Introduction
In my previous article of 13 January 2022 titled “Agreements for buying or selling existing shares” I explained the key provisions expected in such agreements. In this article I focus on managing risks when transacting in existing shares. Share sale and purchase agreements are central to mergers and acquisitions.
Key provisions
For ease of reference I reiterate that key provisions in such agreements include preamble, definitions, conditions precedent, effective date, description of the sale or transaction, description of the shares being sold, purchase price and payment terms, transaction costs, transfer of shares, warranties, breach and dispute resolution.
Managing key risks
There are many risks associated with an exchange of existing shares. Some of the risks are summarised below:
- Lack of understanding of the transaction.
- Percentage shareholding versus number of shares.
- Risk of dilution.
- Purchase price and payment terms.
- Pricing risk.
- Timing of transfer.
- Breach and consequence of breach.
- Currency or inflation risk.
- Death of a party pending full payment or transfer of shares.
- Dispute resolution.
- Board representation.
- Fight for control.
Some of the risks and possible mitigation are explained below.
Lack of understanding of the transaction
Legal practitioners and financial advisors should explain to their clients the nature of the transaction so that there is clear understanding of the transaction and a meeting of the minds. I have had to deal with situations where mere directors think they are shareholders or where investors confuse equity with joint venture or partnership. My view is that it is easy to build an explanation by starting from the well understood agreement of sale for an immovable property. A legal practitioner can then explain the differences and the peculiarities of an agreement for shares.
A preamble to such an agreement goes a long way in giving background and context to the transaction. I find well documented preambles to be useful to clients.
Percentage shareholding versus number of shares
Investors normally target certain percentage shareholding thresholds to have control (at least 51%), be able to pass special resolutions (at least 75%), have significant influence over company decisions (e.g. 40%) through the board of directors or shareholders’ general meetings. However, when shareholding is bought it is through number of shares which then translate to certain percentage (%) shareholding when expressed as a percentage of total issued shares for that class of shares. My advice therefore is that investors should target the number of shares that give them the desired percentage shareholding.
Risk of dilution
Safeguards should be put in place to protect the new investor from having his or her percentage shareholding diluted immediately after acquisition of the shares or some time thereafter. Dilution can be done through for example a rights issue where an existing shareholder is unable or unwilling to follow his or her proportionate rights to the new shares being issued. Creditors or shareholders who are creditors to the company may also want to convert their debt into equity thereby increasing their percentage shareholding to the detriment of the new investor.
Purchase price and payment terms
Like in most agreements it is important to safeguard the parties on the purchase price and payment terms. This includes the agreed amounts, timing of payments and taxes.
Pricing risk
To avoid under or overpricing it is advisable to use professional valuers such as professional accountants to value the shares of a business. This will allow the parties to negotiate fair purchase prices. This is particularly so due to the subject nature of business valuations and the many different ways businesses can be valued.
Timing of transfer of shares
Many times I have had to advise on safeguards on share transfer when payment is through terms. A purchaser would want to receive transfer through share certificates as soon as possible yet a seller prefers to pass transfer only after payment of full purchase price. Other parties may agree on staggered vesting of transfer rights in line with payments made by the purchaser.
Things can be complicated when disputes arise after transfer or one of the parties dies before transfer of the shares.
Breach and consequence of breach
Like in other contracts the agreement should specify what is breach, how to rectify it and consequence of lack of rectification.
Currency or inflation risk
Staggered payments normally expose a seller to currency risk or inflation. It is necessary to include provisions that cushion the seller from loss of value.
Death of a party before conclusion of transaction
Things can be complicated if one or both parties die before payment of full purchase price or transfer of the shares. These situations should be provided for.
Dispute resolution
Disputes are common in business. Efficient and effective dispute resolution mechanisms should be provided for.
Fight for control
New investors usually want certain changes to protect their investment yet existing shareholders who still own shares may prefer the status quo. It is advisable to include provisions on the governance of the company on issues such as board representation and others. It may not be advisable to retain directors appointed by the seller.
Conclusion
Provisions should cover the mitigation of key risks in mergers and acquisitions.
Disclaimer
This simplified article is for general information purposes only and does not constitute the writer’s professional advice.
Godknows (GK) Hofisi, LLB(UNISA), B.Acc(UZ), CA(Z), MBA(EBS,UK) is a legal practitioner / conveyancer, chartered accountant, corporate rescue practitioner, registered tax accountant and consultant in deal structuring and is an experienced director of companies. He writes in his personal capacity. He can be contacted on +263 772 246 900 or gohofisi@gmail.com
