Buying shares requires few actual formalities. No general legal requirement exists for an agreement for the sale of shares to be in writing. In practice, however, a lengthy process using multiple documents is normal. And for good reason! Knowing exactly what you are buying and on what terms is beneficial to both parties. Read this blog to find out more about the processes involved in buying shares in order to acquire a UK business.
Most transactions include the following broad phases:
- Pre-contract documents including confidentiality agreements, heads of terms and exclusivity agreements.
- Due diligence.
- Share purchase agreement.
- Obtaining any third-party consents and approvals.
- Signing the transaction documents and completing transfer.
- Any post-completion formalities.
Buying shares – valuing the target company
A number of approaches can be used to value a private company. Some prospective buyers like to employ multiple methods to draw out what they consider to be a reasonable median. Here are some approaches:
- Market multiple – take a key financial indicator, such as ‘earnings before interest, tax, depreciation and amortisation’ (EBITDA) and multiply it by an agreed number.
- Cash flows – estimate of a company’s future cash flows.
- Net assets – the companies’ total assets less its current liabilities.
- Cash free, debt free basis – the valuation is carried out as if the target company had no cash reserves or outstanding debt. The benefit of this method being that the impact of fluctuating cash and debt levels during the sale process is eliminated.
Completion accounts are commonly used to establish the value of the target company as at completion, with the price subject to the process of preparing and agreeing such accounts. A recent trend has been “locked-box” transactions which means the price of the company is decided by reference to a pre-completion balance sheet and therefore the buyer cannot rely on any price adjustments further down the line. This will normally be accompanied by an obligation for the seller not to engage in activity which might diminish the value of the target company during that period.
Buying shares – heads of terms
Usually at the outset of a deal, the parties will lay out the fundamental aspects of its commercial nature before moving ahead with detailed due diligence or pouring over the finer details of the documentation required. This will often be recorded in what is known as heads of terms (or term sheet, letter of intent or memorandum of understandings).
Heads of terms can be non-binding, partially binding or fully binding. Their legal effect will depend on whether a contract has been formed by the way they are drafted. It is common for heads of terms to be partially binding so that clauses needed to be in place from the outset can be relied upon – this includes provisions concerning costs, confidentiality, exclusivity and governing law.
In order to move ahead with a deal, the buyer and its advisory team will need access to a significant amount of information relating to the target company and its business, some of which will be confidential. Before making such information available, it is standard practice for sellers to require the prospective buyer to enter into a confidentiality agreement (also known interchangeably as a non-disclosure agreement or NDA). This agreement creates contractual controls on the prospective buyer’s use of the confidential information. Ensuring that it does not share it with other parties.
Buying shares – exclusivity agreements
Buyers may well demand an exclusivity agreement from the seller so they do not waste time and money undertaking due diligence and other exercises, only to be told the business is to be sold to another prospective buyer. Exclusivity agreements involve the seller agreeing it will not seek, negotiate or otherwise deal with, other prospective buyers for a specified period of time. The buyer therefore has a period of exclusivity in which it can negotiate and conclude the sale. Exclusivity can be incorporated into heads of terms – in some instances buyers will not agree to a heads of terms document until exclusivity is included.
Due diligence is the process by which a prospective buyer gathers all the information necessary to take a view on whether or not it wishes to go ahead with buying shares. This means the target business will need to be evaluated from all angles, positive and negative, and with many different metrics. This will include an assessment of the target’s financial, legal and commercial position. It is usually carried out by the buyer’s financial and legal advisers as well as its own personnel. The target could also require other areas of expertise when under evaluation, such as environmental consultants or surveyors.
Buying shares – documentation
A share purchase agreement will be the main contractual document in a share purchase transaction. This is usually accompanied by:
- Disclosure letter
- Tax covenant
- Stock transfer form
Share purchase agreement
Although there is no legal requirement for the parties to enter into a share purchase agreement (SPA), when the buyer is acquiring the entire issued share capital of the target company, it is standard practice for the parties to enter into a detailed SPA.
An SPA will record the commercial terms of the transaction – such as how much the shares are being purchased for. It will also specify any conditions to which the transaction is subject. This may include obtaining certain consents or relevant regulatory approval. The SPA will then go on to record any representations and warranties made by the seller in connection with buying shares. This is important to the buyer who remains subject to the English legal principle of caveat emptor, meaning ‘buyer beware’. This means a buyer will not be protected by statutory or common law if the assets acquired do not meet their expectations. Therefore, it is important for a buyer to include these criteria, in the form of representations and warranties, in the SPA.
A buyer will usually also look to protect itself against any post-completion competition from the seller. This will include imposing contractual restrictions on the seller’s ability to establish a competitive business following completion of them buying shares.
The disclosure letter is a key document in any acquisition of the shares in, or the business and assets of, a private company. The letter is prepared by the seller in the transaction and includes general and specific disclosures regarding the seller’s warranties in the acquisition agreement. The buyer will usually agree that the seller will not be liable for a breach of warranty where the matter giving rise to the breach was disclosed in the disclosure letter. A bundle of documents is usually attached to the disclosure letter to support the seller’s disclosures.
Buying shares – tax covenant
Where the buyer is acquiring the entire issued share capital of the target company, it will invariably require the seller to provide a tax covenant. A tax covenant essentially gives the buyer an assurance that the seller will pay for the target business’ unpaid taxes from before completion. The rationale being that if the taxes went unpaid, that would reduce the value of the shares.
Stock transfer form
To obtain legal title to the desired share the buyer will need to receive a duly completed and executed stock transfer form from the seller in relation to the target shares. The transfer must then be approved and registered by the target company following completion.
Buying shares – completing the transaction
Finalising a share purchase transaction involves a two-stage process:
- Exchange – this involves the parties making a legally binding commitment to proceed with buying shares by signing and dating the SPA. If there is a disclosure letter or a separate tax covenant, they will also be signed and delivered at the same time as the SPA.
- Completion – the steps required to implement and conclude the transaction are performed at completion. This will include the seller delivering a duly executed stock transfer form for the sale shares, and the buyer paying the purchase price to the seller.
In many transactions, completion will take place immediately after the parties exchange the SPA, thereby compressing exchange and completion into a single phase (called a simultaneous exchange and completion). Sometimes it is necessary for there to be a gap between exchange and completion because one or more conditions need to be satisfied after the SPA has been signed and buying shares is completed.
Here to help
Buying shares to acquire a business requires few actual legal formalities. However, the long processes (such as due diligence), documents and contractual protections are there to protect buyers who would otherwise find no recourse in general English statutory or common law for being sold a business that does not live up to their expectations. A share purchase agreement, depending on the size and complexity of the transaction, can often run to more than 100 pages! With the toing and froing of such long documents, often filled with important details, this can be laborious, but ultimately rewarding, process.