital Journal 4. Paul M Mahoney Jr & Ragan L Ferraro “Auctions are Becoming More Prevalent in Midmarket Deals” (2004) Boston Business Journal . Peter Martin and Andrew Fearon “Acquisition of the Business” (2003) PLC Private Equity Practice Manual 2.3. Robert Seber “Protecting Against ‘Retrading’ in the Private M&A Auction” (December 2003) The Deal (last

accessed December 2003).

PURCHASE PRICE ADJUSTMENTS Purchase price adjustments

¶3-010

Completion accounts

¶3-020

Locked box

¶3-030

Earn-outs

¶3-040

Editorial information This chapter considers common methods for adjusting and giving comfort around the purchase price paid at completion by reference to completion accounts, locked box mechanisms and deferring payment under earn-out clauses.

¶3-010 Purchase price adjustments This section provides an overview of the following purchase price mechanisms used in sale agreements: • completion accounts • locked box • earn-outs. Overview Purchase price mechanisms are designed to contractualise the parties’ expectations around value and the risks that value changes during the course of the sale process (including after completion in the case of an earn-out). A completion accounts mechanism provides for the provisional

consideration paid at completion by a buyer to a seller to be trued-up or adjusted by reference to a set of accounts drawn up as at the completion date. The provisional purchase price paid at completion is adjusted by the difference between the agreed, expected values of key assets and liabilities of the target business at completion and those actual values shown in the accounts drawn up after completion but as at the completion date. Locked box arrangements, by contrast, are fixed price mechanisms. They do not provide for a “second look” at the business at completion. Instead, the target business is priced exclusively by reference to the most recent set of annual accounts available during the buyer’s due diligence process. In a locked box mechanism, in addition to the usual warranties and conduct of business undertakings given by a seller to a buyer between signing and completion, the seller will also indemnify the buyer for any value extracted from the business and received by the seller in the period between the reference accounts date and completion. It is particularly these leakage indemnities that give rise to the notion of “locking the box” — although the keys are only handed over to the buyer at completion, the mechanism in the contract is designed to ensure that the buyer is given sufficient assurances in the sale agreement that it is comfortable that the seller has been running the business since the reference date in a manner that supports the valuation to be paid at completion. Unlike a completion account adjustment, when employing a locked box mechanism, the primary “value date” for calculation of the purchase price is not the completion date, but the date at which the reference accounts were drawn up (usually four to nine months prior to signing). Subject to the warranties, conduct of business undertakings and leakage indemnities, the fluctuations in the value of the business between the reference date and completion are the buyer’s risk/reward. The locked box is typically viewed as the more seller-friendly mechanism because it gives greater certainty about price, with limited opportunity for the buyer to claim after completion. However, certainty

on price can also be a benefit to the buyer but in a locked box scenario there is a greater onus on the buyer to conduct detailed financial due diligence before signing the deal which can extend the timetable to signing. If there are no recent audited accounts of the target (less than six to nine months old) or if the perimeter of the assets and liabilities to be transferred is different to those captured in the reference accounts (eg on a carve-out sale) it may not be possible to afford the buyer the requisite comfort by using a locked box mechanism. Completion accounts on the other hand, are more buyer-friendly, allowing the buyer to review the accounts in the period after the completion date for fluctuations in working capital (or in some cases, the full balance sheet). The buyer can then bring a claim if items have changed from the assumed or reference financial position. Completion accounts are an important protection for buyers when the target is part of a consolidated group and stand-alone accounts have not previously been prepared. Earn-outs operate by deferring a portion of the purchase price payable by the buyer and making it subject to the achievement by the target business of certain post-completion contingencies. Typically, that will mean some of the purchase price is only payable if the target business generates earnings before interest, taxes, depreciation and amortisation (EBITDA) or profit before tax (PBT) above set values in the one to three years post-completion. Unlike a completion account or locked box mechanism, it is the performance of the target postcompletion that is determinative, which means that the seller will look for contractual assurances in the sale agreement from the buyer concerning how the buyer will operate the target for the earn-out period.

¶3-020 Completion accounts Some of the key issues to consider when using completion accounts adjustments are: • Who prepares the accounts — the buyer or the seller? It is

customary that one party prepares the completion accounts (say within 30 days of completion) with the other party then having a certain period (say 20 days) to review them. Usually the buyer will prepare the accounts which are then reviewed by the seller, as the buyer will own the business after completion, and have access to the relevant books and records and engage the appropriate employees. The seller may argue that as it is more familiar with the accounts, it should have responsibility for their preparation. If the buyer prepares the accounts, the seller should provide reasonable assistance. • Are there de minimis principles? In other words, does there have to be a minimum amount by which either net assets are over/under the reference net assets in aggregate (or a minimum amount for a particular category or line item in the accounts)? Buyers will argue that this is not like a warranty claim and will seek a “dollar for dollar” adjustment (or a very low aggregate amount). • Basis of adjustment: does it cover working capital and net debt or a full balance sheet? In most cases, the completion accounts are based on working capital and net debt only, rather than requiring the parties to prepare a full balance sheet. It is the most common form of adjustment because it focuses on what is often a purchaser’s principal concern: that at completion there might not be sufficient circulating assets to carry on the business of the target without additional funding by the buyer. • What is a working capital and net debt adjustment? In a working capital and net debt adjustment, the price is adjusted by both the amount of the working capital (excluding cash and debt) and the amount of the debt net of the amount of cash and shortterm investments. “Working capital” is typically the excess of current assets over current liabilities (excluding cash, short-term investments, bank overdrafts, bank debt and other debt-like items maturing within one year which all, typically, form part of net debt). It is the

circulating capital of the business which turns over as goods or services are made or supplied, customers pay, and the proceeds are invested in stocks from which further goods or services can be made or supplied. The principal current assets comprise cash (in hand, at bank, or represented by short term securities), book debts (sums owed by customers) and stocks of raw materials, components, consumable items, work in progress, and goods available for sale (in a manufacturing, retail or wholesale business). Current liabilities include any liability which will mature within one year and will typically include sums due on bank overdrafts, loan repayments due within one year, and trade creditors (sums owed to suppliers). The adjustment therefore does not take into account any fixed assets, and assumes that the buyer has satisfied itself about these and/or will rely on warranties/conduct of business undertakings. The formula is appropriate where the precise value and amount of the fixed assets is either known with a sufficient degree of certainty or is not crucial. • What is a net assets adjustment? A net asset adjustment is the most comprehensive of the usual adjustments. The price is adjusted by reference to all assets and liabilities existing at completion, typically with the exception of the intangible assets (eg goodwill and intellectual property, which by their nature cannot be given a value other than a highly subjective one, which should be agreed by the parties). • Is the adjustment capped and are only “unders” covered or does the adjustment work both ways?: – Buyers may seek to have only a shortfall in assets (“unders”) covered by the adjustments or at least cap the amount to be paid for assets over the reference net asset position (“overs”), on the basis that it is within the seller’s ability to manage the target’s net assets so as to come within the target range.

– Another consideration is that buyers may have to finance a higher purchase price than they were expecting at completion (due to “overs” in net assets). In practical terms, buyers need to consider where the extra funding is going to be sourced and if there is any headroom in the debt facilities. – Another option is for the buyer to cap certain categories, such as stock in trade. – The buyer may also require a minimal level of cash at the bank. It will be important that there is sufficient liquidity in the business to meet short-term working capital needs. This is particularly important if it is a leveraged buyout and the Newco requires immediate availability of cash to pay debt facilities. – Another option is that there is no adjustment to the purchase price if the net assets figures fall within a specified target range. • What accounting standards are used? Sellers will argue that the completion accounts should be prepared using their internal accounting standards which may not always be compliant with International Financial Reporting Standards (IFRS). In particular, the target accounts may never have been audited or may never have been prepared on a stand-alone basis. The SPA should clearly set out provisions regarding the specific accounting treatment of key items such as stock, debtors and foreign exchange. Typically, the sale agreement will provide that completion accounts should be prepared on the basis of the following hierarchy: – first, in accordance with the specific accounting treatments detailed in the agreement – secondly, adopting the same accounting principles, policies, treatments and categorisations as were used in the

preparation of the previous audited accounts of the target, and – thirdly, in accordance with local generally accepted accounting principles (GAAP) (or IFRS, depending on which has been used historically by the target). The completion accounts clause should be reviewed by the accountants for Newco before it is agreed. In particular, the accountants should agree the specific accounting policies, the feasibility of the completion accounts preparation timetable, the scope of the review and basis on which the review was undertaken. Stock adjustment If buying a manufacturing or retail business, it is important to carefully consider stock levels, stock quality and whether a stocktake is required. If doing completion accounts, then the completion accounts’ provision can set out the relevant accounting principles for calculating stock. The buyer will need to ensure that stock on hand is at a sufficient level to facilitate trading in the ordinary course while avoiding paying for excessive stock as this will have negative cash-flow implications (pending receipt of monies from the sale of excess stock). It will also be important to ensure the stock acquired is of saleable quality and not soiled, damaged, unseasonal or unsaleable. The SPA should include the mechanics for conducting a stocktake, including where, when and who must be present.

¶3-030 Locked box Because the buyer bears the risks (and rewards) of the target from the reference accounts date and does not get protection from an adjustment by reference to values on the completion date, buyers expect to conduct more thorough financial due diligence and focus on the scope of the protection afforded to them through the leakage indemnities and other protections in the sale contract.

Leakage The basic principle is that “leakage” for the purposes of the indemnity protection should include all transfers of value from the target business to or for the benefit of the seller or its connected parties between the reference accounts date and the completion date. Buyers will want to define “leakage” broadly and expect sellers to carve out specific and quantified items only so such “permitted leakage” items can be priced into the fixed purchase price payable on completion. Some of the key issues to consider when using locked box mechanisms are: • What transfers of value are included in “leakage”? It is standard for “leakage” to be defined generally to include all transfers of value by the target to the sellers including payments to sellers, waivers of claims by the target against sellers, dividends, seller salary, seller bonuses and transaction costs paid or assumed by the target. The buyer will take the view that the sellers are in the best position to know what types of leakage there is likely to be and in the best position to control whether it occurs or not. • What leakage will be permitted? Given the general approach to the definition of leakage, the onus will then be on the seller to identify and quantify the amounts of any payments or other transfers of value that should be allowed pre-completion as permitted leakage. Permitted leakage items often include the amount allowed to be distributed by way of pre-sale dividend (to achieve a cash-free target), a specified amount that may be paid by way of salary or bonus to the seller, and an agreed amount that may be paid by the target in relation to transaction costs. While the indemnity protection is reassuring to buyers, sellers will look to ensure the scope of what constitutes “leakage” for the purposes of such indemnities is limited to value leakage from the target that is actually received by the seller and its connected parties of a type they can control. • What is an “interest run”? Although the primary value date by

reference to which the purchase price is fixed is the reference accounts date, the seller runs the target until closing without receiving the purchase price until then. For example, the reference accounts date might be 30 June but completion does not occur until two months later. Given this, sellers may expect to receive as part of the purchase price a sum representing interest on the value of the target calculated from the reference accounts date to the date of completion. • Does a de minimis or a cap usually apply to leakage claims? Not usually. As for completion accounts adjustments, market practice is to allow for a full “dollar for dollar” adjustment. • What is the time period for claiming under the leakage indemnities? It is customary to limit the time period for bringing leakage claims to between three to six months. Buyers often insist that sellers agree to notify them of any leakage as soon as it occurs.

¶3-040 Earn-outs An earn-out is a mechanism for sharing the risk of post-completion performance with the seller. Earn-outs are structured so that if the target achieves a financial target over a certain time frame, then the sellers receive additional consideration.

Before the GFC, sellers resisted deferred consideration or earn-outs, arguing that after they have sold they have a limited ability to control the operation of the business and should not be at risk for the buyer’s “mismanagement”. However, since the GFC there has been an increased use of earn-outs, driven by uncertainty about future market conditions and valuation. When using an earn-out, the key issues to consider are: • Period: Earn-outs are usually done for a 12-, 24- or perhaps 36-

month period. It is unusual to see longer periods of, say, four or five years. • Metric: The target can be tied to performance of a range of metrics such as revenue, profit, EBITDA or gross margins, or ensuring that key personnel remain involved in the target business. • Lapsing: Should the buyer’s obligation to pay be subject to automatic lapsing and set-off (eg for breach of warranties or breach of restraint)? • Security: How does the deferral become secured (eg if on the sell side, consider escrow accounts, general security agreement, parent guarantee)? • Acceleration: From a seller’s perspective, should the buyer’s obligations to pay accelerate if, for example: – there is a change of control of buyer – insolvency event in relation to the buyer, or – the buyer fails to “operate the business like the sellers”? • Normalisation: When preparing the earn-out accounts, is there any normalisation required, for example to remove the costs of implementing the deal, increased overheads arising from the introduction of the buyer (such as audit fees, non-executive director fees, any management fees payable to the fund or other increased costs such as head-office costs)? • Future changes to accounting standards: Given most earn-out periods will straddle several future accounting periods, provision needs to be made for how the impact of any future changes to accounting standards applicable during the earn-out period will effect earn-out calculations. Although it may initially seem tempting to freeze the standards as

those used to prepare the most recent accounts prior to signing, this approach can be costly and time consuming if changes are subsequently made to applicable standards that require two sets of accounts to be drawn up. Distinctions can be drawn in the sale contract between voluntary changes elected to be made by the buyer (typically prohibited) and mandatory changes required by law. The parties may agree that if there is a future mandatory change that would result in a significant impact to the earn-out calculation, they will discuss it at that time and agree fair adjustments to the earn-out in the circumstances. If so, in order to preserve the enforceability of any such arrangement, it will be necessary to provide for a dispute resolution mechanism such as expert determination. • Exclusions: Do the earn-out accounts need to provide for excluded earnings, for example, arising from asset sales, new product lines or post-completion acquisitions? If there is some key event scheduled to occur after completion, such as the renewal of a key customer contract or the granting of a new operating licence, deferring part of the purchase price until the renewal date is an important protection for the buyer. The inclusion of an earn-out will complicate negotiations and the buyer should be prepared for the sellers to ask for covenants to “operate the business like the sellers” or set objective parameters as to how the business can be operated during the earn-out period (such as no new capex or set sales rebates). These restrictions can stifle new ideas from management and limit the ability to achieve growth. The introduction of rigid operating guidelines is an anathema to the private equity (PE) model which posits firstly radical transformation from management (which requires flexibility) and secondly that those management are rewarded on the eventual exit (whereas the sellers are to be cashed out before the actual exit). The buyer should consider whether a clean break with the seller is preferable to keep the necessary alignment of interests for management.

Sources Chris Tattersall, Jvo Grundler and Sabina Hohenegger “Share purchase agreements: Purchase price mechanisms and current trends in practice” 2nd ed (2012) Ernst & Young . Peter Martin and Andrew Fearon “Acquisition of the Business” (2003) PLC Private Equity Practice Manual 2.3. Ronan O’Sullivan, Ross McNaughton, and James Doe “Pricing mechanisms: locked box vs completion accounts” (January 2012) Practical Law .

SHAREHOLDER ARRANGEMENTS Information rights

¶4-010

Governance

¶4-020

Downside protections

¶4-030

Liquidity clauses

¶4-040

Incentives/ratchets

¶4-050

Editorial information The shareholders’ agreement is the document which governs the arrangements between the shareholders in relation to their holding in the company. In the case of private equity (PE), the agreement will be between the investor and management (and sometimes coinvestors) in relation to their holding in the new company formed to make the bid in the buyout (Newco). The shareholders’ agreement usually covers the following broad

types of provisions: Information Governance rights Rights to information and to inspect the books.

Board structure, quorum, vetoes and deadlocks.

Downside protections

Liquidity

Incentives

Confidentiality, restraint, leaver and default provisions.

Share issues, share sale, dragalongs, tagalongs and matching rights.

In PE deals, ratchets, options and other incentives for management.

¶4-010 Information rights The shareholders’ agreement will normally require the company to provide shareholders with regular updates about the business, such as: Information

Description

Monthly management Profit and loss accounts statement, balance sheet and cash-flow statements, including a comparison to budgets. Audited accounts

Frequency Within a relatively short period after the end of each calendar month, such as two weeks.

Audited financial Within three months statements of the end of the consisting of a financial year. balance sheet of the company and the related statements of

income and cash flows for the financial year then ended (including notes), prepared in accordance with the Accounting Standards. Minutes

Copies of minutes of all board meetings and shareholders’ meetings.

Within three to seven days.

Budgets

Operating budget for its next financial year.

30 days prior to the start of each year.

Demands/offers

Copies of letters of Promptly, within one demand (potential to two days. claims or disputes), letters from the auditors, potential offers from third parties to acquire the business.

Access rights

Controlling Within three to seven shareholders days. (“controllers”) and investors will want additional access and inspection rights, including the right to inspect the books and records of the company and to speak with the company’s auditors

and accountants. General

Any other information Within three to seven reasonably days. requested by controlling shareholders (or in PE deals, the investor) as being information typical for a company of this type to disclose to an investor or information required to satisfy any reporting or auditing requirements of the investor.

The other non-controlling shareholders (or in PE deals the noninvestor shareholders) may also wish to have information and access rights. This is usually limited to those shareholders with a certain percentage holding of the company (at least 5%). The information clause is an important protection for controllers and investors. Shareholders in private companies only have limited rights to information and generally cannot demand copies of the accounts, books or records of the company. Management will obviously have daily access to the records and books of the business, and will also be responsible for preparing the management accounts. Without these protections, controllers and investors have limited legal rights to request such a detailed level of information.

¶4-020 Governance The shareholders’ agreement will contain various provisions in relation to the governance of the company such as veto rights, board composition, observers and deadlocks.

It is important to remember that the breadth of these clauses will depend on the type of deal being done and the comparative bargaining power of the parties. For example, the governance regime in a deal where the investor is a minority investor alongside the original founders will be different to the governance regime in a buyout where the investor has 95% of the economics. Veto rights/critical business matters These provisions list the decisions which require the prior consent of controllers or investor (and their directors) and the percentage required, for example: • entering into or varying material contracts • payment of dividends or other distributions • varying a set dividend policy • exceeding capital expenditure limits • hiring or varying the terms of a key employee • establishing an employee share option plan • amending the annual business plan • appointing or replacing the auditors • conducting business other than in ordinary course • commencing a new product line or launching a new business unit • entering into partnerships or joint ventures • entering into related party transactions • winding up or ceasing to operate the business or a division • incurring material liabilities including taking out a loan or other

interest-bearing debt • amending accounting policies • disposing of or acquiring material assets • instigating or settling litigation other than debt recovery in ordinary course • issuing shares, notes, options or other securities • varying the constitution • creating an encumbrance • undertaking an initial public offering (IPO), and • implementing an exit event including sale of all shares on issue or sale of all, or a substantial part, of the business. Obviously, if a shareholder already controls the board, the need for a detailed schedule of vetoes is less relevant. That said, it is still prudent to manage carefully the authority of management to make decisions in the “ordinary course” without seeking board approval. Board composition The provisions relating to the composition and governance of the board will include: Size

The number of directors to be appointed by each party. In a management buyout (MBO), investors will usually have the right to appoint a majority of the directors to the board (and on the board of each subsidiary). The investor directors will typically be one or two executives from the private equity fund as well as an independent director (often a retired Chief Executive Officer (CEO) or senior executive from within that industry) who may also be the chairperson. In a minority deal, the board is usually

more balanced with the other shareholders (founders, managers, co-investors) having the right to appoint an equal or greater number of directors. Quorum

Controlling shareholders (and in PE the investor) will normally require that its director nominee is present for there to be a “quorum” for board meetings. In other words, if that director is not present then the board is not properly convened and cannot pass binding resolutions. This protects against the risk of the minority or management directors passing resolutions to bind the company without the knowledge of the nominee director. If there are multiple material shareholders, then each one may require that their nominee is also present. The agreement will also need to deal with what happens if quorum is not satisfied for a meeting — in most cases there is a provision that the meeting is adjourned for a certain period of time (say two business days) and those directors present form quorum.

Chairperson The agreement will need to specify who the chairperson is, how they are appointed and whether they have a casting vote. In a PE deal, the chairperson may be a nominee of the investor or possibly an independent director jointly appointed by management and the investors. Share Any minimum shareholding level required to retain qualification certain key rights such as access to information or the right to remove and appoint a director. Fees and expenses

The shareholders’ agreement usually specifies the fees payable to the investor or non-executive directors (in addition to any monitoring fees or arrangement fees required by the investor in a PE deal). Typically, executive directors are not entitled to additional stipends.

Financial or operational difficulty (FOD) If the company has been underperforming, then some shareholders including PE investors may want board control to pass to them. Usually the key triggers are breaking banking covenants or missing budget targets in consecutive quarters. Management will argue that they should be given an opportunity to remedy. Observers Some shareholders prefer not to take up their right to appoint directors, opting to rely on observer rights only. Typically the observer can attend and “observe” board meetings and receive copies of board papers but is not entitled to vote. The appointment of an observer only is usually an attempt to minimise potential exposure under onerous directors’ duties (such as liability for insolvent trading, fiduciary duties to act in the interests of the company, duties to avoid conflicts, etc). It is important to note that under the “shadow director” provisions, an observer may still be liable in the same way as a director. If an observer is deemed to be a shadow director (in other words, though not formally appointed as a director, the person has been acting in the same way as a director by, for example, directing the board and the company on how to act), it will have duties to the company and its shareholders as a whole (not just the shareholder) and may accrue liability for insolvent trading. Deadlocks If there is the potential for a “hung board”, then it will be necessary to consider how the deadlock is going to be resolved. For example, in a PE deal if the investor has two directors and management have two directors and a resolution requires a simple majority of the board to approve a decision, then there is a risk that the board cannot make decisions. A casting vote is a useful way of breaking deadlocks at the board level. If the controlling shareholder or investor has appointed the chairperson, they will be more comfortable with this provision but if the chair is appointed by the founders/managers then this may be less

agreeable. In some cases, the right to appoint the chair will rotate among founders and investors. Other potential mechanisms for resolving deadlocks include: • Escalation: The potential issue is passed on to personnel within the relevant shareholding entities to resolve. • Referral: The deadlock is referred to an independent expert for consideration and advice. • Put/call option: A regime whereby if the parties cannot resolve the dispute and it relates to a fundamental issue affecting the business then the affected parties can offer to sell their shares/purchase the other party’s shares at a certain price, in which case the existing pre-emptive regime would apply. • Russian roulette: A system under which one shareholder may offer to purchase another’s shares at a certain price. The other shareholder then may offer to buy the offerer’s shares at that price, if it wants to. If it does not, then the offerer may purchase the other shareholder’s shares at that price • Silent auction: A variation of the Russian roulette regime, whereby each party lodges a sealed bid for the purchase of the other party’s interest and the highest bidder is obliged to proceed. • Swing man: The parties appoint an independent person (not a director) to be a “swing man”, who has a casting vote on the issue.

¶4-030 Downside protections This section covers: • confidentiality • restrictive covenants • good leavers and bad leavers.

Confidentiality The shareholders’ agreement will include provisions requiring the parties to keep information of the business confidential, to not disclose it to any third party and to take reasonable precautions to protect the information. It will also usually provide that no press releases or other announcements may be made around the transaction without the prior approval of each party. In PE deals, the investors may wish to have prior approval included in the agreement, such that they can publish details (“tombstones”) of their investment without having to get shareholder approval. Common exceptions to confidentiality which may be included in the agreement may relate to the following: • information already known by a party • information in the public domain (other than because of a breach of an obligation of confidence) • information where disclosure is required by law or the order of any court, tribunal or regulatory body such as the stock exchange • in the instance of an investor, disclosure to its employees, officers, advisers and to its own investors/limited partners • disclosure to a potential buyer, as long as it is on a confidential basis. Restrictive covenants The shareholders’ agreement customarily includes restrictive covenants (such as anti-poaching of employees and customers, noncompetes and non-interference with suppliers, customers and other stakeholders) from the management team in order to protect the goodwill of the business. An issue often raised is why have restraints in the shareholders’ agreement when they are already contained in the executive service agreements? Consider:

• A court is more likely to enforce a restrictive covenant contained in a shareholders’ agreement (than one in an executive service agreement): – the courts tend to be more lenient on employees, allowing them to “earn a living”, but – stricter on someone who is a shareholder, acknowledging the “consideration” paid by the investor for these restrictive covenants under the investment or acquisition. • Restrictive covenants in the shareholders’ agreement are given directly to the other shareholders or investors whereas shareholders and investors are not a party to the service agreement (the company may also be reluctant to enforce a restraint, especially if the investor is not in a controlling position). • A restraint period can be tied to when the manager ceases to hold shares rather than to when they cease to be employed. Good leavers and bad leavers This provision covers the effect that a management shareholder ceasing employment will have upon their shareholding, options, ratchets or any board seats. Overview: If there is a “leaver event”, then the shares held by that manager may be subject to a buy-back regime (at a discounted price) and any exit incentive or ratchet may lapse. This may be a contentious provision for managers, as they risk losing their stake in the business at a price potentially less than market value. Definition: In simple terms: Good leaver: Someone who leaves employment due to serious illness, retires after a certain period of service or is terminated without cause. Bad leaver: Someone who resigns before an exit event or termination for a cause which may be triggered by the executive breaching their restraint or engaging in gross misconduct or acting in

bad faith. There is a broad range of ways of defining a “leaver”: • Two tier: The controlling shareholder or investor will usually want the definition of “bad leaver” to be as broad as possible. This can be achieved by having a narrow and specific definition of a good leaver (eg someone who retires after four years or leaves due to serious illness), while the definition of “bad leaver” refers to all other leavers (eg anyone who is a leaver and is not a good leaver, including someone whose employment is terminated, with or without cause, or resigns). • Three tier: A more moderate approach could be to adopt three categories — a “good leaver”, “intermediate leaver” and “bad leaver”: – The definitions of each category would be more lenient, such that: a. a good leaver is someone who retires after three or four years or leaves due to serious illness b. a bad leaver is someone who is terminated for cause including for breaching their restraint, engaging in gross misconduct or bad faith, and c. an intermediate leaver is any other leaver. – The pricing regime would vary between the categories, perhaps so that a good leaver receives market value, an intermediate leaver receives market value less 5% and a bad leaver receives the lower of market value less 10% or issue price. • Single tier: Some controlling shareholders and investors have a tough stance on leavers and have one broad category of leaver only. They consider that anyone who ceases to be employed prior to exit is a leaver and will have their shares bought back (at lower of issue price and market value):

– Obviously, such a provision is fairly draconian and may in fact be unenforceable as a penalty (depending on the circumstances of the case) and will also be strongly resisted by management and their advisers given that the controlling shareholder or investor could simply terminate an executive just before an exit in bad faith and the executive would lose the increase in value from the original issue price. – Worse still managers who have had to borrow money to acquire shares could be exposed to “negative equity” if the market value at the time of being a leaver is less than the loan amount. – A leaver provision of this nature would be more commercially justifiable and enforceable in the context of free equity, “sweat equity”, unvested options or the ratchet (rather than shares held prior to the MBO in the case of a minority deal or secondary deal or where managers have borrowed money to acquire at full value). Sale price: This will vary depending upon whether the leaver is classified as a good leaver or a bad leaver. A bad leaver is generally obliged to sell their shares at the lower of market value (say less 10%) and issue price, a good leaver at market value (or market value less 5%). Incentives: The agreement should also deal with what happens to other incentives such as bonuses, options and ratchets. There is little point in including a leaver regime to buy back shares when all the other incentives stay on foot — they should either lapse or be bought back for an agreed value. Holding period: The period of time a manager leaves after the investment date can also be used in determining whether somebody is a good leaver. For example, if a manager leaves later than three or four years after the date of the investment, they could be treated as a good leaver (or perhaps a portion of the holding could be treated as being covered by the good leaver pricing and the balance under the bad leaver pricing). Conversely, the controlling shareholder or investor

may argue that a leaver is always a bad leaver if he/she “leaves”, regardless of the reason, within the first 12 or 24 months. Without cause: Another issue to consider is whether an individual who has been dismissed “without cause” should be a good leaver. In particular, the management team may argue that a person is still a good leaver if he/she is wrongfully or unfairly dismissed. The risk for the controlling shareholder or investor is that a person may be deemed wrongfully or unfairly dismissed as a consequence of procedural factors. Valuation: The agreement will need to provide a mechanism for the calculation of market value. The key issues to consider are: • Who determines market value: The board is often required to determine a value, perhaps using a formula (such as a multiple of historical/budgeted earnings before interest, taxes, depreciation or amortisation (EBITDA)) or by using the auditor or an independent expert if the board is unwilling to determine the price or if the manager disputes the board-determined price. • Minority interest rule: The market value is usually determined by applying the percentage of the leaver’s shares to the value of the group as a whole (ie not adjusting for the minority interest). Alternatively, the market value can be adjusted for the fact that the leaver holds only a minority interest in the company. • Expert costs: If the value is to be determined by an expert, then it is important to specify who bears the cost of valuation. In some cases for minor shareholdings or companies in distress, the cost of valuation can be relatively large compared to the value of the actual shares. Consider whether to require the leaver to pay at least 50% of the costs of determination or perhaps the full costs if the independent expert validates the board’s valuation. Nominees: The wording will need to be broad enough to ensure permitted transferees and nominee shareholders of the manager are covered by the leaver provisions. Secondary buyouts/minority deals: The standard good/bad leaver

provision is not always appropriate where a manager or founder had an equity interest prior to the MBO, such as in a secondary buyout or where the investor only acquires a minority of the shares from the founders and they are retaining the balance of their holding. They will argue that their holding is already vested at the date of the MBO (and should be treated differently from “sweat equity”) and on leaving, that portion of their shares should not be subject to mandatory transfer provisions.

¶4-040 Liquidity clauses The liquidity clauses cover: • issues of shares • transfers of shares • drag-along • tag-along • matching rights • exit strategy/sunsets. Issues of shares Shareholders will require a pre-emptive right to invest in future issues of shares, to ensure they can maintain their relative proportion of equity in the business. It is customary to carve out certain types of “excluded” share issues such as: • the issue of options or shares under an employee option plan • the issue of shares as part of a merger or strategic partnering deal • the issue of options or warrants as part of debt refinancing • the conversion of existing instruments into ordinary shares (such as convertible notes, warrants, options or convertible preference

shares), and • the issue of shares in circumstances where the board resolves that funding is required on an urgent basis to prevent insolvency or a breach of banking covenants. These excluded issues will dilute everyone’s equity position equally (except the relevant subscriber). Transfers of shares • Pre-emption: If any shareholder intends to sell shares, the remaining shareholders are given an option to acquire their relative proportion of those shares under the pre-emption clause. • Permitted transfers: The pre-emption provisions usually do not apply to certain types of permitted transfers, for example: – In a PE deal, investors can transfer to other entities managed by the same investment manager, replacement custodians or trustees. – Managers can transfer to family members, family trusts and wholly owned companies. – Trustees can transfer to new trustees or to beneficiaries under trust. • Deed of adherence: The agreement should require all transferees to enter into a deed of adherence to bind them to the contractual provisions set out in the shareholders’ agreement. The deed should identify the capacity in which the transferee is adhering (ie investor or management). • Restrictions on sale of shares/lock-ins: As the value of the company is often closely linked to the expertise of key employees, controlling shareholders and investors will usually “lock in” the shares held by employees until such time as the controller or investors have sold their interest or for a minimum holding period of, say, three years. Furthermore, where managers

have been issued shares at a discount (sweat equity) then there is a greater imperative to lock in their shares. Drag-along A trade sale may be frustrated if minority shareholders refuse to sell. This is particularly important as bidders may make their offers conditional upon receiving 100% of the issued capital so that they can form a group for tax and accounting purposes. Drag-along clauses (also called “come along”) force minority shareholders to sell their shares if the controller, investor or a specified percentage of shareholders (usually 75%) accept the third party offer. Without drag-along provisions, the controller or investor would be required to rely on the compulsory acquisition provisions in the Corporations Act 2001, which cover only cash offers not scrip, require expert reports as to valuation and require at least 90% to have accepted. The Act also provides the right for minorities to object to the process in court and provides the court with the discretion to prohibit the acquisition in certain circumstances. Given the cost, uncertainty and complexity of this process, potential bidders are reluctant to rely on these provisions. Drag-along clauses are particularly useful when dealing with a small number of dissident shareholders, perhaps ex-employees or founders, who are no longer involved in the day-to-day running of the business. It is important to note, however, that the courts have been reluctant to enforce drag-along provisions unless they are absolutely clear in their scope and terms. The uncertainty of the enforceability of these provisions often means that controller or investors are unlikely actually to enforce them against the entire management team — moreover a buyer is commercially unlikely to want to proceed to completion without the formal written agreement of management (and their written acceptance of the sale terms, new service arrangements, restrictive covenants and endorsement of the warranties). This commercial imperative may be mitigated if the bidder has its own replacement management team or has had a significant price reduction. Certain issues commonly arise when negotiating a drag-along:

• Power of Attorney (POA): The drag must be supported by a POA provision to allow execution of the transfer forms. • Classes: Consider how the drag-along applies across multiple classes of shares or other securities (like options or loan notes). • Cash and scrip: Drag-along clauses must specify whether the minority shareholders can be forced to accept consideration other than cash. If this is not expressly stated, then the minority shareholders cannot be forced to take shares or loan notes for their shares. The members of the management team are likely to be concerned by a requirement that they can be forced to take shares in an unknown bidder and might request comfort that it is listed, has a certain market size or credit rating and may also request that they have contractual protections similar to the existing shareholders’ agreement. • Floor price: The manager or minority shareholders may require a floor price (such as $5 per share or an equity value of $100m) before the controller or investor can issue a drag-along notice. This ensures they cannot be forced to exit at too low a price (particularly where managers have borrowed money to acquire their shares). Controlling shareholders or investors, however, may be motivated to exit regardless of price, particularly if the entity has been underperforming and will resist a floor price or require that this protection lapses if there is a FOD or if the founders are in breach of the agreements or require that it expires after, say, six years. • Ratchet: The operation of the drag-along should also tie in with the operation of the ratchet. For example, a ratchet mechanism may only apply after a certain period (eg after the third anniversary). Consider how a drag-along before then works — does the ratchet lapse, accelerate or partly apply? • Priority: It is important to ensure that the drag-along overrides the other share transfer provisions. The majority should be able to dispose of shares and issue a drag-along, notwithstanding the

pre-emption and tag-along provisions. Tag-along A tag-along clause provides that a majority shareholder is unable to transfer some or all of its shares without the proposed third party buyer also agreeing to purchase an equivalent proportion of the shares of the other shareholders. From the perspective of a controlling shareholder or investor, granting a tag-along (or piggy-back right) might frustrate its ability to exit — the third party might want the managers to remain shareholders. It also means the controller or investor cannot sell on the shares it intended as part of the sale pool will be allocated to the minority. As a potential compromise, the tag-along may provide that the minority shareholders only have a right to offer their shares for sale to the proposed buyer (in other words, the majority is not obliged to procure the purchase of the minority’s shares). The controller or investor should consider whether the tag-along lapses if a manager has breached the agreements, is a leaver or whether the tag-along expires after, say, five or six years. Matching rights Management teams may ask for the right to match the offer being made by the proposed buyer in a drag-along situation. The controller or investor should be cautious as a matching right represents a significant deterrent to a buyer who will be concerned it is merely being used as a “stalking horse”. The proposed buyer may require some form of break fee (to cover its costs in bidding) should the matching right prevail. As with the tagalong, the controller or investor should consider whether the matching right lapses if a manager has breached the agreement, is a leaver or expires after say five or six years. The controller or investor could also require the management to pay a “deposit” when it elects to match and to prove capacity to fund within 10 days of electing to match. Exit strategy/sunset Controllers or investors are driven by the need to realise the value of

their investment and will want the right to force a trade sale, share sale or float within three or four years. It is common to include a clause in the shareholders’ agreement which sets out the “exit intention” of the shareholders. The main features of the exit clause to consider are: • This provision will need to ensure the controller or investor can appoint an independent investment bank to run a sale process and it should be clear who bears the cost (usually the company). • It may provide that management will give warranties on an exit but that the controller or investor will not be required to give any (other than a warranty as to power, title or authority). • The sunset must be supported by a POA provision to allow execution of the transfer forms. • The managers need to commit to vote their shares in favour of any necessary resolutions required for an IPO, including share reorganisations. • The pre-emptive rights and tag-along clauses should not apply.

¶4-050 Incentives/ratchets Incentive mechanisms for management can take the form of options or an exit ratchet. Option An option may be granted to managers, giving them the right to subscribe for new shares in the company, subject to certain vesting conditions (such as minimum service periods or the company meeting financial hurdles such as EBITDA target) and lapsing provisions (good/bad leaver). The parties should consider the tax treatment carefully before granting options. Ratchet A ratchet is a provision in PE deals which provides that the investors

will pay a certain amount to the management on a “successful” exit event, provided they are still employed as executives. Ratchets are usually based on the return to the investor on an exit event (such as an IPO, share sale or asset sale), if the internal rate of return (IRR) exceeds say 30% or 40%. Often investors may also require a multiple return of say 1.5 or 2 times the original investment (in other words, they need to be returned an actual cash quantum of their investment 1.5 times). The parties should consider the tax ramifications carefully before implementing the ratchet and seek tax advice from a suitably qualified adviser. In particular, the management team will be keen to ensure that the increase in proceeds received is on capital account (not income account). The ratchet is often embedded in the terms of the preference shares held by the investors, so they convert into a lower number of ordinary shares on an exit if the ratchet applies. Every investor will have a different perspective on the quantum of the ratchet, but a simple example could be: • Management hold ordinary shares equal to 20% of the issued capital. • Investor holds preference shares equal to 80% of the issued capital. • The preference share percentage on conversion shall be reduced to 70% (and the management percentage increased by 10% to 30%) if the 40% IRR targets are met in full and pro-rata if the IRR is below that. See the table below. IRR on exit Less than 30%

Ratchet No ratchet

IRR is between 30% The ratchet will and 40% partially apply

Application Preference shares convert one for one (ie 80% of the issued capital). The preference shares will convert

into 1% less equity for each 1% the IRR is over 30%. IRR is in excess of 40%

The ratchet applies in full

Preference shares convert into 70% of the issued capital (not 80%).

For example, if the IRR was 35%, the preference shares would convert into 75% of the issued capital and the ordinary shares would represent 25%. Ratchets are fairly complex provisions to draft and the parties should carefully consider a range of issues, including: • The ratchet should prescriptively define IRR, either in words or an agreed mathematical formula. • It is important to include illustrative examples of how the ratchet works in practice. • When defining IRR, is it the return to the investor before or after the application of the ratchet? It would be customary to define it post-operation of the ratchet. • How will proceeds on an exit event be valued if the consideration includes shares in another entity? If listed, weighted average trading multiples could be referred to and if unlisted, an independent valuation could be sought. • The IRR usually covers all “cash in” (consider then whether it includes dividends and other distributions, board fees to the investors and any original structuring or monitoring fees) and all “cash out” (consider exit costs, entry costs, bridging loans). • Are calculations rounded up or down to the nearest whole number? This is particularly important where the value per share is very high (in turn, consider whether a stock-split is advisable

pre-exit to get the sale price closer to $1 per share, rather than hundreds of thousands or millions of dollars per share). • If there are shareholders other than the management and investor, will the ratchet benefit or dilute all such shareholders equally? This can be quite complex but if there are employee shareholders or option holders (other than the key management team) it may be necessary to create another class of shares for those employees (non-participating) to ensure only the investor is diluted by the ratchet (and those non-participating employees are not diluted). • Who prepares the calculation and what is the dispute resolution mechanism? Source Phil Sanderson “Equity Aspects of Private Equity Transactions” (January/February 2004) PLC Private Equity Practice Manual 2.41.

DUE DILIGENCE Overview

¶5-010

Commercial due diligence

¶5-020

Legal due diligence

¶5-030

Financial due diligence

¶5-040

Management due diligence

¶5-050

Other types of due diligence

¶5-060

Due diligence reports

¶5-070

Editorial information In this chapter, an overview of the due diligence process in

acquisitions and other corporate transactions is provided. The chapter also considers the nature and importance of different types of due diligence and the resulting reports.

¶5-010 Overview This section considers what due diligence is, what the benefits of due diligence are and how transaction risk can be managed, as well as the usual scope of due diligence and its timetable. What is due diligence? Due diligence is a key aspect of any acquisition or investment. It is a programme of critical analysis undertaken prior to an acquisition or investment to ensure that there are no undisclosed liabilities or risks. There are potentially enormous risks associated with buying or investing in any business and the legal adage of caveat emptor or “let the buyer beware” applies. The buyer must be satisfied as to the prospects and viability of the business and should undertake extensive due diligence investigations before committing to a purchase. While appropriate review will not eliminate all risks, the knowledge gained can alert buyers as to what risks may exist, so that they can mitigate them going forward and ensure the deal structure and associated documentation are appropriately tailored. A consistent and well thought-out due diligence protocol will help a buyer compare the merits of different investment proposals. Due diligence can cause problems if the vendor or the target’s management wants to keep the deal confidential (either to the market or its own staff). In these circumstances, the process must be appropriately managed to avoid rumour and conjecture which could adversely impact the deal. While a buyer leads the due diligence process, much of the detailed work will be sourced to outside specialists such as lawyers, bankers, accountants and, depending on the nature of the business, potentially

other specialists such as insurance brokers or environmental consultants. In some cases, large PE houses and corporates can undertake some of the due diligence tasks with their own internal specialists. Benefits of due diligence Too often parties view due diligence as merely a “tick the box” exercise, particularly if it does not uncover any issues. However, when the process uncovers previously unknown risks, trends or shortcomings, or the process is handled poorly and loses the confidence of the buyer, the need for, and value of, undertaking appropriate due diligence becomes clear. Some of the key benefits: • Opportunity to withdraw if serious risks found: If the due diligence process reveals any serious risks, the buyer can withdraw before making a bad investment. Without the benefit of due diligence, buyers risk buying a failing business or inheriting material undisclosed liabilities. • Opportunity to restructure: Alternatively, if the process reveals large but non-fatal liabilities, a buyer can deal with these by restructuring the deal (eg to exclude underperforming divisions), reducing the purchase price or amending the sale documents by broadening warranties, indemnities and conditions. • Avoidance of enforcement costs: Identifying risks at the outset can save the buyer the uncertain and costly exercise of trying to enforce warranties after completion. • Verification: A comprehensive investigation allows the buyer to ensure the financial projections are based on sensible assumptions. • Tailored warranties and conditions: The process may reveal smaller but not insignificant risks associated with running the business, which can be dealt with by including conditions precedent, completion deliverables, specific warranties or

indemnities. • Confidence: Due diligence provides the buyer and any debt provider with a detailed understanding of the business, thus enabling them to invest with confidence. • Integration and 90- or 100-day post-acquisition plans: Sometimes due diligence results in post-acquisition or integration planning, that is, it materially informs the 90- or 100-day plan. There are times when commercial calls will be made on issues and the only way to deal with them is post acquisition. Ways to mitigate discovered risks Below is a table profiling the magnitude of risks which have the potential to be discovered during the due diligence stage and solutions to these risks. Risks and mitigating solutions Magnitude of risk

Solution

Fatal

Buyer withdraws from transaction.

Serious

Buyer to consider whether to withdraw or alternatively: • restructure the deal by excluding certain assets and entering a business sale agreement rather than a share sale agreement • negotiate a significant price reduction • negotiate bank or parent guarantee, and • widen scope and time period of warranties and indemnities.

Moderate

Buyer to: • consider hold-backs or deferred consideration

• negotiate bank or parent guarantee • include in 90- or 100-day plan as a matter to be managed post-acquisition, and • widen scope and time period of warranties and indemnities. Material

Buyer to: • build specific warranties and indemnities into the sale agreement • insist on conditions precedent or completion deliverables (such as obtaining key consents), and • impose pre- and post-completion obligations.

Maximising the benefits of due diligence In order to maximise the benefits of the due diligence process, it is essential to ensure that it has: • The right scope: The transaction should be adequately scoped in order to build the right framework, questionnaire and team within the budget allocated. According to Richard Young, Director, Deloitte: “Typically those with good industry knowledge or knowledge of the target will be able to form a view on the key risks. This should be used to define scope and focus the scope on the priority areas. Having said that you still need a broad scope of coverage to ensure nothing gets missed, but consideration needs to be given as to where in the broad scope, depth should be pursued.” • A logical framework: There should be a consistent, logical framework including: – a clear timetable – a tailored questionnaire

– a list of major areas of concern and clear scope of review – an effective system for managing the process, including clear: a. instructions to advisers and senior management b. points of contact and processes in respect of the provision of information and requests for further information, and c. protocols for receiving updates from advisers, and – effective confidentiality controls to limit leaks to the market and minimise employee disruption of the target. • Cohesive teams: It is essential to create the right team of advisers who understand the needs of the buyer, can implement the due diligence framework, who can understand the target’s business and identify issues affecting the target industry. • Adviser communication: Clear communication between the buyer and its advisers and between the advisers themselves (ie between the accountants and investment bankers doing the financial due diligence and the lawyers doing the legal due diligence) is a necessity, as the issues which arise in one stream of due diligence may be relevant to other streams. It may be helpful to institute regular update calls or meetings to go through outstanding items on the checklist until completion. • A co-operative target: It is important that the management of the target are receptive to the due diligence process and provide an adequate quality and quantity of information. Inadequately planned due diligence programmes will be of limited value to the buyer. Time and energy can be wasted undertaking unnecessary due diligence or pursuing post-completion forcing the buyer to recover losses under the warranties in the sale agreement. Transaction risk

Some businesses are less risky than others. The key is for buyers to know how much risk they are prepared to accept, identify risks before a deal is struck and do what they can to reduce the impact of these on the deal and the future business. Buyers should be clear that the breadth of their due diligence is not the only factor influencing the risk of a deal. The overall “transaction risk” (the risk of finding out undisclosed information about the business after the deal is done) is comprised of three factors — inherent risk, liability risk and due diligence risk. Components of transaction risk Inherent risk • How risky is the business environment? • How risky is the product or service? • Is management trustworthy and competent? • How good are the business’s system controls?

Liability risk

Due diligence risk

• What is the size of the deal? • What if buyers make a mistake? Are they simply overpaying or are they assuming “open-ended” liabilities? • Are the warranties and indemnities adequate?

• How well has the due diligence programme been planned? • Is it possible to procure quality information (eg key executives may have left)? • Is there enough time to gather the information needed (competitive tenders or sales by receivers may be on compressed timetables)?

Transaction risk can be represented in the form of the following equation: Transaction Risk = Inherent Risk + Liability Risk + Due Diligence Risk Overall transaction risk can be reduced if inherent risk, liability risk and

due diligence risk are reduced. • Considerations before due diligence are that: – depending on the nature of the business, inherent risk and liability risk tend to be out of the buyer’s control (until the buyer completes its due diligence, after which it can structure the deal to reduce these risks) – due diligence risk exists because the buyer can rarely control the quality and availability of information provided to it by the target. At best, buyers can minimise this risk by designing an appropriate due diligence programme – high inherent or liability risk = comprehensive due diligence programme required – low inherent or liability risk = reduced due diligence programme may suffice. • After due diligence, depending on what is discovered, the buyer may mitigate: – inherent risk, by requesting warranties and conditions precedent, and – liability risk, by restructuring the deal to buy assets rather than shares, reducing price or broadening the scope of warranties and indemnities. The important thing to note is that risk cannot be eliminated, but it can be reduced with the right transaction approach. Scope The level and scope of due diligence undertaken will depend on the particular transaction, the number of parties involved and the specific needs of the buyer. For instance, in the case of a management buyout where a vendor is only prepared to provide limited warranties, PE providers and debt providers will want to carry out an extensive due diligence review, in contrast to the management team who should

already have good knowledge and understanding of the business. Or, if the buyer is intending to obtain warranty and indemnity (W&I) insurance, the buyer will need to be able to demonstrate that it has conducted adequate diligence in respect of the areas in which it is seeking coverage. The scope will depend on a number of factors, including: • the risk appetite of the buyer’s board • the risk environment the business operates in • the size of the deal • the nature and depth of information already known about the business • the importance of the transaction to the buyer for its future business development, and • how much time the buyer can dedicate to the due diligence stage. Timetable Due diligence can take weeks and sometimes months to complete. Factors affecting due diligence time frames include the: • size and complexity of the deal • depth of due diligence required by the buyer • cooperation of the target, and • availability of sufficient and good quality information. During the due diligence process, the due diligence team may have an ongoing presence at the target’s premises.

¶5-020 Commercial due diligence Commercial due diligence (CDD) is designed to test the assumptions

underpinning the financial projections. It assesses how credible the assumptions are about the market and the company’s positioning within the market. CDD appraisal is more subjective than financial due diligence reviews. Considerations A typical CDD review will consider the following factors: • Competition: This will involve competitor analysis and benchmarking against major competitors including any new competitors entering the market. • Customers: Interviews with key customers and assessment of their satisfaction. • Demographics: The changing demographics in the market may mean the long-term prospects of the business are not viable. • Exit: Future exit opportunities. • Market: A review of market size and prospects for growth and an assessment of key trends and drivers in the market, including competitive positioning and market share. • Obsolescence: Are the products or services sold by the business about to become obsolete through the introduction of new technology For example, streaming, cloud services and USBs are making compact disks obsolete, and media convergence and digital technologies are dramatically affecting business models in a number of sectors. • Regulation: Is the government planning to introduce new legislation which will negatively impact the industry? • Trading: The business’s cyclical trading history, in particular, how the target traded during a recession. • SWOT: The strengths, weaknesses, opportunities and threats for the business.

• Other: An analysis of supply chain, pricing trends for the industry and site visits should all be completed. Providers Different buyers have developed a range of approaches and procedures to manage this task. For example, the commercial review may be done internally by the investment team at the buyer or outsourced to experts. The choice will be driven partly by whether the in-house team has the relevant market expertise and bandwidth. An independent report may also be required by any senior debt providers. In larger deals, the review is usually outsourced to a firm of specialist advisers. The various providers of CDD include: • Management consulting firms: These can range from small boutique firms that focus on certain industry sectors to large multinational firms. • Accounting firms: These often have specialist CDD practices. • Freelancers: In some cases, former senior executives (who may have recently been the Chief Executive Officer (CEO) or a director at a competitor) can provide useful assistance. They can be invaluable because of their extensive knowledge of the market, practical experience and ability to give a high-level view of the target and its prospects. Buyers should ensure individuals they employ are not bound by restraints to a previous employer. Selecting advisers Where a CDD task is outsourced to a specialist, the key considerations in selecting the right adviser will be whether they satisfy the following criteria: • Impartiality: Do they already act for competitors? • Experience: Do they have relevant sector experience? • Research resources: Do they have access to deep research

resources or proprietary data? • Bandwidth: Can they deal with the large amounts of work required to be delivered, usually to a tight timetable? If engaging a small practice or a freelancer, ensure they are geared up for the short timetables endemic to acquisitions. • Cost: Larger consulting firms can be expensive and are typically only used for large transactions.

¶5-030 Legal due diligence Legal due diligence (LDD) will generally commence once a Term Sheet has been signed and exclusivity obtained. A key aspect of LDD is determining the scope of the investigations by setting risk or materiality thresholds and identifying any areas of concern. As LDD often overlaps with other areas (eg tax or environment), it is imperative that there is clear communication between the various experts involved. When establishing a scope for LDD, it is essential to create a thorough yet appropriately targeted due diligence questionnaire. For example, in a management buyout context, if the vendor is responsible for insurance and tax functions, questions concerning these matters should be addressed to the vendor, whereas the management team might be responsible for employee and operational matters so will be the better contact point to provide this information. The weight given to areas of LDD will depend on the nature of the target and its business. For example, the focus of due diligence in an advertising business will be on its customer contracts whereas due diligence for a biotechnology company is likely to focus on its ownership of, and right to exploit, its intellectual property. While the material focus of an LDD will vary, the principal areas covered by the LDD review will include: • Key contracts: All material contracts should be reviewed, including standard terms of trade, maintenance, customer,

supply, licence, joint venture, shareholder and distribution agreements. This review should identify unusual or onerous terms within these contracts, any change in control issues, as well as any consents that are required to give effect to the proposed transaction. • Financial arrangements: Documentation relating to the finance facilities or other financial accommodations of the target company, including relevant loan agreements, guarantees, factoring arrangements, hire purchase, security agreements, mortgages and other ancillary documents should be reviewed. Particular attention should be paid to any need to obtain a financier’s consent to the proposed transaction and determining what assets are subject to a financier’s security interest. • Constituent documents: The constituent documents for the target company and its subsidiaries (if applicable) should be reviewed. It is important to review documents such as shareholders’ agreements and employee share plans which may amend the original constitution or articles of a company. Key matters to identify in this review include any governance requirements relevant to the proposed transaction (such as board and shareholder approvals), as well as any matching rights, preemptive rights (in the case of a share sale) or other restrictions on the proposed transaction. • Insurance: All certificates of currency should be reviewed to determine the range of insurance coverage as well as incidents potentially giving rise to claims and, where relevant, claims history. This will be particularly relevant where the target is a “self-insurer” (ie an insurer of itself and its subsidiary operations). Understanding incidents and claims history can provide an insight into risk areas in the operations of the target. An insurance broker may be better placed to address the adequacy of coverage — particularly where there are significant insurance risks or statutory insurance requirements (an airline company would be an example of this).

• Employees: It is essential to review details of all employees and the terms of their employment as well as determining compliance by the target with employment laws. Not only should employment terms be reviewed, such as employment agreements for key employees, relevant awards and agreements with any trade unions, but compliance with employee-related obligations such as effective health and safety policies, workplace injury, sexual harassment policies and any claims history and incidents should also be reviewed. • Intellectual property: All intellectual property assets (IPAs) used by the target should be reviewed to determine ownership or contractual rights to use those IPAs. Searches of IPA public registers should be undertaken. In Australia, searchable registers exist for patents, trade marks, designs, plant breeders’ rights and business names. However, copyright and circuit layout rights are not registered. Rights of ownership or contractual rights to use IPAs should be reviewed to determine that no intellectual property rights of a third party are being infringed and whether any rights have been granted to third parties to use a company’s IPAs. • Superannuation/pensions: In conjunction with reviewing employee issues, superannuation/pension funds should be investigated with a focus on ensuring all employer payments have been paid, and that the details of the employees who are members of the scheme are current. If the target operates a corporate fund, the fund rules, trust deeds and all relevant valuations and auditor reports should also be reviewed. • Property: A full list of all property assets owned or leased by the target should be established. Land registries should be searched to confirm title and any registered third-party interests, zoning reviewed and searches for outstanding land taxes and landrelated charges undertaken. All leases and licences need to be reviewed having regard to the key terms (expiry, make good provisions and change of control) and compliance with terms. • Litigation/disputes: Searches of court registries should be

undertaken to determine if there is any current litigation in which the target is involved. Existing, threatened or pending disputes should be carefully reviewed (including arbitration, mediation and recently settled litigation). • Regulatory: Any government regulations, or mandatory or voluntary codes that may affect the business of the target and its ongoing operations should be assessed. A review of material transactions and past activities is also useful to ensure compliance with government regulations has occurred. Such regulatory issues may include obtaining approval from the Australian Competition and Consumer Commission (ACCC) or, where a buyer is a foreign company, clearance by the Foreign Investment Review Board (FIRB) may be necessary. • Tax: Depending on the expertise of the team, due diligence on tax may form part of either the legal or the financial due diligence. This review needs to confirm that the target’s stated tax liabilities are accurate, including a review of all tax returns and other relevant claims made, for example research and development (R&D) claims. A review of any tax audits should also be made. • Licences/permits: Where any licences or permits are necessary for the target to conduct its business, those permits should be reviewed as to currency, whether any limitation or special conditions are imposed on them, to determine compliance with licence and permit terms and requirements and whether any change in control requires new licences or permits to be obtained or if they can be assigned. • Environmental: There should be a review of all environmental licences and approvals, as well as any audits, improvement notices or similar notices from relevant government authorities for an appropriate period (eg the preceding three-year period). • Public registers: These should be searched to verify the target’s disclosed information. Examples of registers in Australia which should be searched include national registers such as the

company register operated by the Australian Securities and Investments Commission (ASIC), the intellectual property registers operated by IP Australia and the Personal Properties Securities Register (PPSR). State-based registers include those for land and real property and litigation. • Anti-money laundering (AML): Whether the target company knows its customers should be assessed. Where the target is a reporting entity, the buyer must review its customer due diligence policies, procedures, and controls to ensure instances of money laundering or terrorism financing by its customers can be effectively detected and reported. • Environmental, social and governance (ESG): This involves assessing the target’s track record in respect of ESG matters, including whether it has ESG policies in place (ie if it is a signatory of the Principles of Responsible Investment (PRI)), to determine if the target aligns with the buyer’s responsible organisational culture. Targets with conscionable ESG practices can pose lower inherent and liability risk for the buyer. This due diligence review should also include investigating complaints made against the business in respect of breaches of ESG requirements such as pollution or discrimination complaints. See Chapter 12 (Responsible Investing and ESG Issues) for more details.

¶5-040 Financial due diligence Financial due diligence (FDD) occurs at an early stage in the transaction. The FDD report will consider the internal consistency of the financial information provided, however, it is not an audit and typically does not include any general opinions or assurances about a company. These are typically beyond the scope of FDD. A firm of accountants with a specialist due diligence division (“Transaction Support” or TS) is usually retained to undertake an FDD review. The FDD is used to gain comfort both as to what the vendor has presented as the financial performance and position of the business

and in relation to key parts of the investment thesis but also to inform valuation, funding requirements and completion mechanisms. At its core, it should provide a view of earnings historical and forecast, working capital, cash flows and capital expenditure. Discussions with management are critical to understanding the underlying performance of the business. Even if a “Vendor Due Diligence Report” is provided, FDD should be carried out to review the vendor report and provide any “top-up” FDD focused on specific risk areas. Sources of information: The FDD team will obtain its information from a number of sources, including: • management accounts • historical budgets • business plans • tax returns • audit files • interviews with management • board minutes • policy manuals • customer contracts, and • legal files. A detailed list of information required for the FDD should be provided to the target’s management early in the process so they can collect and prepare the information ready for the due diligence. Coverage The areas typically covered in FDD include: • Background: This will set the context by providing an overview of

the target’s history, its structure and a description of the business. It may also contain a summary of the target’s objectives and management structure. • Projections: The financial projections of the target are reviewed to identify the key assumptions. Those assumptions are then tested against historical trends, current trading and potential future events. Major performance risks and unaccounted-for opportunities tend to be a focus. • Working capital and cash flow: The target’s cash flows and historical working capital movements. • Balance sheet: A balance sheet review, including the position of current assets and liabilities which are being acquired and current trading position. • Reporting systems: The financial reporting processes and related business systems such as marketing, IT, purchasing and production. • Employees: This review focuses on the financial aspect of the employment arrangements such as accurate provisions for leave entitlements, payment of superannuation contributions and redundancy liabilities. It may also cover labour relations issues, turnover and staff levels. • Tax: A review of tax compliance and also the taxation impact of the proposed transaction. • Post-acquisition impacts: Any issues arising from the proposed transaction, including the effect on key customers and key contracts are considered.

¶5-050 Management due diligence An appropriate cultural fit and a management team aligned with the buyer’s vision and expectations are critical elements to achieving a

successful outcome for the buyer. As a result, a buyer will be continually appraising the management team throughout a transaction from the first “pitch meeting” and beyond. Buyers need to assess the management team and its strengths, weaknesses and experience against their view of an optimum management structure and ideal personnel to meet their requirements post-acquisition looking for any: • gaps in expertise, • under- or over-capacity issues, or • key person risk – ie risk that key personnel will leave after the transaction resulting in material detriment to the business. Buyers should follow a detailed process: • Résumés: Each résumé should be closely reviewed and the rationale behind career decisions explored. Why did they change career direction? Does their experience clearly equip them for this role? • References: Personnel files should be reviewed as these are a guide to performance within the organisation and can also provide information on any issues with colleagues and peers. Referees provided by management team members should be contacted and networks accessed to identify independent sources of information such as colleagues, customers, clients, advisers, lenders and associates. This will develop as broad and wellinformed a picture as possible. • Searches: A check for court cases, criminal records and bankruptcy should be undertaken. It is important that executives are open and honest about past failures — a buyer may forgive prior failure if it is raised upfront but the buyer will lose all confidence in the executive if that background is discovered unexpectedly from the due diligence process. • Testing: Some buyers use psychometric testing or occupational

psychologists as an additional check. This input tends to focus on “emotional intelligence”, including an executive’s leadership style and ability to relate to colleagues, rather than on competence. • Feedback: Feedback from the key advisers on the deal should be requested. How did they relate to the members of the management team? Were they professional, helpful, experienced? How did they cope under pressure?

¶5-060 Other types of due diligence In addition to the main due diligence investigations noted at the front of this chapter, which are undertaken essentially in all transactions, there are numerous specialised due diligence reports that can be done which cater to specific aspects of a transaction. Below are examples of some additional due diligence reports that might be required when they are not sufficiently dealt with (if at all) in the due diligence investigations discussed earlier. Environmental due diligence Environmental due diligence is important for target businesses operating in certain sectors, such as manufacturing/storage, mining, motor, chemical and heavy engineering. Environmental liability for contamination attaches to the present occupier of the property. This is the case even if the present occupier was not originally responsible for the contamination. The potentially enormous costs of addressing environmental problems along with reputational risks mean a detailed environmental due diligence should be carefully considered. Depending on the target, the scope of the review can range from a “desk-top” analysis of licences to a comprehensive investigation including site visits. Environmental due diligence can be costly, and the presence of severe contamination issues may affect the price of the business, or lead to the inclusion of specific indemnities from the vendor in the sale and purchase agreement. Technical due diligence

When a target is acquired on the back of its technical position, its intellectual property or product superiority over its competition, or being the first to market and able to leverage its intellectual property monopolies, then buyers may commission a report focused on these aspects. Typical issues might include: • how long the current technical advantage will last • ownership and rights to use intellectual property assets • a technical review of competing technologies • channels to market for new technologies • reliability of production and ability to service current and projected volume increases, and • potential for new product innovation. Information technology (IT) due diligence Depending on the criticality of the systems to the overall operation of the business, specialist review may need to be given to this area. If the business has in-house developed and supported systems or systems that are critical to day-to-day business operation, IT due diligence should be undertaken to assess risk areas, quality of support and potential development/capex requirements.

¶5-070 Due diligence reports This section discusses: • the nature and scope of reports • who the report will be addressed to • management review of reports, and • “hold harmless” letters.

Nature and scope of reports Once the information has been collected and reviewed, the reviewers will prepare their due diligence report. The report should clearly state: • the areas covered • what instructions were given • the materiality thresholds • who the report is addressed to • liability limitations on the report provider • assumptions and qualifications • any limitations on the recipient’s ability to rely on the report, and • what information was provided to the reviewers, including the due diligence questionnaire with the target’s replies. Depending on the materiality thresholds set and the depth of the due diligence, the report will most commonly be prepared on an “exceptions only basis” rather than providing a full analysis. An “exceptions only” report only highlights issues which are outside the materiality thresholds which have been set or differ from the norm in the industry in which the target is operating. The due diligence provider will: • highlight areas of concern • draw conclusions and provide recommendations, and • request further information if needed. A report which merely lists or summarises the information collected but provides no analysis or conclusions on the risks and viability of the target will be of limited use.

Who is the report addressed to? The due diligence report is “addressed” to the party who commissioned the report, typically this will be the buyer. If a new company has been formed to acquire the target in the transaction (Newco) and is being used to acquire the shares or assets, then the report will be addressed to both Newco and the holding company. In addition, any other financiers such as equity co-investors, seniordebt or mezzanine-debt providers may also request that the report is either formally addressed to them or that they are provided with a copy of the report. It is unlikely that each stakeholder will want to incur the expense of conducting their own due diligence nor wish to engage their own teams to do due diligence. Clearly, the lawyers acting for the buyer will need to carefully consider whether they address the report to those other parties, as it creates professional indemnity issues for them. In particular, the breadth and scope of the review is conducted with specific instructions from their client (the buyer) for the purpose of acquiring the business (rather than looking at the adequacy of security for a debt provider). Some advisers will seek to disclaim liability when sending their reports to non-instructing parties as the report was not prepared with their needs in mind. Alternatively, they will allow that party to rely on their report on a prescriptive basis (eg subject to exclusions in the engagement letter). Management review of reports The due diligence report must inform the buyer about the target and is prepared by advisers based on the buyer’s instructions. However, it is valuable to involve the target’s management in the process by regularly updating them when issues arise and allowing them to comment on the draft report, especially when managers are responsible for some aspect of the report. Maintaining communication with management assists with: • efficiently procuring information • identifying errors or material issues known to management which

may not be known to the party preparing the report • removing inconsistencies, ambiguities or misrepresentations, and • providing a fair and balanced report. Most reports are drafted conservatively, particularly if the due diligence is constrained or sufficient high-quality information is unavailable. This may cause a report to overemphasise risks without appropriate consideration of upsides which may moderate or justify the risk. An unbalanced report can harm the transaction by creating doubts and concerns which could have been addressed prior to finalising the report. “Hold harmless” letters “Hold harmless” letters are commonly encountered in the context of a financial due diligence where the investigating accountant seeks access to the working papers of the target’s auditors for the audit of the previous years’ accounts. Before releasing these papers, the auditors may ask for a “hold harmless” letter which prevents the buyer from suing them for any decisions the buyer makes based on the auditor’s information. Typically, the auditor’s reason is that they prepared the papers in the context of an audit only and not for the purpose of analysing the value of the target for acquisition purposes. The auditor may ask to be indemnified in respect of all claims brought by the buyer, the target business or anyone else in connection with any liability or loss that the auditor may suffer as a result of information discovered in the working papers. The buyer should carefully consider whether they give an indemnity to the auditor and if they do, the scope should be limited or they may unintentionally find themselves giving the auditors an indemnity for claims by old owners for a previous negligent audit. If the buyer does not provide a “hold harmless” letter the auditor may withhold the information. While this is not likely to be fatal to the due

diligence process it will involve additional work and lower quality information may need to be relied upon. Sources Peter Martin and Andrew Fearon “Acquisition of the Business” (2003) PLC Private Equity Practice Manual 2.3. Sunil Patel “Commercial Due Diligence — Is It Worth It?” (paper presented at seminar, Due Diligence in Business Acquisitions hosted by Legal and Accounting Management Seminars (LAAMS) NSW, 8 March 2001). Garry Sharp, Alex Shinder (3rd rev. ed) Buyouts: A Guide for the Management Team (Euromoney Books and Montagu Private Equity, London, 2008).

PART B — PRIVATE EQUITY INTRODUCTION TO PRIVATE EQUITY Key definitions

¶6-010

Overview of PE

¶6-020

Overview of financial structure

¶6-030

Overview of the buyout process ¶6-040

Editorial information This chapter provides an introduction to private equity (PE), looking at some of the key terms necessary to an understanding of this area and giving an overview of PE in general.

¶6-010 Key definitions “Private equity” generally refers to investments in shares (rather than debt) of unlisted companies (rather than publicly quoted securities) using money from funds specifically established to invest in such securities. The investors are “patient capital” not usually requiring regular repayment of principal and interest (like a bank). There are some exceptions to this definition. In particular, some funds will invest by using convertible notes or other debt instruments. Also, some funds invest into publicly listed companies, whether as part of a public-toprivate transaction (PTP) or through private investment in public equity (PIPE) (see below). PE falls into three general categories — buyouts, venture capital and expansion capital. Buyouts

The different types of buyouts are: • Management buyout (MBO): Management buyout refers to a transaction where the existing management buy the business from the current owners (sellers), usually supported by PE investors (investors) and often using a mixture of senior debt and sometimes junior or mezzanine debt. • Leveraged buyout (LBO): A leveraged buyout generally refers to any MBO more heavily weighted towards debt finance than equity. • Management buy-in (MBI): A management buy-in involves a buyout with a new management team. • Buy-in/management buyout (BIMBO): This combines existing management (that tend to have extensive knowledge of the business) with a new management team that “buys-in” to the business (and often contributes new entrepreneurial ideas to the business). • Institutional buyout (IBO): An institutional buyout is where a PE fund acquires a whole company or a division of a larger group in a transaction led by that fund or institution. The PE provider usually owns most of the equity and directs the strategy and operations of the business with management owning only a small stake in the business. • Public-to-private (PTP): These are transactions that involve the MBO of a publicly listed company with the buyer subsequently taking that entity private. PTPs are often fuelled by management’s frustration with an illiquid market for small- to mid-cap companies, continuous disclosure and relatively short reporting time frames, costs of maintaining public listings (including Australian Securities Exchange (ASX) listing fees, continuous disclosure costs and share registries) and relatively low broker coverage of small caps that may contribute to a perception of an undervalued stock. A “PIPE” (private investment in public equity) generally refers to the

situation where the company remains listed after the investment by the fund. • Roll-ups: Roll-ups refer to buying several smaller businesses and combining them into one larger group often with a view to exiting through an initial public offering (IPO) that provides public investors with potential exposure to niche sectors. The enlarged group may benefit from reduced costs through economies of scale (spreading fixed costs over greater volume, improved buying power and lower funding costs, etc) as well as revenue synergies resulting from cross selling of products, pooling of marketing, etc. Publicly listed exit multiples will also often be at a premium to private acquisition multiples where the larger group is clearly more valuable than the underlying fragmented businesses. • Secondary MBO: A secondary management buyout is where an MBO occurs of a business that has previously undergone an MBO. Another PE firm with the same or a new management team will fund this transaction providing an exit for the previous financial sponsors. Venture capital The second category is venture capital (VC) which typically refers to the funding of an early stage business to help it expand (as opposed to a buyout, which involves the acquisition of an existing mature business). It often refers to the funding of emerging businesses, particularly in the e-commerce, technology and bioscience sectors. Venture-backed companies are typically not yet profitable, may be at an early stage of developing their products and services and have limited trading histories. Expansion capital A third category of deals is expansion capital or development capital. This involves the funding of already existing businesses but unlike VC, the businesses typically have longer trading histories, their products/services are commercialised and they are profitable.

¶6-020 Overview of PE This section considers: • Where do PE funds get their money? • What are the sources of PE opportunities? • Why do sellers consider selling business units to management teams? • How has PE performed? • Why are PE deals so successful? • Who are the key stakeholders in a buyout? • What are investors looking for? • Characteristics of a PE investment • Comparison of PE to debt • Advantages and disadvantages of PE • The role of the Australian Venture Capital and Private Equity Association Limited (AVCAL). Where do PE funds get their money? The PE fundraising in Australia reached a 10-year high in FY2017 with $3.35b raised. The PE funds source most of their funding from superannuation and pension funds and to a lesser extent, high-networth individuals. In the United States, pension funds allocate around 7% of their funds under management to this asset class. In Australia, the allocation is somewhat smaller, at around 2%. The sources of capital for Australian PE managers has become more globalised in FY2017. For the first time in FY2017, foreign investors committed $2.51b more than domestic investors in a 12-month period.

There are also “captive” funds that invest funds on behalf of their parent company which may be an institution, bank, pension or superannuation fund, or insurance company. Most funds, however, are “independents” meaning they are owned by the founding executives (known as general partners or GPs) who manage the funds on behalf of their investors (known as limited partners or LPs) who are likely to be superannuation or pension funds. A number of funds were originally captives and were spun-off to become independents, for example: • Next Capital from Macquarie Bank • Accretion from Rothschild • Quadrant from Westpac • Ironbridge from Gresham. What are the sources of PE opportunities? Some of the more common sources of opportunities are: Source

Explanation

Non-core assets

A larger business group decides that a part of the business has become “non-core”.

Succession issues

The founder or owner of the company wishes to retire.

Origination by advisers

Third party facilitators like investment banks, accountants and lawyers may match PE firms and buy-in teams with potential sellers.

Australian Competition and Consumer Commission (ACCC)

In some cases, the ACCC may force a bidder to divest part of a recently acquired group for competition reasons.

Disgruntled

The existing management may initiate the

management

transaction as they feel they are not receiving the parent company support required to enable them to achieve their goals for the business.

Divergent interests

The existing shareholders have divergent aspirations for the company and one or more wish to exit.

Insolvency

The receiver or administrator of a company in liquidation wishes to sell the business or part of it as a going concern.

Unwanted acquisitions

A buyer acquires a “bundle” of businesses but does not wish to operate all of them.

Where management initiate the buyout they need to be careful to manage potential conflicts of interest. Employees and directors have duties to the company to protect confidential information and also to act in the best interests of the company. Management should seek appropriate prior written consent from the company. These issues are considered more fully in Chapter 7 (Preliminary Issues in Private Equity Transactions). The MBOs have traditionally resulted from succession issues within private companies or from a parent company’s decision to divest a “non-core asset”. In more recent times, the trend has been more for the funds to originate the transaction, often with an entrepreneurial management buy-in team (MBI) and/or an existing management team that has a passion to own and grow its business. The expected “boom” in PTPs has not eventuated. Undertaking a PTP is complex from a legal and tax perspective and also requires navigating the high stake governance regime on board rooms (which usually means exclusivity is out of the question). Why do sellers consider selling business units to management teams? The seller, usually through the board, must determine the best way to sell the business. It may decide to run a sales process with several trade buyers and provide management with an opportunity to bid

against trade buyers. While this competitive tension can maximise the likely price, it also risks “tainting” the business by risking sensitive information falling into competitors’ hands thus reducing the likelihood of a successful sale at full value. Having only a small field of logical competitors/trade buyers often heightens these concerns. Additionally, a management team that is uncomfortable with the potential acquirer can jeopardise an open sales process. Therefore, a seller will often enable the management team to have a first look at the business and, if the MBO team can meet the seller’s price expectations, will enter into exclusive arrangements to complete due diligence and documentation. The exclusive MBO process enables the seller to sell the business to those that understand the intrinsic value better than most outside parties, while minimising the risk of damaging confidential leaks. If MBO discussions falter, then the seller may revert to an open sales process. This is usually preferable to starting an unsuccessful sales process and then reverting to an MBO. Otherwise, the MBO team is clearly the only remaining buyer and this negotiating power may lead to a sub-optimal outcome for the seller. Other reasons for selling to an MBO team include: • An MBO is sometimes seen by the seller as a final chance to reward loyal senior management, particularly in privately held businesses. • An MBO is a faster and easier way of exiting. As the management already know the business, the sale process can be streamlined in a number of aspects (including reduced due diligence and warranty negotiations). • The MBOs are often more acceptable to other stakeholders including the broader workforce, unions, customers and suppliers. How has PE performed? The PE has consistently outperformed other asset classes for a number of years, including investment in listed equities and property.

AVCAL Chief Executive Yasser El-Ansary points to the consistently high returns on PE in stating “the numbers show that on average, the PE and VC asset class delivers returns of about 4% above listed markets, measured over the medium to long-term”. Why are PE deals so successful? One potential explanation for the success of PE deals is the alignment of “principal and agent” interests. In an MBO, the members of the management team are no longer just employees, they are also owners with a potentially large and direct interest in the performance of the company. The PE investors are also exit focused. From the very first day they acquire the asset, the new owners are considering how best to sell it (who is the logical trade buyer? Is it suitable for an IPO? Would it fit well into another investor’s existing portfolio?). This focus on being “exit ready” means they can avoid the mistakes commonly made by other owners. For example, PE owners will: • enter into long-term customer contracts giving guaranteed future business, whereas some family owners are happy with “handshake contracts” • provide a professional and aggressive executive team, who are focused on growth and exit; in a family-owned business the focus is likely to be on continuity within the family • avoid joint ventures or licences which constrict exits (such as granting an exclusive territory to the main competitor of the business’s most logical acquirer). The PE investors also ensure that their management teams are very focused on exits by aligning their remuneration with the size and timing of an exit. It could also be argued that PE investors are professional business builders, with experience in managing costs, organic growth, international expansion and strategic acquisitions. This will vary between funds, of course, and some players have different skill sets

and backgrounds than others. Financial engineering is another potential driver for the high performance of PE-backed businesses. The introduction of leverage or debt into the financial structure of a company can have significant effects on returns (both positive and negative). Who are the key stakeholders in a buyout? The key stakeholders involved in a buyout are as follows: • Seller and its advisers: As set out above, the seller is typically a larger parent company or a retiring founder. The seller will be represented by various advisers (lawyers, tax advisers and accountants) and in larger transactions may also be represented by an investment bank appointed to manage the sale process. • PE fund or investor: The PE firm will provide the equity capital to finance the acquisition and will help originate, structure and manage the process. The firm will then continue to add value, usually at board level, for several years throughout their investment horizon (typically three to five years). • Investor’s lawyers: The investor’s lawyers will have a significant role to play in structuring and implementing the transaction, including conducting due diligence on the target company, drafting and settling the investment agreements (typically comprised of a subscription agreement and shareholders’ agreement), finalising the executive service agreements with the key managers, settling the share or asset sale documents and negotiating any bank facility agreements and other banking security documents. • Management team: It is important to carefully select who will be included in the MBO team to drive the business forward post acquisition and to receive the benefits of the equity incentives. Investors will usually insist that the management team members invest a material amount of their personal net worth into the new company.

• Lawyers for the management team: Their role is typically focused on advising the management on their service agreements with the new company formed to make the bid in the buyout (Newco), their fiduciary duties (particularly for an existing management team which is acquiring the business from a parent company), advising on the investment documents with the PE fund and finally ensuring that the sale and purchase agreements do not place an unfair burden on the management team (particularly with respect to seller-type warranties). • Debt provider: The debt provider is typically a bank that provides senior debt in the form of a facility with a fixed and floating charge to secure the debt. The bank will be separately represented by another law firm, who in addition to settling the security documentation, will also review the due diligence reports prepared by the investor’s lawyers and accountants. • Mezzanine debt: This debt sits between the senior debt and the equity finance. It carries a greater interest rate than the senior debt because it is subordinated to the senior debt. The mezzanine debt can also have an “equity kicker” in the form of options or warrants over unissued capital. This part of the capital structure is an emerging asset class in Australia. • Investigating accountants: Accountants will be appointed by the PE fund to conduct due diligence on the target company including a review of the business plan and financial projections. • Other advisers: Depending on the size, complexity and industry sector of the buyout a number of other advisers may also be retained, including insurance specialists, tax advisers, environmental specialists, actuaries (for businesses with large superannuation schemes) and market or strategy consultants. What are investors looking for? Investors will look for the following characteristics in an investment target: strong management, superior business and a match with their

investment preferences (such as life-cycle stage and industry sector). Quality of management: It is said that PE investors “bet the jockey, not the horse”. Investors will need to examine the quality and track record of the management team. They will look for a team which has well-rounded skills and the experience to accomplish the objectives/strategies set out in its business plan. If the team is incomplete or inexperienced, the investor may need to supplement the team (or back a new “buy-in” team). Also, as the investment typically will last for a number of years and involve a good deal of close discussions, it is important that investors back management which they can build a strong and open relationship with. Superior business: The investor will be looking for the potential to generate strong returns, usually benchmarked as being greater than an investment in the listed market. Each investor will have a different strategy but they will be looking for: opportunities either to grow the business organically or by acquisition; sustainable barriers to entry; a large potential market, preferably with high growth; and a product which is easily differentiated from its competitors. PE funds have their performance measured by the internal rate of return (IRR) on the funds invested. This is effectively a compound rate of interest calculated over the fund’s life. They will generally target 15% to 20%. Investment preferences: Most investors have a set of investment preferences across industry sector, holding period, geography, deal size and life-cycle stage: • Industry focus: Investors will typically concentrate on certain industry sectors rather than investing in all industries. To attract investment, sellers and management teams need to ensure they approach investors whose mandate covers their sector. Many PE funds expressly exclude certain sectors from their mandate (eg most will not invest in businesses which are commodity based, rural, mining, property or IT businesses). Under Venture Capital Limited Partnership (VCLP) rules, the target cannot have as its primary activity property development, land ownership, finance or construction.

• Holding period: Investors will have different time horizons over which they can hold their investment. This will depend on their investment charter, the type of fund structure and whether the fund is independent or captive (the latter may have more flexible rules on holding periods). The longer the investment must be held by the investor, the harder it is to achieve their target IRR which for most PE investors, rules out investments such as timberland assets or developing pharmaceutical products where the lead times can be 10 years or more. • Location: Many investors have rules about which geographic regions they prefer to invest in. Under the VCLP rules, the target must have at least 50% of its staff/assets located in Australia. • Size and stage of transaction: Just as funds typically concentrate on particular industries, they will also usually focus on different sizes and stages of investment: – Some specialise in large transactions in mature businesses (usually pre-IPO), where in turn the role of management may be considered less important than in a small deal. – Most PE funds avoid seed, start-up and early stage investments and focus on expansion and buyout type deals. – Pre-expansion deals are higher risk as the business model is generally unproven (and may even be pre-earnings). Venture capitalists tend to focus on the start-up stage and seed deals are covered by “angel” type investors. – Some funds will specialise further and only do certain types of deals (such as secondaries or turnaround transactions). – The different stages of investment are set out in the following diagram which indicates generally the level of funding typically required.

Corporate structure: A large part of being “investment ready” is having a clean corporate structure. This includes not having a widely diversified shareholding (large shareholders’ bases are prone to “greenmail”, that is, being exposed to the risk that one or more minor shareholders refuse to sell as part of the exit purely to leverage a greater return and make it difficult to achieve consensus) and maintaining a distinction between the company’s assets and those of the founding shareholders (family-owned businesses are notorious for intermingling personal liabilities, assets and expenses with those of the company). What should management be looking for in the investor? The management team seeking to find a PE fund to back them should consider: Investment preferences

The team should look to match the investment preferences of the various investors as to size and stages, time horizon, industry sector and geographical location.

Experience

What other companies in the industry has the fund invested in, and what has its track record been?

Future funding

Can the investor provide further rounds of funding? Can they introduce management into overseas finance markets?

Value-added services

Does the fund offer: • industry-specific knowledge? • financial and strategic planning? • recruitment of key personnel? • acquisition identification? • access to international markets and technology?

AVCAL

Is the fund a member of the AVCAL? This association has adopted an industry code of conduct which establishes a minimum set of principles that members are to observe.

Co-Investors

Would the fund be willing to work alongside other investors? Are there other investors they think should be invited to co-invest in the deal?

Other factors

Does the fund demonstrate: • credibility, integrity and ability to maintain confidentiality? • a track record of PE principals successfully doing deals of this nature? • the ability to structure and fund the MBO? • a transparent investment and approval process?

• a complementary fit with management? Jeremy Samuel, Managing Director of Anacacia Capital (a fund which focuses on growth buyouts of small-medium enterprises), said: “Private equity is a relationship business. The fit between the private equity firm and the entrepreneur or management team is as important as the financial numbers. Companies looking for capital should look carefully at the web sites of the private equity firms and choose the appropriate firms to contact based on their size, situation and aspirations.” Advantages and disadvantages of PE From the perspective of a founder or MBO team, the main advantages of partnering with a PE investor are that it can provide: • ongoing strategic, operational and financial advice. It will typically have nominee directors appointed to the company’s board and will often become intimately involved with the strategic direction of the company • introductions to an extensive network of strategic partners both domestically and internationally, and may also identify potential acquisition targets for the business and facilitate the acquisition • experience in the process of preparing a company for an exit whether via an IPO of its shares onto the ASX or an overseas stock exchange or through a trade sale. On the downside, the MBO team may find that a PE investor (relative to other sources of capital): • may look to realise its investment in a company in three to six years. If management’s business plan contemplates a longer timetable before providing liquidity, PE may not be appropriate • will typically be more sophisticated and may drive a harder bargain. Management need to consider whether they want all of a small pie or part of a bigger one

• is more likely to want to influence the strategic direction of the company • is more likely to be interested in taking control of the company, especially if the management is unable to drive the business. Characteristics of a PE investment The PE investments have several characteristics that set them apart from other forms of business ownership, particularly the public markets. According to AVCAL, the following are all relevant:1 • Alignment of interests: This has two aspects. Firstly, there is the alignment of investor and GP interests through legal agreements and performance fees. Also, GPs usually co-invest their own money up to a certain amount (generally 2% to 5% of the fund) to further demonstrate their commitment and alignment of interest with the LPs. Secondly, the investee-company managementownership model aligns the interests of senior management with other shareholders. • A long-term investor: The PE investors develop a comprehensive long-term plan together with company management to grow the business and increase its value. The PE investments have an average five- to seven-year holding period and place long-term growth in underlying value ahead of shortterm profit considerations. This ownership period is considerably more than the average holding period of ASX stocks at 1.2 years. • Detailed due diligence: Before investing in a business, PE firms conduct a thorough analysis to gain a detailed insight into the business’s strengths and weaknesses, its growth potential and the prerequisites for achieving this growth. • Active stewardship and expertise: Representatives of PE firms actively focus on matters such as strategic planning, recruitment of senior managers and access to important networks and international markets, thus bringing far more than just capital to the table. PE firms usually have one of their partners as a board

member of the investee company, and bring strong governance systems and processes to investee companies. Comparison of PE to debt The following table sets out the relative differences between debt and PE financing from the investor’s perspective: Debt financing

Private equity

Form of investment

The company borrows In return for the funds, money which it has to the investor receives a repay later, with interest percentage stake in the capital of the company

Investor’s source of return

Interest

Growth in the value of the investor’s shares

Return on investment

5–10% per annum

An IRR of 15–20%

Protection for investor

Charge or mortgage over the assets of the company

Board seats, preferential shareholder rights, dragalong rights

Risk

Low (as secured assets Medium to high can be sold if company defaults)

Considerations Adequacy of collateral for investor

Management team and market potential of company

Time before investor generates income

Usually one month

Typically three to six years

Means of exit for investor

Loan repayment

IPO or trade sale

About AVCAL The AVCAL is a national association which represents the PE and VC industries. AVCAL’s members comprise most of the active private equity and VC firms in Australia. These firms provide capital for early stage companies, later stage expansion capital, and capital for management buyouts of established companies. The AVCAL database contains comprehensive data on the activities of VC and PE firms (both active and no longer active). The AVCAL members adhere to a set of standards to ensure consistent reporting to investors. This is achieved through the use of an industry investment reporting guide, a guide for the valuation of assets, a code of conduct, a code of corporate governance, and the embedding of global industry environmental, social and governance (ESG) practices for the PE industry. The formalisation of good governance practices for Australian PE firms demonstrates that the industry holds itself to high standards. PE firms must also adhere to other regulatory requirements (such as corporations law and tax obligations, where applicable). For more information, see their website: . Footnotes 1

The Australian Private Equity and Venture Capital Association Ltd “Private Equity and Venture Capital Explained — Fact Sheet” (December 2011) AVCAL .

¶6-030 Overview of financial structure

A buyout will usually be financed from two key sources: • equity from the PE fund and from the management team • debt from the bank and, in some cases, mezzanine debt. These two sources are explained below. Equity finance In simple terms, a new company (Newco) is usually formed and the investor and management will subscribe for shares in the Newco. The equity may take the form of ordinary shares for both management and the fund. Some investors prefer to hold preference shares or convertible loan notes which may rank in priority for dividends (or interest, in the case of notes) and return of capital on a winding-up. In some cases, there might also be co-investors. These might be other PE funds or high-net-worth individuals (eg the non-executive director might wish to invest). These co-investors usually hold the same type of shares or notes as the lead investor. Debt finance The Newco will then enter into a loan facility agreement with the bank. The facility will be secured by a fixed and floating charge over the assets of the Newco and also the assets of the target company. The Newco might also have other types of facilities in place to fund a working capital post deal (such as an overdraft, receivables financing, etc). In some deals, you might see a fourth type of financing known as mezzanine debt (provided by specialist institutions such as Fortress, Intermediate Capital Group and Investec). This will rank behind the senior debt in priority for repayment of principal and interest, and on a winding-up, but before the equity. The mezzanine debt might take the form of a facility or loan note secured by a second-ranking charge. As the mezzanine is taking a higher level of risk than the senior debt, it will have a higher interest rate (say 3% or 4% higher) and perhaps also some options or “warrants” which are rights to subscribe for equity capital on an exit (known as the “equity kicker”).

The following diagram shows the inter-relationships between the stakeholders and the key legal documents involved:

A simple example of financing structure ABC Private Equity has formed a Newco to acquire all the shares in XYZ, the target company. The purchase price of XYZ is $100m. The source of financing for the Newco is: Equity:

ABC Private Equity $55m Co-investor

$3m

Management

$2m

Sub-total

$60m

Debt: Senior

$35m

Mezzanine

$5m

Sub-total

$40m

¶6-040 Overview of the buyout process Most PE transactions have a common structure and similar process but there will be important differences between the different types of buyouts. An IBO would be structured differently from an MBO and in turn an MBI will follow a different process than the other types of buyouts. Another important driver of process will be the source of the transaction. Buying from a forced seller (such as a receiver) will be quite different from buying from a seller that is comfortable holding onto the asset. Similarly competitive tender processes (otherwise known as auction sales) will also be structured differently. The following diagram summarises the process from the investor’s perspective:

The following table summarises the key steps in a traditional management buyout. As stated above, the different types of buyouts will have a different process. The key stages of an MBO are generally: Prepare business plan

• The management team will prepare a detailed business plan including financial projections. • The plan will document the agreed strategy and set out how management plan to achieve the business objectives. It will be an important

part of the finance raising process. • The plan needs to explain the financial record of the business, and the projected performance post-deal. • A reporting accountant may be appointed to review the plan, test the assumptions and recalculate the figures should the assumptions prove invalid (such as lower sales, higher rental charges, fluctuations in foreign exchange (FX) or interest rates, etc). Finalise management team

The key stakeholders need to agree the participating management team. The buyout team will need to determine how much capital it is willing to invest alongside the debt and equity funders.

Seek approval from Before the management team speaks to an seller’s board external PE provider under a traditional MBO structure it is important that they seek approval from their parent company. It is critical to manage the conflicts of interest between management and the seller. Select potential PE investor(s)

It is important that both the seller and management have confidence in the PE firm to deliver on any indicative offer.

Term sheets

Each deal will involve three different term sheets which set out the basic framework for the deal: • Acquisition term sheet: with the shareholders of the target, this will govern key terms of the purchase — price, parties, extent of warranties, adjustment to price. The term sheet may also grant the investor an exclusivity period in which to conduct its due

diligence inquiries. • Equity term sheet: between investor and the management team. Key issues to be resolved at this stage include the form of the investment, any protections to be given to the investors, rights of the investors to appoint board representatives, pre-emptive rights and exit strategies. • Debt term sheet: between investor/Newco and the senior debt provider. This is usually signed once the other aspects of the deal have progressed. Appoint advisers

The next step would be to appoint the various advisers for the stakeholders, including lawyers and accountants for the PE fund, management and the debt providers.

Conduct due diligence

• Once the term sheets have been executed, the fund and its advisers will undertake due diligence. • This involves a detailed examination of the company to assess the feasibility of the business. It may cover legal, accounting, tax, insurance and environmental issues. • In many respects the due diligence process will be similar for any other acquisition of a business. An important difference is that in an MBO the management team often knows more about the business which is being sold than the executives at the seller. • Generally, due diligence will focus on the key risk areas of the target company and aim to verify the early commercial review including the maintainable earnings and ensure that the

business owns all its key assets to produce those earnings. • It will also assess the terms of key contracts (such as change of control provisions), looking for undisclosed liabilities such as current litigation or contract disputes, etc. Obtain debt funding The next stage of the buyout is to secure the debt funding. This will typically include senior debt (which is usually secured by a fixed and floating charge) and may also include mezzanine debt (which will be subordinated to the senior debt). Prepare and negotiate legal documentation

• Once the due diligence process has commenced, the lawyers for the fund will typically prepare legal documents which govern the relationships between the various stakeholders. • There will be an array of different legal contracts, depending on the structure of the deal. In general, there will be: – Equity: subscription agreement, constitution for the Newco, executive service agreement for management, preference share terms, loan notes terms and shareholders’ agreement – Acquisition: share purchase agreement or business purchase agreement – Debt: facility and security documents. • The documents are generally signed simultaneously, given the high degree of interdependence between the funding of the Newco and the sale of assets by the seller.

Between exchange and completion

In the period after exchange of contracts, the various conditions precedent will be satisfied, usually including: • Investment committee approval for the fund • Approval and/or notification from the Foreign Investment Review Board (FIRB) if there is a foreign buyer. • Regulatory approvals from ACCC (if the deal will result in a substantial lessening of competition) • Landlord consents • Consents from key customers and suppliers (if required) • Offers are made to staff and assignments of material contracts are obtained (in case of a business purchase).

Completion

At completion, the legal contracts become effective. The subscribers will provide equity capital to the Newco, the banks will provide debt to the Newco, and the Newco will pay these funds to the sellers under the purchase agreements.

The entire process typically takes two to three months but may take longer in more complex transactions (or when the sale is put to competitive tender). Sources The Australian Private Equity and Venture Capital Association Ltd “2017 Yearbook — Australian Private Equity and Venture Capital Activity Report” (November 2017) AVCAL .

Bain & Company “Global Private Equity Report 2011” (March 2011) Bain and Company Australia . Simon Beddow “Overview: Private Equity and Buyouts” (2003) PLC Private Equity Practice Manual 1.1.

Cambridge Associates LLC “Cambridge Associates LLC Australia Private Equity & Venture Capital Index & Selected Benchmark Statistics — Private Investments” (September 2015)