A divisional acquisition involves the purchase of a business unit of a larger parent seller entity, where the seller will continue to operate other lines of business following the closing of the divisional divestiture. While the acquisition of a divisional enterprise will have many features in common with the acquisition of an entire enterprise, the assets and liabilities associated with the divisional enterprise — especially one that is not a separate legal entity — may be less well defined than in the case of an entire business. Moreover, the operations of the division typically are closely entwined with those of the parent, a situation that creates numerous legal issues for parties to the transaction (and their advisors) that do not normally arise in the acquisition of a stand-alone enterprise. This article discusses some of the more important of these issues.
Form of Acquisition
The divisional enterprise may or may not be organized as a separate legal entity that is a subsidiary of the parent. In the case of a target divisional enterprise that is a separate legal entity (e.g., a subsidiary corporation or limited liability company), the acquisition may take the form of a merger, stock purchase or asset purchase. When, however, the target division is not separately organized, the acquisition must be accomplished via an asset purchase.
Preparing for the Divisional Disposition
As described below, a key aspect of documenting a divisional acquisition involves precisely defining the assets and liabilities to be included in the transaction. In the first instance, it is incumbent upon the seller and its counsel to make these determinations, and to provide guidance to the purchaser and its counsel who necessarily will start with less knowledge of the underlying facts. Sellers therefore should position themselves to educate would-be buyers as to the details of the divisional assets and liabilities proposed to be included in the divestiture as early in the sale process as possible. One way of accomplishing this is through careful preparation of the initial drafts of the term sheet (if one is employed) and of the proposed purchase agreement. Especially in the context of a divisional disposition, sellers should facilitate the due diligence process by preparing detailed disclosure schedules early in the purchase agreement negotiation process.
Divisional enterprises often do not maintain separate financial statements, and to the extent they do the financial statements may not be audited. Depending on the nature of the assets to be sold, the absence of audited financial statements may negatively impact their value and have a chilling effect on the sale process generally. Buyers are less likely to aggressively value a business when there are questions as to its financial performance as represented by the seller. The absence of reliable financials may also negatively impact a purchaser’s ability to use debt to finance its purchase. In addition, if the purchaser is a public company, then depending upon the size of the purchaser relative to the target, the purchaser may be required to file audited financial statements for the divisional enterprise with the Securities and Exchange Commission. Consequently, sellers lacking audited financial statements for a divisional enterprise proposed to be sold should consider preparing them in advance of commencing the sale process.
Special Due Diligence Considerations
Purchasers should carefully evaluate the consequences that separating the divisional enterprise from its seller will have upon the division’s business going forward and its related value. Any intracompany transactions that are not conducted on market terms may affect valuation. For instance, purchasers should investigate whether the seller has provided necessary services to the division, and if so whether the associated costs have been properly recorded and charged at market rates. Likewise, purchasers should determine whether the division may benefit from certain economies in procuring goods or services by virtue of its ownership by a much larger enterprise that may no longer be available to it as a stand-alone entity.
Defining the Acquired Assets
In an acquisition of a stand-alone enterprise, the purchaser either acquires the target and with it all of its assets (in the case of a merger or stock purchase), or acquires all of the target’s assets (in the case of an asset purchase). Although the purchaser must take care to ensure that the closing of the sale transaction will not result in the termination of the target’s contractual rights or governmental permits, or otherwise negatively impact the target assets, defining the assets to be included in the sale transaction generally does not present difficult issues.
In contrast, defining clearly what assets are to be acquired is a key aspect of structuring a divisional acquisition that is of significant concern to both the purchaser and seller. If the transaction is structured as an asset purchase, all of the assets necessary for the operation of the target’s business must be specifically identified and conveyed. Even when the divisional enterprise is separately organized, and the transaction is structured as a merger or stock purchase, the seller must determine whether the target entity owns assets that should be retained by the seller, and if so convey them separately to the seller or an appropriate affiliate prior to or at the closing. In any event, the purchaser must be sure that it obtains all assets required to operate the acquired business, and the seller must ensure that it does not inadvertently convey any assets that are essential to its continuing operations. This is a process that can involve substantial effort, and it is prudent for the seller to facilitate it by identifying the relevant assets as specifically as possible during the due diligence phase.
Defining the Assumed Liabilities
Defining the liabilities that are to be retained (in a merger or stock purchase) or assumed (in an asset purchase) by the divisional enterprise following the closing presents issues similar to those relating to defining the assets that are to be retained by or conveyed to it as described above. The issue of which liabilities are to be retained and which are to be conveyed is likely to be heavily negotiated, and care must be taken to ensure that the asset purchase agreement clearly reflects the parties’ business understanding. As in the case of defining the assets to be conveyed, the seller should make every effort to identify the liabilities to be assumed early in the sale process.
Regarding the treatment of contracts relating to the divisional enterprise, the purchaser may seek to have the purchase agreement list all of the contracts to be assumed, and the seller may wish to define them more generically. A related issue is that frequently the seller or an affiliate will have provided guarantees or other credit support, or entered into other contractual arrangements, for the benefit of the target division. For example, the seller may have guaranteed a credit facility provided to the target by a third party lender, or entered directly into a lease of facilities or equipment used by the target. Ideally, at closing the purchaser will substitute other arrangements that are satisfactory to the seller, but in some cases this may not be feasible. For instance, if following closing the credit of the purchaser or the target company will be weaker than that of the seller, the other party to the contractual arrangements may be unwilling to accept substitute arrangements proposed by the purchaser. In that case, it may be necessary for the seller and purchaser to negotiate arrangements whereby the seller will continue to provide the arrangements on an interim basis.
Contingent liabilities relating to the divisional enterprise can often present difficult issues. For example, if the division is a defendant in a potentially significant lawsuit, it may materially effect its valuation. One approach is for the seller to retain the related liabilities, control the litigation and indemnify the purchaser. Alternatively, the parties may wish to negotiate purchase price adjustments to come into play upon the final resolution of the litigation.
Purchase Price Adjustment
In the typical acquisition agreement, the purchase price is adjusted post-closing based on the change in the target’s net working capital between the date the agreement is signed and the closing date. This procedure may be complicated by the lack of adequate financial information relating to the divisional target. One approach to the problem is to conduct a post-closing audit of the closing date balance sheet of the target, and to make the net working capital adjustment by reference to the audited balance sheet.
Shared Internal Resources; Transition Services
Divisional enterprises often share certain business resources with their parents. These may include physical resources such as office space, computers and the like, as well as personnel resources such as accounting, legal, human resources, research and development and so forth. In all such cases, the parties must reach agreement as to which one will own the assets, or continue to employ the personnel, following the closing. Then, they must make appropriate arrangements whereby the other party will have appropriate access to the shared resources following closing. For example, in the case of intangible assets such as intellectual property, the party that is to own the asset after the closing will grant the other party a license to use it on some basis. Where the shared resources in question are physical assets or employees — such as real estate or equipment, or accounting or legal personnel — the problem may be addressed via a transition services agreement, whereby the parties agree how the party that is to own or employ the previously common resources following the closing will make them available to the other party on a shared basis for a period following the closing that is sufficiently long to permit that party to make alternative arrangements.
Shared Services Provided by Third Parties
Divisional enterprises often share services provided by third parties under contracts entered into by their parent entities. Examples include the following:
- Property casualty insurance
- Employee medical insurance
- Other employee benefit arrangements
In such cases, during the pre-closing period, the acquirer must put in place substitute arrangements to cover the target company from and after closing. In the case of complex enterprises, this can be a relatively long lead item and purchasers should plan accordingly.