Often in acquisitions of a privately owned business, the Acquiror acquires all of the issued and outstanding shares of the target company (in a Share Purchase transaction) or substantially all of the assets of the target company (in an Asset Purchase transaction). This is because, in most cases, Acquirors want to completely acquire the acquired business, and Vendors wish to dispose of their interest therein in exchange for the acquisition consideration. However, in some cases, Acquirors instead seek to acquire less than all of the shares of the target company, and the Vendors may wish to retain a direct equity interest in the target company.
This Practice Guide considers some potential implications and issues that can arise in a partial sale Share Purchase transaction.
In some cases owners of privately held businesses are not looking to sell their business and retire (either immediately or in the near future), and realize the proceeds from the sale of their entire interest (e.g. to fund retirement and life thereafter), but instead wish to continue to be actively involved in the business for the foreseeable (at least near to mid-term) future. However, in these circumstances owners may wish to receive sooner, rather than later, a significant portion of the return for their investment and hard work in building the value in the acquired business, and use a portion of the proceeds pre-retirement. In exchange for this initial partial return, the owners may be prepared to give up control over the business, but retain a significant financial stake in the business, including future growth.
From an Acquiror’s perspective, some Acquirors, particularly financial purchasers, seek opportunities to invest in companies that have a strong management team in place that will remain in place and continue to drive the future business growth, and not need to assume full control of the governance of the target company or the acquired business. Such purchasers may be willing to acquire less than 100% interest in such a company that has growth potential to support cash flows required to generate the returns sought by investors in the financial purchaser. Such purchasers may be willing to provide financial support for the business, including the initial purchase price for the acquired interest. Acquisition of less than 100% reduces the upfront payment required from the Acquiror, and may lessen the need for leverage or debt funding for the purchase price. Having owner-entrepreneurs continue to be both involved as an employee (or consultant contractor) and direct owner of a significant equity interest serves to provide them with a greater incentive to drive future growth for the business, which benefits both themselves and the Acquiror.
In these situations, the percentage of the shares of the target company sold can vary. For example, one alternative might be an acquisition of 50% of the shares, with 50% retained by the Vendors. It may be that if the Acquiror may wish to consolidate its financial statements with the target company’s, it may wish to acquire slightly over 50% (e.g. 50.1% or 51%), so as to acquire control.
Another possibility may be for the Acquiror to acquire control, and possibly a high enough percentage that it could potentially pass a special resolution (e.g. 67%), but where certain matters that require approval by special resolution are subject to provisions in a negotiated Shareholder Agreement (see below).
There are obviously other variations (e.g. acquisition of 75% or 80%, or higher). However, acquiring 80% or more dilutes the benefits of the retained interest, and incentives for the Vendor to assist in creating, and participating in, future growth.
Distinguishing an Acquisition Payable Partly in Securities
The situation described above can be distinguished from a share purchase transaction where the Vendors sell all of the shares of the target company in exchange for consideration which is in the form of, or includes, securities of the Acquiror. In that case, the Vendors do not retain a direct interest in the target company, but would, post closing, acquire an interest in the Acquiror. In most cases (other than a “reverse take over” share exchange transaction), the interest in the Acquiror is a minority interest, such that the Vendors often do not acquire any governance rights. In any event, the target company becomes a wholly owned subsidiary of the Acquiror.
Issues and Implications
Share Purchase Agreement
In general, an acquisition of less than all of the shares of the target company does not significantly change most of the material provisions of the Share Purchase Agreement. The Vendors still typically are required to give representations and warranties to the Purchaser regarding not only their title to and ownership of the transferred shares, but also regarding the target company and its assets, liabilities, financial condition and other matters typically included in a Share Purchase Agreement for all of the shares.
One potentially significant difference is that, in an acquisition of less than all of the shares, absent express provisions that could be included in the agreement to change this result, damages suffered by the purchaser for breach of representations and warranties relating to the target company would potentially be limited to the percentage interest acquired. For example, if there were undisclosed liabilities of the target company in the amount of $100,000 in breach of a representation and warranty, and the Purchaser acquired 75% of the shares of the target company, the damages suffered by the Purchaser would seem to be $75,000, rather than the full $100,000.
Similarly, if the Share Purchase Agreement includes a working capital adjustment, the amount payable under the working capital adjustment should reflect the percentage interest being acquired. For example, if the Agreement involves the acquisition of 60% of the outstanding shares of the target company, and provides for a working capital adjustment to the extent the actual working capital at Closing exceeds or is less than a $500,000 target working capital, if the actual working capital was in fact $600,000, the Purchaser should pay $60,000 to the Vendors, rather than $100,000, pursuant to the adjustment. Likewise, if the actual working capital was $400,000, the Vendors should pay $60,000, not $100,000 pursuant to the adjustment.
A significant implication of the partial sale structure described above is that typically, in addition to the Acquisition Agreement, the Parties (the Vendor(s) and the Purchaser) will negotiate and enter into a Shareholder Agreement in respect of the target company. Possibly even more so than the Acquisition Agreement, shareholder agreements are not “off the shelf” or “change the party names” precedent documents. Provisions which are included in such agreements, and the terms of those provisions, are almost always subject to negotiation, often heavy negotiation. As a result, incremental legal fees on both sides are not insignificant.
In this context, a Shareholder Agreement will likely include the following concepts:
- Agreement of the shareholders regarding rights of shareholders to nominate directors. For example, in the case of the acquisition of 50% of the target company shares, each of the Purchaser, on the one hand, and the Vendor(s), on the other hand, might be entitled to nominate 50% (e.g. 2 of 4) of the directors of the target company. In an acquisition of 67%, the Purchaser may be entitled to nominate two thirds (e.g. 1 of 3, or 2 of 6) directors and the Vendor(s) the balance.
- Restrictions on share transfers (e.g. without the consent of all other shareholders), except as otherwise expressly permitted.
- A right of first refusal pursuant to which any shareholder wishing to sell shares (other than with consent of the other shareholder(s)) must first offer the shares to the other shareholders.
- Restrictions on issuance of new shares, and a pre-emptive right requiring new shares to be offered pro-rata to existing shareholders.
- “Drag along” rights pursuant to which if a specified majority (e.g. 2/3rds, but possibly whatever percentage may be held by the Purchaser, if that is less than 2/3rds) agrees to sell shares to a third party, they can require the other (minority) shareholder to also sell at the same price and on the same terms, and “tag along” rights entitling minority shareholders to require that their shares also be acquired at the same price and on the same terms.
- Mandatory forced sale of shares in certain circumstances (e.g. death of the shareholder or principal of a corporate shareholder), insolvency of a shareholder of termination of employment of a shareholder (or principal of a corporate shareholder) that is an employee (e.g. the Vendors).
- Provisions that restrict the target company from taking certain actions without the consent of a specified percent of the shareholders. Such provisions are generally intended to provide protection to minority shareholders (e.g. the Vendors) to effectively give them a veto over decisions that otherwise could potentially be made by the majority shareholder (e.g. the Purchaser) or a majority of directors, which, for example, otherwise would likely be the case if the Purchaser acquires at least 67% of the shares and is entitled to nominate a majority of the directors.
It is important to keep in mind in relation to the last point above that, where the target company is a British Columbia company, the Business Corporations Act (British Columbia) does not include provisions included in most other Canadian corporate statutes expressly recognizing that a “unanimous shareholder agreement” may “fetter the discretion” of directors. In the absence of such a statutory provision, unless the Articles of the target company include a provision transferring powers of directors to the shareholder (which is not standard, and likely would need to be added to the Articles by an amendment to the Articles at the time the Shareholder Agreement is entered into), provisions in a Shareholder Agreement which can be considered to fetter the discretion of directors and restrict matters which otherwise can be approved by directors may be held by a court to be invalid.
For a further discussion of this and other issues regarding Shareholder Agreements, see the “Shareholder Agreements in an M&A Context” Practice Guide.
In the circumstances described above, where owners of a privately held business are selling a significant part of their interest in the target company, but at the same time retaining a significant interest and continuing to remain involved in the business not only for the very near term, but also for a longer time period, it is not unusual that the Purchaser might seek to impose:
- Non-competition and non-solicitation covenants in the Acquisition Agreement (or in a separate agreement contemplated in, and often attached a schedule to, the Acquisition Agreement) which restrict the Vendors from competing with, or soliciting clients and employees of, the business for some period of time post Closing, which is generally supported on the basis that the Vendors are receiving valuable consideration for the sale of the interest and such competition or solicitation would deprive the Purchaser of value that they are paying for under the acquisition transaction;
- Non-competition and non-solicitation covenants applicable to the Vendors and their principals in the Shareholder Agreement which typically are applicable for so long as the Vendor remains a shareholder, and for a period following such Vendor disposing of the interest in the target company retained at Closing; and
- Non-competition and non-solicitation covenants applicable to the Vendors (or the principals thereof) in employment or consulting or contractor agreements to be entered into between those persons which are applicable during the period that remain employed or retained by the target company, and for some period after termination thereof.
Despite the greatest of intentions, in some cases, one or more Vendors may determine that they do not wish to remain involved in the business after a period of time that is less than was originally contemplated. This may be because a Vendor, for so many years, was his or her own boss not having to answer to anyone, and has difficulty adapting to this no longer being the case.
When this occurs, a carefully drafted Shareholder Agreement will hopefully provide for a mechanism for the sale and purchase of the departing shareholder’s shares (assuming the Purchaser, which usually is the case, is willing to buy out the departing shareholder (or fund the target company to do so)). In many cases the Shareholder Agreement provisions might just serve as a potential default position, absent mutual agreement between the parties, and the parties will agree on an alternate negotiated exit for the selling shareholder, and acquisition of the interest retained by such holder.
A partial sale of a significant interest in a target company to a third party Purchaser, can provide the Vendor with an excellent opportunity to receive a partial return on their investment, as well as retaining a significant direct equity stake in the business and strong incentive to help contribute to its future growth. At the same time, this arrangement can reduce the up front acquisition cost for a Purchaser, and possibly permit a Purchaser to use cash flow from the business, in part, to help fund the subsequent acquisition of the remaining investment in the future when the Vendor wishes to resign and retire from the business.
This structure results in some additional complications, including, in particular, the need for a Shareholder Agreement, which can be a complicated and heavily negotiated agreement. However, all of these complications are matters that can be coordinated with the assistance of experienced advisors.