This is the second in a series of articles highlighting common issues to consider
when purchasing a business.

The first article dealt with the practical considerations when identifying assets and how to correctly describe such assets in the transaction agreements, as well as calculating the purchase consideration in respect thereof.

As previously noted, the sale and purchase of a business is usually more complex and comprehensive to implement than a sale and transfer of shares, and can take longer to complete. There are a myriad commercial reasons why a purchaser may wish to pursue a business acquisition rather than a share acquisition, including that the purchaser need not assume any of the seller’s liabilities incurred before transfer (unless expressly agreed otherwise, and excluding employee related liabilities). However, almost invariably, there will be prepayments to or by the seller (if only rent and rates) and consideration should be given as to how these should be apportioned. It is also worthwhile to briefly highlight the scope of warranties under a sale of business agreement, as these are generally one of the most contentious items of negotiating the transaction agreements.

Apportionment of Responsibility

Interim period undertakings are designed to protect the buyer from the seller eroding the business being purchased. Buyers often require that the seller undertakes to continue conducting the business “in the ordinary course”, and not to enter into any agreement which would alter the ordinary course of the business.

Where signing of the transaction documents and completion occurs simultaneously, few interim period undertakings are given, as most will be unnecessary. However, the position is slightly more complicated where the effective date of transfer, for accounting purposes, is different from the date on which completion of the transaction occurs.

Where the effective date of transfer predates the completion date, certain questions must be considered and negotiated, for example –

• although the parties may have agreed that transfer takes place before completion, the revenue authorities may consider the income of the business to be that of the seller during this period; thus, the seller’s tax liability in these circumstances needs to be taken into account;

• what responsibility should the purchaser assume for liabilities arising after the transfer date: all liabilities (in that the purchaser receives the profit), or only those arising in the ordinary course of business; and

• practically, it should be considered whether revenues and costs can be identified and allocated before and after the date of transfer.

Warranties

As noted above, the scope of warranties is often one of the most contentious items of negotiation. Warranties are generally expressed as statements of fact, which may be qualified by means of a disclosure letter. This, ideally, should allow both parties to consider the business’ factual position and allow the buyer to renegotiate its price, should a material issue be identified.

The purpose of warranties is two-fold

• firstly, to shake the skeletons – out of the closet, in respect of the business, so that the buyer is provided with some reassurance about the quality of the business it is buying; and

• secondly, to provide an opportunity for redress if the business is not as warranted.

Warranties are particularly important in instances where there is a gap between the signature date of the agreement, and completion. If, during this period, matters arise which are in breach of the warranties, the buyer should have the opportunity to terminate the agreement or renegotiate the purchase consideration. For this reason, it is important to minimise the time between signing and completion.

The buyer should consider which information about the business is important to it, and structure the warranties to address those items. This will depend on the nature of the business; for example, in a manufacturing or wholesaling business the physical condition of the assets is important. In a service business, supplier, customer and employee contracts are important. Warranties that certain facts are not true should also be considered and included.

If a warranty is breached, the buyer would ordinarily be entitled to claim damages resulting from the breach of that warranty. Practically, it needs to be considered how such damages will be quantified, but an appropriately worded clause in the transaction agreement may address this. Buyers should also be aware that they have a general duty to mitigate their loss in these circumstances.

In certain instances, it may also be appropriate to deal with a potential breach of warranties as an adjustment to the purchase consideration, or have it covered by an indemnity provided by the seller, particularly where the transaction contemplates the preparation of completion accounts and/or stock taking at completion. Another option is to tie it in with the retention of part of the purchase consideration or the payment of deferred consideration.

Of course, whenever an indemnity is provided, buyers should anticipate that sellers will request limitations on their liability, often in the form of time or amount based limitations. Indemnities and limitation of liability, including warranty and indemnity insurance, will be discussed in more detail in further articles.

Conclusion

The whole question of warranties, disclosures and the information process needs to be carefully planned and controlled. It is also useful to have a draft of the disclosure letter prepared as soon as possible, to encourage the parties to agree, at an early stage of the negotiations, what would be accepted as disclosure. Parties are encouraged to engage their transaction advisers at the outset, so that they are fully aware of and, preferably, the conduit for documents passing between parties.

Jaco Meyer is a Director and Haafizah Khota an Associate in Corporate & Commercial | Cliffe Dekker Hofmeyr.

This article first appeared in DealMakers, SA’s quarterly M&A publication
DealMakers is SA’s M&A publication
www.dealmakerssouthafrica.com