Sale and purchase agreements – how to avoid the unexpected
Care needs to be taken when drafting sale and purchase agreements, in order to avoid unpleasant surprises
The economic downturn may result in the disposal of many businesses, but every recession presents an opportunity for investors.
The age old tension between buyers and sellers will continue to exist, with sellers seeking the greatest price possible and with buyers looking to invest at the lowest possible price.
Understandably, this can cause conflict and unease between buyers and sellers. So how can both parties, especially during a period of financial strain, ensure that any sale and purchase goes smoothly and as planned?
It is vital to draft a sale and purchase agreement (SPA) which sets out the key commercial and pricing negotiations and a clear unambiguous understanding of what is included in the deal. Sometimes genuine misunderstandings can arise between parties as to what they think is agreed and what is not. It is common and could become more so for either the buyer or seller to exploit a loosely worded agreement to their advantage.
A well thought out and properly structured SPA will include how the price adjustments are to be calculated, and checks should be carried out to make sure they work correctly.
Parties agree a price which can move up or down on completion, depending on what is agreed in the terms of adjustments. This movement can be considerable. Whether it is a cash free, debt free deal, or whether there is to be a working capital adjustment, net asset adjustment or a price dependent on a multiple of profits, care must be taken.
An example of where this can go horribly wrong is where a buyer failed to take sufficient due diligence and the seller managed to manipulate the price.
The agreed price was based on net assets plus goodwill. The buyer felt the business was declining and asked for the goodwill to be based on the annualised profits for six months.
Since the buyer believed that the profits were decreasing steadily over time, he thought this would be to his benefit. But the seller managed to bring forward nine months work into the six month period. As the payment of goodwill, based on an annualised six months' profit, was stated in the SPA, a very high goodwill figure was determined.
Warranties: say what you mean
Getting the warranties right is the other half of the battle to achieve a successful deal. For buyers and sellers, they offer protection, outlining exactly what is being bought. Are you taking on debts, liabilities, litigation, profits and stock?
The warranties are scheduled at the back end of the SPA to provide factual statements by the sellers,and are a large part of the agreement. In order to work out what warranties are required, a buyer needs to carry out a thorough due diligence exercise so they understand exactly what is being purchased and where they feel they need protection.
Accounting and financial issues should be addressed in the SPA to ensure the price adjustment is clear and is what both parties envisaged.
SPA's invariably set out how the completion accounts are to be prepared. Whether a full profit and loss account and/or a full balance sheet, or just a statement of working capital, completion accounts do not need to show a true and fair view, and that should be spelled out in the SPA. The only important figure is the bottom line, the figure used to calculate the price adjustment.
The completion accounts, or working capital statement, ideally need to be prepared on the same basis as is used to obtain the target net assets/working capital or other management information. You need to look at how the target was arrived at and what provisions were made. The completion balance sheet or working capital statement should ideally adopt the same policies – otherwise there could be a mismatch that might be exploited. A clear hierarchy of principles in preparing the completion accounts is essential.
The SPA should set out which party will prepare the completion account while the other party will then have a period to review. Timescales should be realistic. If preparing, there is an advantage as there is some control. Against this, the reviewer can selectively challenge the accounts. Generally, it is more advantageous to be the party preparing.
The agreement will go on to state the procedure to be applied if the parties do not agree with the completion accounts and how any dispute is to be resolved.
Financial warranties are often a neglected area of the SPA and a potential source of trouble. Stay clear of ambiguous wording by ensuring you are clear about exactly what the vendor is warranting. For example, ambiguous wording such as that there is no deterioration in the business – what does "deterioration" mean; how much does something (and what is that something: turnover, profit or levels of working capital), have to deteriorate before the statement in the warranty is no longer true – is it £50,000, £500,000 or £5m?
And, the most important advice to getting the sale and purchase agreements right is start afresh each time. Never amend a previous agreement – it might land your client and therefore you in trouble.
Peter Graham is Forensic and Investigation Services Director at Grant Thornton, Scotland