Risks to avoid when selling your business

Are you thinking about selling your business? During 2018 and 2019 Paris Smith’s Corporate team have enjoyed successive years of record transactions both in terms of volume and value. In 2019 we advised on transactions worth more than £1billion. However, although trade and especially private equity buyers are becoming more active, there remains a level of risk aversion which can cause deals to be seriously disrupted if the business operations of a target company are insufficiently robust to withstand a detailed due diligence review.

16 risks to avoid when selling your business

We have listed below some issues which have arisen during due diligence, and which have either caused a deal to be aborted or resulted in an increased escrow or price cut at the expense of the sellers. Nearly all of them could have been avoided, or at least mitigated before commencement of a deal process.

1. Deficient intellectual property arrangements.

This has been a key issue on a number of transactions, including failure to ensure that:

• key IP developed by contractors for the target is either licensed or assigned to the target;
• the target retained ownership of background IP created by the target for its customers, which was required for other products developed by the target;
• the terms on which the target had shared ownership of IP with a third party were properly documented, and
• the target had complied with usage restrictions imposed on open source software.

2. Promises given to employees or third parties

Promises given to employees or third parties relating to shares and/or exit bonuses, which have not been properly documented (or which have been documented but were structured in a tax inefficient manner, which can have an adverse impact on the target as well as the employee).

3. Failure to keep control of shares owned by former employees

Failure to keep control of shares owned by former employees, and a lack of a contractual mechanism (usually covered by a “drag along” provision in the target’s articles association) to enable control of an exit process.

4. Contamination of sales arrangements

For example, one target which had granted exclusive territories to its distributors or agents, was required by a large corporate purchaser to terminate (at substantial cost) those arrangements in order to allow the purchaser to sell its own products alongside the target’s product range within the purchaser’s existing distribution arrangements.

5. Contamination of restrictive covenants

For example, one target had previously sold its business in the US under the terms of an agreement which prohibited the target and its affiliates (which was drafted to include any future buyer of the target) from doing business in the US.

6. Change of control risks

These are often a problem, but in one case this was exacerbated by a target which had amended key contracts (without legal advice) with the intention of making them terminable by the target in the event of a change of control, but which actually made them terminable by the third party.

7. Buy-back of shares

Several examples of historic buy-back of shares which had not complied with the Companies Act. Unlike many examples of incorrect filings at Companies House (which are becoming much more prevalent especially with the use of online filings), defective share buy-backs cannot be subsequently rectified and are void.

8. Group reorganisation risks

These will also be closely examined by a buyer, and defects in structure and implementation are not unusual. There can also be problems even where the paperwork is correct; for example, where a target which has undertaken recent intra group asset transfers is subject to a substantial tax clawback on leaving its group. Intra group undervalue transactions are also a risk area.

9. Unlawful payments of dividends

Unlawful historic payments of dividends in circumstances where there were insufficient distributable reserves and/or the statutory requirements had not been followed.

10. Tax schemes entered into by the target

Tax schemes entered into by the target, often involving disguised remuneration, which represent a contingent tax liability that could take many years to unravel.

11. Breaches of data protection legislation

Multiple examples of breaches of data protection legislation, which (especially since the introduction of GDPR and subsequent high profile cases involving large fines) has been increasingly identified as a material risk.

12. Anti-bribery policies and procedures

Failures to implement and monitor appropriate anti-bribery policies and procedures.

13. Breaches of regulated activities

Breaches of regulated activities, especially failures to comply with the strict FCA provisions relating to the provision of consumer credit.

14. Absence of enforceable restrictive covenants in key employee contracts

15. Reports on asbestos

Failure to comply with requirements to obtain reports on (and manage the presence of) asbestos in buildings, which can be a criminal offence and accordingly makes certain categories of buyer especially nervous. Historic asbestos risk relating to the conduct of the target’s actual business activities can also be a significant risk, albeit in a relatively small category of deals.

16. Deficient insurance arrangements

Deficient insurance arrangements, especially where historic coverage has been obtained on an “events occurred” rather than a “claims made” basis. Many buyers will conduct specific DD on insurance. The fallout from Covid-19 means that there will be more focus on business interruption coverage and specific pandemic insurance (as well as other tailored coverage such as pollution, where applicable).

If you would like to discuss the legal aspects of preparing your business for sale, or advice generally on M&A transactions, please contact Jonathon Roy, Michael Moore, Amanda Brockwell or Richard Atcherley. 

If you are thinking of selling your business to an overseas buyer you may like to read our blog “10 potential pitfalls to avoid when selling a business to overseas buyers“.

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