13 Sep 2012

Understanding sale agreements: the key issues part 2

by Nick Miller

Understanding what's being transferred to the buyer, and how much it's paying, is crucial for sellers who want to manage their risk and maximise their return.

As we saw in the last article, practically speaking sellers will need to give some level of warranties to buyers and it will be in sellers' interests to disclose against those warranties carefully. In this article, we'll look at what might seem straightforward issues, but can really give rise to significant headaches for sellers: what are you selling or transferring to the buyer, how much money are you getting – and how many risks remain after the transaction?

Purchase price adjustments – how are they to be calculated?

Sale agreements commonly provide for a purchase price adjustment based on working capital or net assets. In other words, if the working capital/net assets of the business on completion of the sale exceeds a stipulated target level (either agreed between the buyer and the seller or determined by reference to a base balance sheet), then the purchase price is increased by the excess. Conversely, the purchase price is decreased if the working capital/net assets falls below the stipulated target level.

A key issue in documenting the purchase price adjustment will be ensuring that appropriate accounting policies and practices are used in measuring the working capital/net assets of the business on completion. It will usually be in a seller’s interest for these to be the accounting policies and practices assumed in the stipulated target level, so that you're comparing apples to apples.

In the case of a stipulated target level determined by reference to a base balance sheet, these should, from the seller's perspective, be the accounting policies and practices assumed in the base balance sheet.

In the case of a stipulated target level agreed by the buyer and the seller, parties should clarify the accounting policies and practices assumed in the agreed position (for example, what inventory valuation methodology is to be used and how any debtor provisions are calculated), otherwise the buyer and the seller could have different pictures as to what precisely constitutes (for example) $2 million of working capital.

In either case, the accounting policies and practices should be documented in the sale agreement, so that both parties know how the purchase price adjustment is to be calculated. Simply stating that the International Financial Reporting Standards or Australian Accounting Standards are to be applied is not good enough. This is because in most instances these do not prescribe a particular treatment or methodology, but leave open a number of permissible options. Instead, it would be in the interests of both the parties to really drill down and agree the precise accounting treatments and methodologies to be applied.

Another key issue in relation to purchase price adjustments, particularly from a seller perspective, is to ensure that the working capital/net assets are appropriately defined so as to exclude liabilities for which the seller is indemnifying the buyer.

Unless these liabilities are excluded, there is the potential for the buyer to be double compensated: firstly via the indemnity, and secondly via the reduction in the purchase price resulting from the inclusion of a provision for that liability in the calculation of the working capital/net assets of the business.

What happens to your employees when you transfer the business?

In a business sale (as opposed to share sale), employees might claim redundancy pay from the seller unless the buyer offers them employment on terms:

  • which are substantially similar to; and
  • considered on an overall basis, no less favourable than,

the terms or conditions they already enjoy.

Accordingly, the sale agreement should oblige the buyer to make offers to all employees of the business on these terms. It should also require the buyer to indemnify the seller against any loss that the seller incurs as a result of the buyer failing to make complying offers.

The buyer might not want to do this (at least in relation to certain employees). This may be because the relevant terms of employment are too generous, or it wishes to preserve flexibility in the business' employment arrangements.

Practically speaking, the seller would then need to discount the buyer's offer by the potential redundancy exposure which the buyer is effectively requiring the seller to bear in the transaction. This may mean that the relevant buyer's offer becomes so unattractive as to be rejected or initiate a re-negotiation between the parties.

Transferring your business contracts

Business contracts (eg. customer and supplier contracts) can be transferred from a seller to buyer in two ways as part of a business sale transaction:

  • the seller can assign the benefit of the business contract to the buyer; or
  • the business contract can be novated from the seller to the buyer.

There is a key difference between the two. An assignment of the benefit of a business contract is an arrangement between the buyer and the seller which entitles the buyer to all of the benefits under the business contract, but requires it to perform all of the seller's obligations. This performance component is not binding against the counterparty to the business contract.

By contrast, novation of a business contract (which requires the seller, the buyer and the counterparty to sign a novation agreement) terminates the original contract and creates a new contract between the buyer and the counterparty.

The significance of this distinction is that under an assignment the counterparty is technically free to pursue the seller for damages if the buyer defaults. The seller may be able to sue the buyer for breaching its promise in the sale agreement to perform the obligations under the business contract, but the seller is depending on the buyer's creditworthiness to be able to recover.

This is in contrast to a novation, where the counterparty's only remedy for a breach of the business contract occurring after the novation is against the buyer, as it is no longer in a contractual relationship with the seller.

Generally speaking, assignment is more common than novation (this is particularly the case in the context of property leases), because assignments (subject to the terms of the particular business contract) generally do not require the involvement of the counterparty to the business contract and so are more easy to achieve.

Novation nonetheless can be worth pushing for, especially for contracts under which the seller still has substantial future obligations to be performed. Alternatively, the seller might seek a guarantee from the buyer's parent company or some security from the buyer for the performance of its obligations under the sale agreement.

Thanks to Adrian Quah for his help in writing this article

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.