Why is it important to understand the proposed transaction type before starting your due diligence?
Keep your due diligence review relevant to the proposed transaction type, and save your client time and money.
Executive summary
This article provides guidance for junior legal professionals and buyers conducting due diligence for 2 transaction types—private asset sales and private share sales—and outlines the critical differences between them from a due diligence (or "document review") perspective.
Even if you're using AI to review documents, it's important to use a checklist to make sure the AI identifies all the key issues based on (a) the document type; and (b) transaction type. Also some of the key issues might not be apparent from the document (e.g. the parties are related) so the AI could miss them altogether.
Introduction
Is your client buying assets or shares?
Before starting any legal due diligence, do you know whether your client (the Buyer) is buying the assets (or business) of a company (Asset Sale) or the shares of a company (Share Sale)?
There are many factors influencing the decision of an Asset Sale versus a Share Sale but that is not within the scope of this article and generally involves other important considerations such as tax.
You should expect to be told the transaction type by the lawyer managing the project (Team Lead) in an onboarding meeting. However, it’s possible your client has not decided yet. If this is the case, you will likely need to consider both options in your document review.
If your client changes the transaction type mid-way through the due diligence, the scope of your work may change. The Team Lead should share these changes with all deal team members on a centralised deal portal. Some law firms use a Microsoft Teams / Sharepoint workspace or a specialised due diligence project management tool, like Due to keep everyone up-to-date. If the team isn't informed of changes, this can result in unnecessary time and money being spent on due diligence.
But first, what is an Asset Sale?
An Asset Sale occurs when the buyer is buying the assets or a business owned by an entity (we only consider Asset Sales involving a company in this article). This requires those assets of the company (including contracts with third parties) that are being sold to be transferred (or assigned) to the Buyer.
How does an Asset Sale compare to a Share Sale?
A Share Sale occurs when the Buyer is buying the shares of a company (the Target Company) from its shareholders, and the shares are transferred from the current shareholders to the Buyer. There is no need to assign or transfer individual assets or contracts for a Shale Sale as all assets and liabilities are sold to the Buyer.
Why should you use a due diligence checklist?
Before starting, you should ask the Team Lead to share in the team portal a review checklist for each document type that needs to be reviewed. You use this checklist to ensure you extract and summarise the key clauses of each document and can accurately identify the key issues or “red flags” from your review.
The checklist you use will be different based on:
- document type (e.g. a shareholders deed and a supplier contract have different provisions that need to be reviewed)
- proposed transaction type (e.g. for a share sale, you will likely need to consider the change of control clause in a customer contract)
What if I don't have any checklists?
If there are no checklists available, consider one of the following options:
- look on your firm's document management system for a past example;
- ask a trusted colleague;
- use Due's checklists available to download for free on our website;
- sign up for a free Due account and use our pre-loaded templates to review your documents - see demo below
What is an example key document I will need to review for a Share Sale?
1. Shareholders agreement
For a Share Sale, it's imperative there is a smooth transfer of shares from the shareholders to the Buyer to complete the transaction.
Normally there will be restrictions on a shareholder from transferring or selling their shares held in a private company. The specific restrictions are often found in the Target Company’s constitution or shareholders agreement. If there are restrictions in both of these, then consider which document overrides the other if there is an inconsistency between them.
Pre-emptive rights
Assuming not all shareholders are selling their shares, a common type of restriction on a selling shareholder selling their shares is called a “pre-emptive right”. A pre-emptive right gives the other existing shareholders the opportunity to purchase the shares to be sold or transferred before they are offered to third parties.
What does this mean for your client, the Buyer?
If your client is trying to buy the shares from the selling shareholder, you should make them aware of the pre-emption process because this might hinder or delay their ability to purchase the shares. A typical process will require notice to other shareholders, and an offer period for existing shareholders to make an offer. If the selling shareholder doesn’t accept the offer then it can sell the shares to a third party within a certain period. The sale to a third party will generally need to be on more favourable terms to the seller than the terms offered by another shareholder.
Tag along rights
If this a ‘tag along’ right exists, then your client (the Buyer) might be required to also purchase the other shareholder’s shares who can "tag along", generally on the same terms as they are buying the selling shareholder’s shares.
What does this mean for your client, the Buyer?
If ‘minority’ shareholders have tag along rights, your client should be aware of this as the Buyer's sale terms may need to extend to minority shareholders.
Drag along rights
This right grants the majority shareholders the right to force the minority shareholders to accept a sale of their shares, even if the minority shareholders do not want to.
What does this mean for your client, the Buyer?
This right can be attractive to the Buyer as they can buy 100% of the shares of the Target Company, without having minority shareholders remain on the share register.
2. Material contracts
The material contracts are an important part of the Target Company’s business and can include (among others):
- customer contracts (revenue generating contracts)
- The material contracts are an important part of the Target Company’s business and can include (among others):
For a Share Sale, you will need to review the change of control clause in the material contracts to see if there is a restriction or prohibition on there being a change of control of the Target Company under the contract.
What does "change of control" mean?
First, you need to consider when the contract deems there to be a change of control of the Target Company (as a party to the contract). Although there is no fixed meaning of change of control, it commonly means one or more of the following:
- a party to the contract is acquired so there is a change in who owns the shares of that party
- a party to the contract sells all or a majority of its assets
- a party undergoes a merger
- a party undergoes a change in management
- a party undergoes a change in the board of directors
Then, review the change of control clause to see if there is a restriction or prohibition on there being a change of control that applies to the Target Company.
What is the change of control restriction?
The most common change of control restrictions include:
- Cannot occur: A change of control in a party is strictly prohibited under the contract. If this occurs, then the Target Company could be in breach of the contract and risk the contract being terminated
- Consent: The consent of the counterparty to the change of control is required before the change of control can occur
- Other conditions: Certain other conditions need to be satisfied before a change of control can validly occur in addition to consent or notice conditions
- Notice: Notice of the change of control must be given to the other party.
- Additional rights: A change of control gives the counterparty any additional rights, for example, the right to terminate the contract, payment of a fee, or a renegotiation right.
- Silent: Change of control is not specifically mentioned in the contract.
If there is no change of control clause, check whether the assignment clause applies to a change of control. If that is the case, then the provisions in the assignment clause will need to be considered.
Will the change of control restriction be triggered by the proposed transaction?
You will need to consider whether the proposed transaction will trigger the operation of the change of control restriction and therefore the provision must be complied with. The below course of action is recommended.
- Yes, clause is triggered — Action required — see next section
- No, it is not triggered — No action required
- Unsure whether it is triggered — Ask your supervisor
Required action if restriction is triggered
Identify what action is required by looking at the contract (e.g. obtain the counterparty’s consent). Consider raising this restriction as a “red flag” in your due diligence report so your client can act on this and obtain counterparty consent sooner rather than later to avoid any hold-ups at completion.
Example
To finish, let's walk through an example.
Cardio, Inc (Supplier) has a customer contract with Medtron, Inc (Purchaser) for the purchase of medical devices manufacturered by Cardio, Inc (Medical Supply Contract).
I used Due to review this contract and below are the results from reviewing the change of control clause in the Medical Supply Contract.
Step 1 - is there a change of control restriction?
Yes
Step 2 - does a change of control restriction apply to the target company, Cardio, Inc?
Yes. Based on the results shown below, the change of control restriction only applies to the Cardio, Inc (the Purchaser).
Yes. Based on the results shown below, the change of control restriction only applies to the Cardio, Inc (the Purchaser).
Yes. The proposed transaction falls within category 1 of the change of control definition. As such the restriction will be triggered.
Step 4 - what is the change of control restriction?
- 1) The Supplier shall immediately notify the Purchaser upon the occurrence of a Change of Control.
- 2) After notification, the Purchaser has the right to terminate the Agreement effective immediately.
- 3) Upon termination due to a Change of Control, Purchaser would be permitted to exercise the "Back-Up Manufacturing Right".
Step 5 - what is the required action?
The Supplier must immediately notify the Purchaser upon the occurrence of a Change of Control.
Step 6 - raise this as a red flag for your client
As the Purchaser can terminate the contract, this is likely to affect the purchase price or valuation of the target company. Given this, it's likely to be a red flag issue to raise with your client. Based on your client's circumstances, you should also provide a suitable recommendation.