M&A Basic Principles – Part I4 June 2024

In this series of articles, we will explore those principles as they relate to M&A. This edition focusses on the typical phases of a transaction.

Identifying a potential acquisition target

The initial stage of the transaction process begins with the identification of a potential target company through analysis and market research. Whilst conducting a target screening may help find a suitable target, the sales process is often initiated and organised by the seller, investment banks, M&A advisors and/or other consultants who provide interested buyers with insights into the company by means of a teaser or an information memorandum (“IM”). This latter is usually subject to a limitation of liability regarding possible inaccuracies within the information it provides.

Letter of Intent, MoU and Term Sheet

After identifying a potential target company, an interested buyer may submit a “Letter of Intent” (“LoI”) indicating its serious intention to negotiate and willingness to enter a contract with the potential contractual partner. Letters of intent are usually sent in advance of the conclusion of a financially and legally binding contract. Typically, letters of intent contain so-called non-binding clauses and are, therefore, not legally binding regarding the conclusion of the agreement in question. Instead, they generally specify in writing the positions on certain contract terms and conditions of the party issuing the letter. The terms “Memorandum of Understanding” (“MoU”) and “Term Sheet” are often used synonymously with the term letter of intent, in each case stipulating the parties’ common understanding which is later specified in the company purchase agreement. For example, the parties may set out information and provisions regarding confidentiality and exclusivity as well as possible rights of termination of contract negotiations. In a bidding process, the party’s serious interest is regularly expressed by its non-binding purchase offer (the “indicative bid” or “indicative offer”).

NDA

At the same time or within the LoI (or MoU or Term Sheet), parties usually agree to maintain confidentiality of information shared by each party in the course of the transaction and, if applicable, also as regards the fact that negotiations are being conducted at all. Such a non-disclosure agreement (“NDA”) creates an additional level of trust for all parties involved.

Due Diligence

To assess the quality of the target company, due diligence is carried out to identify potential risks and address challenges with respect to the legal, financial, technical and/or tax status of the target company. The scope of due diligence usually depends on the expectations of the buyer and the cooperation of the seller, in particular regarding documents provided about the target company and the questions answered by the seller. In M&A practice, a distinction is made between red flag and full scope due diligence. Whilst red flag due diligence examines the most significant risks identifying them as “red flags” and possible “deal breakers”, full scope due diligence presents a comprehensive picture of the legal situation of the target company.

The results of the due diligence will determine whether to proceed with the transaction. In some cases, such as during a bidding process, there is also a due diligence report produced by the seller itself (so-called vendor due diligence report) which allows potential buyers to assess the target company quickly and, consequently, possibly speed up the entire process. Sellers may also provide prospective buyers with so-called legal fact books, which are, in contrast to a due diligence report, limited to a purely descriptive presentation of the company without providing any legal assessments.

Signing: Asset Deal vs. Share Deal

The highlight of the M&A process is the signing of the legally binding acquisition documents. The content of the company purchase document essentially depends on the parties’ preferred transaction structure where commercial, business, legal and tax reasons play a decisive role. In a share deal, a company’s shares are sold and transferred from its shareholder(s) to the buyer. In contrast, an asset deal only involves the purchase of certain defined assets and liabilities of a company such as real property, contracts or claims. As well as the results of the due diligence, the advantages and disadvantages of both a share and asset sale structure should be considered. In some cases, the seller specifies the deal structure at the beginning of the transaction process. In Germany, some purchase agreements, such as the sale and transfer of shares in a GmbH and the sale and transfer of property, must be notarised (notariell beurkundet) to be legally valid.

Closing

From a legal perspective, the most crucial phase of a transaction involving the actual transfer of assets or shares in a company is its so-called closing or completion.

In the acquisition documents, specific recommendations for action for risks identified in the due diligence are usually included as conditions precedent to the transaction and linked to certain legal consequences. For example, the transfer may be subject to merger control clearances and the obligation to obtain the approval of certain bodies or committees, such as a shareholders’ meeting or the supervisory board of the seller, before transferring ownership in the company or its assets. Such conditions precedent for the transfer are also referred to as “closing conditions”. Typically, the seller has an interest in minimising the number and scope of the closing conditions in order not to jeopardise the transaction’s success. The buyer, on the other hand, wants to minimise uncertainties related to the target company. The parties therefore usually agree on a “longstop date” by which the closing conditions must be satisfied or waived for the closing to take place at the latest. As a result, signing and closing can be several months apart but may also take place on the same day.

On the closing date, i.e., the day on which the closing occurs, the parties typically undertake to perform additional obligations (so-called closing actions) such as changing the company’s management, delivering key corporate documents and payment of the purchase price and receipt of the purchase price respectively. The parties usually confirm the fulfilment or waiver of the closing conditions and the closing actions in a closing memorandum.

Break-Up Fees

At any time during the transaction process, parties may agree an obligation to bear costs should contract negotiations fail or certain conditions are not satisfied (the “break-up fee”). Depending on the interests involved, this obligation may apply to the buyer, the seller or even the target company. In Germany, the agreement of a break-up fee may be subject to formal requirements due to the potentially not inconsiderable financial burden on one party.