The story of Bill Gates and Microsoft sums up what the IT industry is about -immense wealth generated by very clever people working with little more thanideas and information. Not surprisingly, the value of IT businesses is tied upin assets represented by people and intellectual property. By their nature,these are more ephemeral than the bricks and mortar or plant and machinery thatlawyers are used to dealing with.
All major law firms have an impressive line-up of corporate lawyers who spendtheir days (and nights) working on corporate transactions. One day they might beselling a retail chain; the next, they might be buying a technology business.Those lawyers are supported by an extended team of specialists in IT,intellectual property, tax, employment and pensions, and so on. At its best, thewell oiled corporate law machine can complete massive transactions in the faceof impossible deadlines; in the worst cases, the individuals who make up theteam may operate with tunnel vision, with little or no knowledge of the businessobjectives of the deal. This danger is especially acute when buying and sellingIT businesses, because of their intangible stock in trade.
This article examines:
- the composition and management of the professional team
- the Information Memorandum
- due diligence
- identifying what you are buying
- the Sale Agreement
- warranties and disclosure letter
- employees
- premises differences between `straight acquisition’ and outsourcing
- post-completion.
We have approached these topics from the purchaser’s point of view, althoughmany of the points made apply equally to a vendor.
The Professional Team
The first step involves assembling the professional team who will work on thedeal. Typically, this team will possess a range of commercial, financial,technical and legal skills and be drawn from the client’s own organisation andfrom its professional advisers. Ideally, the members of the team will haveworked together before, and have similar levels of experience. But very oftenthe business people are `deal virgins’ advised by lawyers who view thetransaction as routine. A danger arises of the tail wagging the dog – thelawyers need to remember that their role is to fulfil the client’s commercialobjectives, not to debate `boilerplate’ in the early hours of the morning.
Like any team, they need time together to work out a game plan and establishthe positions in which they are going to play. A captain needs appointing(usually the most senior and experienced player from the client). The teamshould include someone who will be involved in running the target business afterthe acquisition has been completed – this capitalises on knowledge of the targetbusiness which will be acquired during due diligence and contract negotiations.
It helps for the team to have a couple of practice sessions before startingthe game in earnest. This could take the form of a structured workshop involvingall the members of the team, covering deal objectives, roles, tactics andtimetable. The same information should be made available to them in advance ofthe workshop – this might include an Information Memorandum (see below),brochures, accounts and other information describing the target business.
Once the game starts, it remains important for team members to communicatewith each other, through meetings, reports and other means.
Information Memorandum
With a sale of any substance, one can expect the vendor to have taken thetrouble to prepare an Information Memorandum describing the business for sale.Typically, this will be a report addressing the management, market positioning,products and services and financial performance of the business. This isessential reading for the purchaser’s team. Even at this stage, it ought to bepossible to determine how `standalone’ the business is, or whether it reliesheavily on support (both financial and managerial) from the vendor. The greaterthe dependency, the greater the risk of hidden costs in running the business.
Due Diligence
There may be site visits – to meet people working in the target business, or to check asset lists or the state of a building. Some thought should be given as to how those visits can be arranged in secrecy, if people in the target business are unaware that the business is up for sale. |
Due diligence plays a central role in buying IT businesses as much of thevalue is intangible, in the form of people and intellectual property rights. Theultimate objective is to achieve a thorough understanding of the targetbusiness, so that the purchaser can make informed decisions about price, riskand warranties.
A purchaser may have a number of aims for due diligence:
- to understand the vendor’s business
- to check which staff will or will not be transferring (with all that implies)
- to assess the quality of management and staff who will be transferring
- to check the vendor’s asset register and asset valuations
- to carry out technical audits on software products which form part of the vendor’s portfolio
- to review the economics of the target business, including its accounts, revenue, costs and order book
- to investigate ownership of intellectual property rights
- to audit contracts with customers and suppliers in order to identify special risks or hidden liabilities
- to inspect properties to check their suitability for running the business, and to see their state of repair
- to plan for transfer of the target business to the purchaser, and its integration into the purchaser’s business.
These objectives can be achieved in a number of ways. It has become commonpractice for vendors’ solicitors to set up data rooms containing paper fileswhich have been catalogued by reference to subject area, such as intellectualproperty or contracts. Many readers will be familiar with the horrors ofspending days in a stuffy meeting room, reading thousands of documents. Amethodical approach is needed – so that every member of the team is followingthe same approach, and reporting their results in the same way.
If a vendor has gone to significant time, trouble and expense to prepare adata room, they generally expect the contents of the data room to be treated aspart of the disclosure letter, so that the purchaser is taken to have knowledgeof all the information contained in it (see below). This fact, coupled with thecommon experience that vital information may have been left out of the data room(by accident or design), means that there is a heavy onus on the due diligenceteam. It should not be entrusted to trainee solicitors with little or nosupervision.
There may be site visits – to meet people working in the target business, orto check asset lists or the state of a building. Some thought should be given asto how those visits can be arranged in secrecy, if people in the target businessare unaware that the business is up for sale. They may take place after hours orat the weekend; one even hears of purchasers pretending to be potentialcustomers, so that they can be shown round without attracting too muchattention. This level of subterfuge is difficult to maintain if the purchaserneeds access to detailed information about products or particular projects.
Given the potential breadth (and depth) of due diligence, it needs to beplanned, so that the team has clear terms of reference, defined roles and atimetable. If due diligence is carried out well, the results can give apurchaser valuable information, which may be used to re-negotiate the price ormay lead to a decision not to proceed with the purchase.
Y2K poses special problems. As vendors’ standard sale agreements nowroutinely exclude any form of Y2K warranty, the barrack room lawyer’s favouritelatin saying – caveat emptor – is as true as ever. Year 2000 should be atthe top of every purchaser’s checklist.
Vendors should consider preparing an information pack on their Y2K programme,in order to pre-empt inevitable requests for information, and save time andmoney. This should contain an inventory of all hardware and software componentsused in the business, together with details of their compliance status against arecognised standard, such as the BSI’s Definition of Year 2000 Conformity. Thiscould take the form of a spreadsheet, supported by evidence, such as testresults or letters from suppliers (many suppliers are also publishinginformation about the Y2K status of their products on the Web). The informationneeds to be sufficiently detailed to address all key components – even a simplenetwork may involve a dozen or more components – PC, server, tape driver,printer, hub, Windows, networking software, virus checker, back-up software andso on.
A well organised data room ought to list relevant trade marks. The businessmay use unregistered trade names (for example, a product name). Trade marksearches should be carried out, to check that there is no risk of infringing athird party’s registered trade mark. The assets may include domain names – withthe explosive growth of e-commerce, a domain name may become both an importantbrand and a delivery channel for products or services. Given the internationalnature of the Web, registrations may need to be checked in a number ofcountries; these checks should be supplemented by searches using Web searchengines.
Identifying What You Are Buying
The basic alternatives available to a vendor are to sell either the shares ofa limited company which comprises the business, or to sell the assets of thebusiness (including goodwill, property and other tangible and intangibleassets). In either case a purchaser must check carefully that it is getting allthe elements it requires. For instance, it may not be immediately apparent(particularly to a lawyer) that:
- intellectual property rights or building leases are held not by the target company but by the holding company with no automatic right to sub-license or sub-lease out of the group
- staff have been recently `re-organised’ out of the business in such a way as to reduce the apparent wage bill, but would in fact fall under the TUPE legislation and transfer (with their attendant rights) in any event
- staff possessing crucial knowledge of the products or customers have been transferred out of the business
- there are many `situations vacant’ in the business or vacancies have been hastily and/or inappropriately filled
- long-term contracts with customers under which prices may be increased annually in line with RPI may be woefully inadequate in a sector where wage inflation climbs much more steeply
- the business has been bolstered or subsidised by a parent company or another division of the business
- boundaries have been drawn so recently around the part of the vendor’s business to be sold that few if any meaningful figures for the historical cost of running it are available and the sales forecasts provided are highly suspect.
Purchasing the shares of a company is a `clean’ transaction in the sense thatthe purchaser acquires all of the company as at the date of sale and all thecompany’s contracts remain undisturbed (as long as they do not containprovisions allowing termination on a change of shareholder in the business). Thepurchaser takes on all the liabilities within the company.
By contrast, acquiring assets (in theory) enables a purchaser to `pick andchoose’ the assets and liabilities it wishes or is prepared to take on (with theexception of TUPE staff whose transfer is automatic). It also brings into thetransaction a whole host of third parties whose consent is likely to be needed.Contracts with customers in the IT industry are likely to be overtly orimpliedly personal and therefore non-assignable without consent. In an idealworld, consents would be sought in advance or a contract would be exchanged andcompletion delayed until all consents were in the bag. However, it isexceedingly rare in a straight purchase (perhaps less rare in an acquisitionlinked to an outsourcing deal) for the commercial realities to allow for such aleisurely approach. Often the deal is completed on the basis that the vendorwill assist in getting the necessary consents post-completion. In practice, itis extremely difficult to unravel any part of the transaction where consentsprove hard to get. Suppliers in this sector have also been known to have noscruples in demanding a high price for consent knowing the purchaser is `over abarrel’.
The purchaser should isolate the most important contracts for which consentto assignment or novation is needed, concentrating on:
- contracts (often software licences) without which the business cannot operate or would be placed in breach of other contracts or in respect of which an injunction would be fatal
- high value or strategic customer contracts where some handholding and reassurance of the customer is in order
- third parties with whom the purchaser has had previous `run-ins’ and who cannot be counted on to be helpful
- third parties known to put a high price on consent (so as to ascertain the likely cost and pass it on to or share it with the vendor).
The Sale Agreement
In practice, it is extremely difficult to unravel any part of the transaction where consents prove hard to get. Suppliers in this sector have also been known to have no scruples in demanding a high price for consent knowing the purchaser is `over a barrel’. |
A common pre-cursor of the sale agreement is the term sheet or heads ofterms. Obviously, this would habitually be marked `subject to contract’. Thisleaves room for manoeuvre; however howls of moral outrage frequently ensue ifeither party tries to depart too far from the original deal with or without astrong reason. Although not legally essential, it is entirely sensible to havesuch a term sheet prepared as a method of discussing and agreeing thefundamentals. This should mean that the (inevitably lengthy) sale agreement willbe nearer the mark from the start although there will still be plenty ofdrafting points to argue.
The structure of the sale agreement is relatively standard with the mainclauses covering such areas as what is being sold, the price, completionmechanics, restrictions on the vendor, confidentiality and so on. Substantialschedules cover for example (depending on whether the sale is of shares orassets): the lists of assets, taxation matters, staff, pensions, contracts,warranties and protection provisions for the vendor. Being in control of thedrafting of the agreement can be a useful tool in the negotiation process.
It should not be forgotten in the economic modelling for the acquisition thatstamp duty will normally be payable. Duty is 0.5% on the consideration forshares. Since the 1999 Budget on the consideration for certain assets, eg`goodwill’ and `fixed’ (as opposed to `loose’) plant and equipment and on thevalue of book debts, stamp duty starts at 1% (over £60,000) and rises to 3.5%(over £500,000).
Warranties and Disclosure Letter
In the context of the sale of a business, a warranty is a promise by thevendor that a particular statement of fact is true. If the statement of fact isuntrue, the purchaser may be able to sue the vendor for damages for breach ofcontract. For example, the vendor may warrant that: `The Vendor owns thecopyright in the ABC System’. The spectacle of lawyers arguing over thewarranties has entered the mythology of corporate deal making.
Unless a particularly thorough and recent due diligence exercise has been carried out, the disclosure letter is bound to contain some surprises on which the purchaser will have to take a view. |
The last decade has seen a noticeable change of attitude by vendors andpurchasers – vendors have been more inclined to offer `no warranty’ deals andpurchasers lay more emphasis on due diligence on the basis that:
- it is better to have prior warning of problems so that they can be tackled in a planned way with co-operation on all sides
- pre-contract, the purchaser has greater bargaining power to negotiate on price as a result of problems coming to light than it would on post-contract warranty claims
- some problems may destroy an IT business or create great loss of face in the marketplace and a financial warranty claim would not be adequate recompense
- it may not be realistic for the purchaser to confront the vendor with a warranty claim if it needs to preserve a continuing relationship with the vendor (eg because the acquisition was part of an IT outsourcing transaction with the purchaser providing services over a protracted period to the vendor)
- warranty claims soak up management time at a time when the purchaser should be spending its time integrating and consolidating the business
- in the IT sector warranty claims are likely to be far more complex and therefore costly to argue than, say, a claim that `you warranted there were 500 widgets in the stockyard and there are only 300′.
In respect of those warranties which are given, various limitations will beput in place by the vendor. The main ones will be:
- time limits within which any warranty claim must be lodged (typically with a more generous time limit for claims under tax warranties if appropriate)
- a financial cap on individual and/or aggregated claims
- (in order to avoid `small’ nuisance claims) financial thresholds to be reached before any claim will be entertained.
Because the drafting convention is to keep the warranties as generalstatements of fact uncomplicated by exceptions and because facts change right upto the moment of completion, the vendor creates further protection by issuing adisclosure letter to stand alongside the sale agreement. The disclosure lettercontains details of existing breaches of the warranties. No claim can be made bythe purchaser under a warranty to the extent that disclosure has been made.Disclosure can have a dramatic effect on the economics of the deal.
Frequently (either for legitimate reasons or as a conscious tactic) thedisclosure letter is the last draft document to be seen by the purchaser. It isusually also the document which goes through the most intensive last-minutechanges. Unless a particularly thorough and recent due diligence exercise hasbeen carried out, the disclosure letter is bound to contain some surprises onwhich the purchaser will have to take a view. The pressure will be on because atthis point a huge amount of time and effort will have been invested in theproposed purchase and completion is in sight. At this stage, the `thrill of thechase’ can cause normally cautious business people to be swept along in the rushto complete in the face of disclosures they would not have accepted at anearlier stage.
Employees
The prospect of acquiring expert staff is often a key factor in themotivation for buying an IT business. They may be expert in particular softwareproducts or in new sectors such as e-commerce. As such people are currently at apremium and it is a hard, expensive and time-consuming task to recruit thempiecemeal, obtaining them en bloc via a business purchase may be veryattractive.
Unlike recruitment of staff in the marketplace, taking on staff as part of abusiness purchase brings in the stringency of the Transfer of Undertakings(Protection of Employment ) Regulations 1981 (as amended) or `TUPE’. TUPE isintended to protect staff on the transfer of a business by preserving theirrights and transferring them automatically to the purchaser. It does not need tooperate on most share sales as in that case the employment contracts (as withmost other contracts) remain undisturbed.
The case law concerning TUPE has been prolific, fast-moving and frequentlycontradictory. However, it is worth noting that TUPE does not (at present) applyto pension rights. There have always been some seeds of doubt on this score andmoves are afoot to legislate to include them. In most deals, efforts are made toprovide equivalent pension benefits – if only because, in the IT sector, staffretention is an issue.
The purchaser takes on all other rights of the employee:
- any existing right to go to an employment tribunal for compensation or damages for past incidents of sex/race discrimination (there is no upper limit on the damages for these)
- credit for past years service which is relevant to any calculations of compensation for unfair dismissal/redundancy
- bonuses earned but unpaid – again this can be especially relevant in the IT sector and can involve a myriad of schemes, byzantine in their complexity, which have evolved over time
- accrued holiday pay
- any enhanced benefits promised at the last appraisal
- obligations to consult with relevant staff before completion of the deal are a feature of TUPE – sometimes more honoured in the breach than the observance.
Premises
In the excitement of the deal, it is easy to forget that there will be a business to run at the end of it. |
Because of the nature of the IT sector, it is generally more locationindependent than many other business sectors. However, even if the intention isto move the business to alternative premises, it will rarely be practicable tomake such a move on the completion day. Taking the example of purchasing theassets of a single division of a large IT business (where parts of the vendor’spremises are to be made available to the purchaser in the short term),considerations to bear in mind will include:
- can the premises be made secure
- is sufficient car-parking to be provided
- what services need to be purchased from the vendor, eg reception, cleaning, security
- is the consent of any relevant landlord forthcoming for such occupation
- can sufficient flexibility be negotiated such that the purchaser can vacate on short notice when it is ready
- can the relevant hardware/software/ hubs/network be uncoupled from the vendor’s system and/or firewalls be created
- are any onerous repairing obligations being taken on.
Differences between a Straight Acquisition and Outsourcing
The relationship and balance of power between (1) vendor and purchaser on anasset sale and (2) customer/IT service provider under an outsourcing contractmay be fundamentally different (although both relationships involve the sale andpurchase of assets). In general, the purchaser calls the shots in the formercase, whereas the situation is reversed under the outsourcing scenario. Lawyersrepresenting service providers will be familiar with the tremendous salespressures imposed on their clients by customers organising a contract racebetween rival bidders. They may get tired of the saying `this is a no warrantydeal’, as the prospective customer refuses to give even the most patheticwarranties on assets which it will be transferring to the service provider. As aresult, due diligence assumes even more importance. However, one should not putblind faith in due diligence – experience has shown that a 5 or 10% error indisclosed budgeted running costs can have a devastating effect on the serviceprovider’s profit margin for out sourced IT services.
With outsourcing, the parties will not be going their separate ways after theassets have changed hands but will be embarking on a longer-term commercialrelationship with the purchaser selling services back to the vendor. Thepurchaser/ service provider can find itself in the double jeopardy situation ofnot having received what it intended to purchase and as a result being in breachof the outsourcing contract. The ongoing relationship also acts as a powerfuldisincentive to any potential warranty claim or claim for an adjustment in thepurchase price the purchaser may have otherwise sought.
A positive feature of outsourcing can be that the purchaser has the luxury ofmore time and fewer secrecy constraints which undoubtedly facilitates duediligence. It is also more likely to be a practical proposition to have aninterval between exchange of contracts and completion during which all necessaryconsents to assignment of contracts and novation can be sought.
Post – completion
In the excitement of the deal, it is easy to forget that there will be abusiness to run at the end of it. The successful integration of new staff intothe purchaser’s organisation is of paramount importance, given the valueassociated with people in an IT business. At its most basic, they will want tofeel `loved’ by their new employer. This can be expressed through presentationsfrom senior management, social events, individual induction and/or counsellingsessions, as well as pay rises or bonuses. Key individuals should have beenidentified during due diligence and contract negotiations, and they should besingled out for special attention.
The purchaser will usually put their own management into the acquisition -this may be someone who was involved in due diligence and the contractnegotiation. In other cases, the deal team may hand over the running of the newbusiness to new people. In that event, one would expect there to be a formalbriefing of the new management team by the deal team, supported by relevantpapers, such as the sale agreement, disclosure letter and reports from duediligence.
In many cases, the purchaser will need to buy services from the vendor for athree- or six-month period after completion (so- called transitional services).Transitional services may include payroll, switchboard, network services, andany other services which a purchaser is unable to put in place at completion. Inall but the most simple case, the transitional services contract usually takesthe form of a draft in an agreed form, executed moments after the SaleAgreement. Apart from provisions dealing with charging, it may include a ServiceLevel Agreement, depending on the nature of the services.
Deal Makers, Not Deal Breakers
Lawyers need to be more than corporate technicians – we need to understand the businesses we are helping to buy and sell. |
Lawyers need to be more than corporate technicians – we need to understandthe businesses we are helping to buy and sell. One expects an understanding ofthe subtle differences between product and services businesses, and the way inwhich this might affect contracts, risk, intellectual property rights and theculture of the people working in the business. These differences, in turn, willaffect how a lawyer does his or her job. Some understanding of technology ishelpful, as well as the ability to read spreadsheets and financial models. Thisexperience can be gained in a number of ways – doing deals, working in-house inthe IT industry, training with a commercial bias, and so on.
