The benefits of due diligence in drafting sale and purchase agreements for M&A deals

In mergers and acquisitions (M&A), acquiring a business or an asset without conducting a due diligence investigation (DDI) substantially increases the risk, particularly to the acquirer. Not only is the DDI important to understand the nature of the business, its affairs, and its assets and liabilities, conducting a DDI on the company to be acquired (Target Company) may inform the negotiation and/or drafting of the sale and purchase agreement for shares or business (Sale Agreement), particularly in relation to the purchase consideration, suspensive conditions, warranties and indemnities, and post-closing obligations.

An M&A transaction often requires a financial, legal and tax DDI, typically to identify any red flags which could be deal breakers or diminish the value of the Target Company, which would impact the purchase consideration payable under the Sale Agreement. These red flags will determine whether or not the acquirer continues to negotiate the transaction and subsequently conclude the Sale Agreement with the owner/s of the Target Company or business (Seller/s).

Notwithstanding the red flags, the acquirer may still be interested in the transaction, provided that the risks identified can be mitigated through, among other things, (i) an adjustment to the purchase consideration; (ii) the Sale Agreement being subject to suspensive conditions, i.e. conditional on certain events taking place prior to the Sale Agreement becoming effective; (iii) warranties and indemnities being given by the Seller in favour of the acquirer; and (iv) post-closing obligations of the Target Company.

This article will provide an overview of the way in which a legal DDI will highlight the aspects which are vital to protect the acquirer’s interests in a Sale Agreement.

ADJUSTMENTS TO THE PURCHASE CONSIDERATION

The DDI may be beneficial in negotiating the purchase consideration. For example, during the DDI, a penalty payable to a regulatory authority as a result of a breach of environmental laws or the termination of a material supply agreement with preferential terms which, if replaced, may increase the overall expenses of the Target Company, may be identified. In such instance, the acquirer may wish to negotiate:

• a discount to the purchase consideration; or
• structuring the payment mechanism in the Sale Agreement in a way which mitigates the financial exposure to the acquirer, such as:

(i) retaining a portion of the purchase consideration in escrow pending settlement of such penalty or conclusion of a renewal to such contract; or
(ii) requesting a guarantee to be issued by a reputable bank or the parent company of the Seller in favour of the acquirer as a suspensive condition, pending settlement of such penalty or conclusion of a renewal to such contract.

SUSPENSIVE CONDITIONS

In order to ensure that the deficiencies identified in relation to the Target Company are dealt with prior to the implementation of the acquisition, to the extent possible, the acquirer will include certain suspensive conditions in the Sale Agreement.

For example, the DDI will reveal material agreements between the Target Company and third parties (usually lenders, customers or clients, and suppliers) in terms of which prior written approval or notification is required for the proposed transaction. For instance, the proposed transaction may trigger a change of control which requires approval of, or notification to a counterparty in the case of a sale of shares, or consent for assignment in the case of a transfer of business. Such approvals/consents and notifications ought to be included in the Sale Agreement as suspensive conditions. Similarly, it may be discovered during the review of accreditations, licences or registrations that regulatory approval from a regulator or governmental body is required prior to the implementation of the Sale Agreement.

In addition to approvals or notifications, although not always ideal for deal certainty, and especially when there is a need to close the deal expeditiously, there could be documents or information which the acquirer requires to consider which may not be available during the period of the due diligence, and these can be included in the suspensive conditions. Further, during the DDI, it may come to light that certain agreements would need to be renewed or would terminate as a result of the M&A transaction.

The renewal of, or entry into such agreements (such as a lease agreement) on terms and conditions acceptable to the acquirer may be included as a suspensive condition, so as to ensure the smooth operation of the Target Company or business post implementation of the Sale Agreement.

Where non-compliances have been identified during the DDI, the acquirer may agree for regularisation to be a suspensive condition if the Seller is not prepared to indemnify the acquirer for any claims which may occur as a result of such non-compliance. The suspensive condition will provide the Seller with the opportunity to rectify such non-compliances or irregularities prior to the M&A transaction becoming effective.

WARRANTIES AND INDEMNITIES

If the acquirer cannot ascertain certain information during its DDI, and the seller cannot provide confirmation, for example, that there is no threatened litigation against the Target Company, the acquirer may request that the Seller warrants this position. If not true or correct, the acquirer can take some comfort in bringing a claim for damages for a breach of the warranty. If the Seller has negotiated a limitation of liability, the acquirer must consider this limitation in light of the potential risk and financial magnitude posed by the risks identified, or which may potentially arise.

The acquirer may also request indemnification in the Sale Agreement against potential risks identified in the DDI. For instance, the Target Company may be involved in a legal dispute where it may or may not be successful. In another instance, statutory non-compliance may be identified in the DDI where no claim or action has been brought. If the acquirer is indemnified by the Seller, the Seller will recover its loss on a Rand-for-Rand basis when claiming under an indemnity, provided that this is permitted by the wording of the Sale Agreement.

Legally, indemnities provide benefits that warranties do not, and one may be appropriate over the other in the context of the Sale Agreement and the negotiations. However, both are important for mitigating risks identified during the DDI.

CONCLUSION

While the costs for conducting a DDI may appear to be prohibitive, such costs are a justifiable expense when considering the potential legal, financial and reputational risks associated with acquiring shares in a Target Company, or the business of a Seller, ill-informed and unprepared.

Understanding the importance of a DDI and how to utilise its findings offers a greater chance of a successful M&A transaction for all parties involved.

Thandiwe Nhlapho is a Senior Associate and Roxanna Valayathum a Director in Corporate & Commercial | Cliffe Dekker Hofmeyr

This article first appeared in DealMakers AFRICA, the continent’s quarterly M&A publication.

DealMakers AFRICA is a quarterly M&A publication
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