The mergers and acquisitions market for independent legal businesses remains strong. Barely a week goes by without an announcement of another acquisition by a consolidator and the number of regulated firms has started to decrease after many years of stability.
Seller-side activity tends to be driven by economic, financial, demographic and regulatory factors. Buyer-side activity tends to be driven by a belief that technological innovation, economies of scale and increased buying power will ultimately lead to improved profits and capital value.
Most of the legal businesses catching the eye of potential buyers are structured as limited companies (or limited liability partnerships) and most selling owners are keen to achieve fair value for their lifetime of investment and effort in building their businesses.
So, how should the owners of legal businesses best approach the sale of their legal business and how can they give themselves the best possible chance of realising fair value?
This article takes you behind the scenes of a typical company sale (though most issues are common to LLPs too) to illustrate some of the techniques used to help owners get the right deal. Hopefully, what follows will be reassuringly familiar to many and encourage others to take on the challenge with greater confidence.
Let’s assume that you have received an indicative offer for the entire share capital of your legal business from a potential buyer. You have conducted your own headline due diligence on the potential buyer and been advised by your accountants that the indicative offer is in the right ballpark. You and your co-shareholders have elected not to go to market to seek competing bids from other potential buyers. You are agreed that this is a sensible time to sell, the buyer looks to be a good one for you, your employees and your clients, and you are keen to proceed.
Your chosen legal advisers have given you a fee budget for the transaction and, entirely reasonably, you want to know from them what they will be doing for their money and what value you can expect from instructing them. The explanation should go something like this.
Understanding the deal drivers - Transaction lawyers are often criticised for not spending enough time listening to their clients, to properly understand why the transaction is taking place and what the key objectives are. The process of selling a company 'belongs' to the sellers and not to their advisers, and so the tactics and timetable should be worked up collaboratively.
Engagement letters - The engagement letters of all professional advisers (including lawyers, accountants, corporate finance advisers and other due diligence providers) are legal contracts and should, ideally, be considered with the benefit of legal advice. Typically, this advice will cover the scope of the professional’s work, the fees they propose to charge, how and when the fees are to be paid, and the wording of any proposed limits on liability. As it is the shareholders of the company, rather than the company itself, that will be the selling party, other issues include the recoverability of VAT and what fees, if any, are due if the transaction does not complete.
Confidentiality agreements - Before entering any meaningful discussions with a potential buyer, it is essential that a properly drafted confidentiality agreement (a non-disclosure agreement or NDA) is put in place. This is to protect the company’s confidential business data including information about finances, clients, employees and know-how. Lawyers will advise on issues such as who the contracting parties to the confidentiality agreement should be, how to define the nature of the transaction, how long the agreement should last and, importantly, the contractual remedies available in the event that the potential buyer breaches its terms.
Heads of terms - Converting an indicative offer into formal heads of terms is a key step in any transaction, as it establishes the ground rules between the parties, gets some agreement on key deal points and flushes out any potential stumbling blocks at an early stage. The process aims to minimise the risk of everyone wasting time and money. Heads of terms can be drafted by the sellers themselves with input from their financial and legal advisers or drafted by the advisers for the sellers to approve. Important legal issues are around the overall legal structure of the deal, which matters the deal is conditional upon, who the contracting parties should be, which elements of the heads of terms are binding and non-binding, confidentiality and exclusivity. Buyers tend to push for some form of exclusivity period to reduce the risk of them investing money in instructing advisers and conducting due diligence only to have the deal pulled from under them. Not all sellers agree to this and those that do should take great care not to lock themselves into one specific buyer on onerous terms.
Enquiry memorandum - Prior to preparing the first draft of the sale and purchase agreement based on the agreed heads of terms, the buyer's lawyers will very likely send through to the sellers or their lawyers a long list of questions about the business. The aim of this 'enquiry memorandum' is to help the buyer better understand the detail of the business and to formulate a due diligence plan. Many of the questions create traps for the unwary, as the buyer will no doubt seek to rely on the answers given during or after the transaction. The job of the sellers' lawyers is to ensure that answers are given in the correct way. There is an element of protocol to this based on established commercial practice and, correctly done, the answers should offer the selling shareholders a high level of protection from future claims for breach of warranty, non-disclosure, or misrepresentation.
Dealroom - To avoid exchanging large volumes of documentation and data by email or in paper format, it is now common to set up an online dealroom where everything is stored in a secure password-protected environment accessible only by the parties and their professional advisers. The dealroom provides a single repository for all information that a seller wishes to provide to a buyer. The sellers' lawyers usually set up the dealroom, advise on how information should be presented and then manage the access to it.
Due diligence - This is the process by which the buyer attempts to verify that the asset being bought is worth what they have offered. As well as reviewing the sellers' responses to the enquiry memorandum and the contents of the dealroom, the buyer and the buyer's professional advisers may want to conduct other investigations into the company. These investigations might include interviewing selected staff and clients (once it is clear the deal will happen), auditing IT systems and financial data and reviewing legal contracts and intellectual property rights. The role of the sellers' lawyers is to advise on issues of confidentiality and assist the sellers in responding to any issues arising from the buyer's due diligence process in the right way. Using lawyers with an in-depth knowledge of your industry sector will give you a significant advantage.
Sale and purchase agreement - This is commonly drafted by the buyer's lawyers and it is the job of the sellers' lawyers to go through it carefully and amend it in a way that protects the selling shareholders. The agreement should reflect the agreed heads of terms and include details of the company being sold, the price being paid, the payment structure and the security being given in relation to any deferred consideration. It will also include any restrictive covenants being given by the selling shareholders regarding their future business activities and the terms of any ongoing involvement the sellers may have with the company. The agreement will also reflect any warranties (contractual promises) that the buyers will ask the selling shareholders to give about the company. Negotiating the terms of the agreement is where the skills and experience of the sellers' lawyers are perhaps most in evidence as this tends to be where the 'deal' is won or lost. How hard a bargain each party can drive depends to a large degree on their relative bargaining positions, but it is fair to say that a good lawyer can play a poor hand more effectively that a poor lawyer can play a good one. Securing the right deal is about knowing which cards to play and when to play them. For sellers, a good outcome is achieved when, at completion, the headline price offered at the outset has not been reduced without good reason and that, following completion, there are unlikely to be any warranty claims that could claw back the sale proceeds paid to the sellers. Much of the negotiation tends to be around the nature and form of the warranties being given and the limitations as to when and how the buyer can make a claim under the warranties.
Disclosure letter - Selling shareholders can be protected from a claim for breach of a warranty in the sale and purchase agreement in three main ways. The first way is for the warranties to be worded correctly. So, for example, a warranty that says, 'there is no outstanding litigation against the company' can be qualified to say, 'the warrantors have not received written notice of any litigation against the company'. This may appear to be semantics, but it can make all the difference if it turns out that a claim had been brought against the company, but this had not yet come to the notice of the shareholders. The second way is to limit the buyer's ability to bring a warranty claim by limiting the time within which a claim can be brought and by excluding minor breaches below certain value limits (called 'de minimis' claims). The third way is via a document called a disclosure letter. This letter is issued by the sellers with the assistance of their lawyers shortly before completion. It discloses anything that the sellers want to make the buyer aware of that could cause the sellers to be in breach of a warranty. So, taking the same warranty above as an example, the disclosure letter might say 'with regard to warranty X, the sellers disclose that a claim has been brought against the company by XYZ Limited, details of which are attached to this disclosure letter in Appendix 1'. If the buyer accepts this disclosure (without the protection of an indemnity, a retention or a price adjustment) and proceeds to complete the transaction, the buyer will not be able to sue the selling shareholders for breach of that warranty arising from the disclosed matter. Had the warranty not been disclosed against in this way, the chances are the buyer could bring such a claim.
Pre-completion consents and consultations - Completion of the sale of a company may be dependent on the sellers securing various consents from banks, regulators, competition authorities and others. Selling a legal business will require the consent of the relevant legal regulator. Lawyers with experience of dealing with regulated businesses and regulators will have a thorough understanding of how the timing of these needs to be woven into the deal structure and conditionality. Completion may also be dependent on carrying out certain consultations, for example with the company's employees. Managing these issues can be tricky and time-consuming and needs the sellers and their professional advisers to work closely together to make this run smoothly.
Completion - At last, the day comes when the due diligence process has been finalised, the documentation is agreed, all necessary consents have been obtained, consultations have been concluded and the parties are ready to complete. Pre-lockdown, the parties would generally meet accompanied by their advisers, sign all the documentation and complete the transaction. Lockdown has proved that remote completions are perfectly possible for most transactions, but it is likely that many will still prefer the emotional closure that a physical completion meeting brings. Whilst completion itself should be a largely administrative process, it is surprising how often issues are raised at the last minute, and the sellers' lawyers may need to act robustly to bring matters to a satisfactory conclusion. The last job for the sellers' lawyers is to receive payment for the shares, settle any agreed liabilities, distribute the net proceeds to the selling shareholders and attend to any post-completion formalities.
Oh, and pop a socially distanced champagne cork to enable the parties to toast a successful outcome!
O’Connors Legal Services Limited