Mergers and acquisitions basics: how an M&A deal works from heads of terms to completion

How do M&A deals actually work? The best way to explain the basics of mergers and acquisitions is to walk through the timeline of a deal from start to finish: heads of terms, due diligence, the sale and purchase agreement, completion and the post-completion steps, including the stamp duty that a lot of buyers forget to budget for. Below is that timeline, with the points that matter most at each stage.

Heads of terms (day 0)

The deal starts with heads of terms. In short, heads of terms are a summary of the deal. They set out what the parties have agreed, and that summary is later translated into a much longer sale and purchase agreement, whether that is a share purchase agreement or an asset purchase agreement.

A few key things are settled at this stage: what the purchase price is, and whether that price is locked or is based on completion accounts, along with whether the deal is a share or asset purchase and any exclusivity for the buyer. Typically the heads of terms will also state that the buyer will be conducting due diligence on the target business, which brings us to the next stage.

Although heads of terms are short, they govern the progress of the whole deal. What is agreed here tends to set the shape of everything that follows, so it pays to get them right rather than treating them as a formality.

Due diligence and the virtual data room

The buyer, or the buyer's solicitors, creates a list of questions to be sent to the seller's solicitors. The sellers then compile the documentation that evidences the answers to those questions and upload it to what is called a virtual data room. The seller uploads information, the buyer accesses it, and the buyer conducts due diligence on the target business from there.

The term "data room" comes from how acquisitions used to be done. Buyers would physically attend the premises of the target business, and the sellers would set up a room on site where the buyer's advisers would spend the day looking at documents from morning until evening, go home, and come back the next morning to do the same. The virtual version replaces the room with a secure online folder structure.

Once the buyer's advisers have reviewed the documents, they will usually have follow-up questions. Those go back to the seller, who responds by disclosing further documents or making clarifications. It is an iterative process rather than a single exchange, and the quality of the original questions largely determines how many rounds it takes.

Red flag report versus full due diligence report

When the review is done, the buyer's advisers, typically the solicitors and the accountants, prepare a due diligence report for the buyer to digest. Reports come in two main forms:

• A red flag report. The advisers report only on the red flags or issues they have identified with the target business.
• A full report. The advisers report on everything, summarising the whole target business for the buyer.

What I like to do when I deliver a legal due diligence report is to identify the legal issues and then also quote for the remedial work that would be required to put them right. That quote is then used by the buyer to negotiate a price reduction with the sellers if they want one. If a reduction is achieved, the buyer is getting a better business for the same money. If it is not, the buyer is not compelled to carry out the remedial work, and certainly not before they have even bought the business.

Caveat emptor: buyer beware

Why spend so much time on due diligence? Because when it comes to buying a business, the concept of caveat emptor applies: let the buyer beware. In simple terms, it is the buyer's obligation to satisfy themselves as to the state of the business and to make sure they are happy with it.

It is not like a consumer product you order online and can send back within a 14-day cooling-off period. If you bought it, you had better be happy with it. That is what makes due diligence so important: it is how you make an informed decision, and the right one, before there is no going back.

SPA warranties and indemnities

Once due diligence is complete, the buyer's solicitors draft the SPA, the sale and purchase agreement, together with the ancillary documents. It is the buyer's solicitors who draft these, and they are then negotiated with the seller's solicitors.

As a buyer you want to include as many warranties and indemnities in the SPA as possible. Warranties are promises the sellers make about the state of the business. For example, you might want a warranty stating that the target business has always paid its corporation tax and does not owe any tax to HMRC. Indemnities go a step further: rather than a promise that something is true, they are an obligation on the sellers to reimburse you if a specified problem arises.

Breach of warranty and the right of set-off

If a warranty turns out to be untrue, the buyer can sue the sellers for breach of warranty. There are then two ways to recover the money:

• Set-off against deferred consideration. If part of the purchase price is still outstanding, the buyer can set the claim off against the deferred payment rather than paying it in full and claiming separately.
• A claim against the sellers. If the entire price has already been paid, the buyer will need to claim against the sellers and get them to pay.

An important point: the right of set-off is not an automatic right. You should include it expressly in your SPA, and ideally it should be in the heads of terms as well, because if it is not in the heads of terms it typically will not make it into the SPA either.

Completion and post-completion steps

Once the buyer and seller have agreed the form of the SPA and the ancillary documents, the deal is ready to proceed to completion. Exchange and completion, in short, are where the contracts are signed and the money is transferred from the buyer to the seller. This is the point at which ownership actually changes hands and everything agreed in the heads of terms and the SPA takes effect.

Then come the post-completion procedural matters. These are especially relevant to share purchases. For example, you will want to issue new share certificates, update the statutory registers, and update the Companies House profile of the target company to reflect the new directors and the new people with significant control. These steps are administrative, but skipping them leaves the public record showing the old ownership, which causes problems later.

Stamp duty on share purchases

A lot of people forget about stamp duty and do not budget for it when looking to buy a business. Stamp duty is payable on the purchase of shares where the purchase price is above £1,000. At the time of recording, it is payable at 0.5% of the purchase price. It is not a large percentage, but on a sizeable acquisition it is a real sum, and it needs to be in the budget from the outset.

Next steps

If you are approaching your first acquisition, use this timeline as the map: get the heads of terms right, run proper due diligence before you are committed, make sure the SPA carries the warranties, indemnities and set-off rights you need, and budget for stamp duty and the post-completion filings. For how to draft heads of terms so they work in your favour, see Heads of terms when buying a business, and speak to a corporate solicitor before the heads of terms are signed.