Acquisition: An Opportunity to Acquire Budding Businesses
The first wave of the COVID-19 pandemic had caused severe economic dislocations in the country entailing a major slowdown in the Indian economy. Amidst the slowdown, while small companies were still trying to recover from the destruction caused by the first wave, the advent of an unprecedented second wave has made them increasingly vulnerable to corporate dissolution. Over here we shall be discussing in detail “Acquisitions” and how the same can assist to preserve their business operations in the aftermath of the second wave of COVID-19. An acquisition is the purchase of controlling interest by an acquirer in the share capital, assets, and/or liabilities of the target company. Such acquisitions are usually initiated by well-capitalized large organizations to absorb the small ones. Acquisitions that are structured and negotiated well have various benefits for the target and acquiring companies attached to them.
The Importance of Acquisitions
On the surface, an acquisition might look beneficial in terms of improving the long-term growth and profits only of the acquirer. However, a carefully structured and negotiated deal can have unending advantages for the target company, too. For example, in the aftermath of the first and second wave of COVID-19, where companies have become vulnerable to corporate dissolution, are suffering from shortage of funds, or are under the pressure of banks, getting acquired is the best option available to them. This option gives the sellers an opportunity to get themselves out of debt, protect the interest of their customers, employees, and also get some money from the deal. However, businesses fail where they wait ‘until it’s too late’ and everyone faces the brunt of it.
In contrast, even an asset purchase, where the assets and liabilities are cherry picked by the acquirer, helps the sellers in saving their business. Furthermore, after an acquisition, owners of small businesses no longer have to sign personal guarantees or pledge personal assets on a daily basis to borrow capital from financial institutions. Sellers are thus absolved from this kind of daily pressure and can focus their attention on growing their existing business or pursuing other interests. Additionally, they can also experience buying synergies in various forms like, expanding offerings to the existing consumers, enhanced benefits for employees including geographical relocation, access to various resources held by the acquirer, et cetera.
How Acquisitions Work in India
So, what exactly happens to the assets, liabilities, employees, shares, et cetera, in the case of an acquisition? Before answering those questions, it is important to understand that in M&A transactions, the mode of acquisition is equally important to the company that is being acquired because the disadvantages caused by the choice of a wrong structure can outweigh the advantages of the entire transaction. While acquiring a company, the acquirer has various acquisition structures to choose from. They may either choose to acquire the entire company that conducts a business by purchasing its shares or acquire only the business of the company through an asset purchase, where the acquirer gets to cherry pick the assets and liabilities of a company. The acquirer also has an option to carry out the acquisition through a slump sale where the whole business of the target gets transferred to the acquiring company.
Types of Acquisition Structures
By virtue of having a legal personality, a company is separate from its owners and thus capable of owning rights, assets, liabilities, business, et cetera, in its name. As shares represent the complete underlying value of assets and liabilities of the company, share acquisition is a common manner of acquiring a company, where the buyer acquires the shares of a company from its shareholders. Thus, although only shares change hands, everything owned by the company including its business, rights, and liabilities is transferred. A share purchase is brought into effect through a share purchase agreement.
Business Transfer (Slump Sale)
According to section 2(42C) of the Income Tax Act, 1961, in a slump sale, one or multiple business undertakings are transferred as a whole on a ‘going concern’ basis for a lump-sum consideration. Slump sales are brought into effect through a business transfer agreement which helps the parties execute a business transfer. It can be drafted in the form of an agreement to sell or a deed of conveyance. Largely, the business transfer agreements are subject to negotiations and eventually executed within two months from the day of conceiving the slump sale.
In an asset purchase, the business of the target company is acquired by cherry-picking specified assets, rights, and liabilities that form the business of the target company. Simply put, it is an itemized sale of assets of an undertaking in a bit-by-bit manner. Thus, the acquirer gets to precisely negotiate the assets and liabilities which will be transferred, and the rest continue to remain with the target company. Asset purchases, too, are brought into effect by a business transfer agreement.
Effect of the Acquisition on:
Before reading about the effects on each of the categories, it is important to understand that these would vary significantly based on the structure and terms and conditions of the acquisition.
- Assets and Liabilities: In case of an asset purchase, the acquirer gets to pick and choose the assets and liabilities that they would like to acquire while the remaining assets and liabilities are retained by the target company. However, in the case of a slump sale, the contracts, licenses, registration, permits, et cetera are transferred to the acquirer. A major factor to consider is whether these assets are assignable in nature? If yes, they can merely be assigned to the acquirer by a new instrument. If not, the existing contracts, licenses, registrations should be terminated, and acquirer will have to enter into new contracts with the third party.
- Employees: In case of an asset purchase, there is no significant effect on employment. However, in the case of a business transfer or share purchase where either the business of the company or the company itself is acquired, the employment structure undergoes massive changes. Where the intent of the acquisition is to acquire the talent and experience of the employees, it is possible that none of the employees would be laid off and would continue their employment with the acquiring organization. In this case, the employees will have to comply with policies of the acquirer and applicable laws. However, in cases of overlap of departments, the acquirer would want to terminate the employment of redundant employees in compliance with the applicable laws.
- Shares: The share prices of a company become highly volatile during and after an acquisition. Usually, in the short term, the share prices of a target company increase as the acquiring company pays a premium price i.e., higher than the market price, for the acquisition. This provides an incentive for the target to sell their company. Conversely, in the short term, the share price of the acquiring company falls because in order to finance the acquisition they turn to their free reserves, incur debt, et cetera. However, in the long run, the share price of the acquiring company experience an upward movement provided the management values the target and integrates it into the acquiring company properly.
- Organization: In the case of an asset purchase, the organization continues to function as it did but with the remaining assets and liabilities. However, in case of a business transfer or share purchase, the acquirer decides the fate of the target company. This has to be negotiated before structuring the acquisition so as to get optimal results. In some cases, the acquirer takes over the management of the target company and transforms it completely while in other cases the acquirer allows the target company to work under the main organization without interrupting its business operations.
Steps in Acquisition
Searching for a Potential Target
The primary goal of any business activity is to increase efficiency and maximize its profit. Where the acquiring company believes that acquisition of another company’s business, assets, or the company itself is necessary, the acquirer would have to foremost look for a potential target company. This can be done by identifying the growing sectors, framing a list of targets functioning in that sector, and locating a target company that aligns with the acquirer’s aims and objectives.
Preliminary Due Diligence
The management of the acquiring company then consults with the management of the target entity to discuss the acquisition. At this stage, preliminary due diligence is conducted to uncover the red flags and ensure whether the target entity meets the criteria for acquisition. If it does not, the transaction is either canceled or executed with requisite amendments.
Letter of Intent
After the preliminary due diligence, the legality of business transfer is consummated. The objective of having a letter of intent is to ensure that the parties involved are on the same page and there is a meeting of minds on the consideration and other material terms of the transaction. It is important to conduct this step before the others as it ensures that the parties are in agreement before spending significant resources and legal fees in pursuance of the transaction. The advocates of the acquirer draft the letter of intent which is then submitted to the seller. While the letter of intent lays down the basics of the deal, it is subject to amendments post extensive due diligence. This letter can also contain an exclusivity agreement that prohibits parties from entering into competitive bids for a particular period of time.
This agreement is drafted to protect the interest of the target company and safeguard the information so provided to the acquiring company during the due diligence process.
Extensive Due Diligence
The extensive due diligence involves a full assessment of the potential risks related to every branch of the target company. It analyzes the financials and business operations of the company extensively. Furthermore, it also looks into the insurance, material contracts, corporate status, intellectual property, employment, litigation, financing, tax, and regulatory concerns that a target company might face.
Share Purchase Agreement /Business Transfer Agreement
After the due diligence is conducted, based on the acquisition structure, the parties draft the share purchase agreement or the asset purchase agreement to finalize the deal. In the case of a listed company, the SEBI Substantial Acquisition of Shares and Takeover Regulations, 1997, (Takeover Code) would apply.
The final actions, as contemplated by the agreement are subsequently implemented during the closing where agreements and exhibits are finalized, complied with, and signed. In the case of share transfer, SH-4 forms are executed while in the case of an asset transfer, particular documents like conveyance deed for sale of land, assignment agreement for IP transfer and so on are required.
Precautions to be Taken before meaking Acquisition
While the acquiring company performs an extensive due diligence on the target company as a precautionary measure, there are a certain measure that should be undertaken by the target company, too, before it can get acquired. These include outsourcing valuations to make sure that they do not settle for a lucrative offer and actually get paid for their objective worth. Additionally, getting competing offers can also help the seller get the best deal. Furthermore, having a team of professionals especially advisors, is extremely important to make sure that the acquisition does not go sideways, and the expectations of the target company are met with. Moreover, it is important to understand the offer completely than selling for a lucrative price. Hence, make sure that every detail is understood, and no key-terms are overlooked.
Legal Compliances in Acquisition
Legal Compliances under the Companies Act, 2013
While proceeding with an acquisition, the transferor company should ensure that transferring a business undertaking is authorized by its MOA whereas, the transferee company should ensure that its object clause authorizes the company to carry the business acquired. If not, the MOA should be amended. Additionally, public companies are mandated to pass a special in a general meeting according to section 180(1) (a) of the Companies Act, 2013. However, private companies have been exempted from this requirement vide Notification No. F. No. 1/1/2014-CL V dated June 5, 2015.
Legal Compliances under the Competition Act, 2002
An acquisition of one or more enterprises, where certain prescribed assets or turnover thresholds are crossed, will need to comply with the merger control provisions contained in Sections 5 and 6 of the Competition Act, 2002 and the Competition Commission of India (Procedure for transaction of business relating to combinations) Regulations, 2011, which sets out the mechanism for implementation of the merger control provisions under the Act. If the acquisition classifies as a combination according to the Competition Act, 2002, then it would require the prior consent of the Competition Commission of India, failing which, the companies could be held liable for gun-jumping. After the combination is notified, the Commission examines whether it would cause an appreciable adverse effect on competition.
To determine whether the acquisition is a combination, it has to go through the preliminary assessment test. In the parties test if the combined total assets are valued more than Rs. 2000 crores and the total turnover, more than Rs. 8000 crores of the target and the acquiring company, then the jurisdictional threshold is breached, and the combination will have to be notified. Additionally, according to the group test where total assets are more than Rs. 8000 crores and a total turnover of more than Rs. 24000 crores of the group companies, the financial threshold is breached. If the companies breach these thresholds their transaction would be qualified as a combination and prior approval of the Competition Commission of India would be mandatory. An exemption is granted to small companies through the target exemption test. Where the total assets of the target company are lesser than Rs. 350 crores and total turnover are lesser than Rs. 1000 crores, this exemption can be availed. This exemption has been granted by the Competition Commission of India to facilitate M&A activities for small companies. Additionally, an exemption is also granted for investment-only transactions and transactions done under the ‘ordinary course of business’ under Schedule 1 of the combination regulations as such transactions do not have appreciable adverse effects on competition.
Legal Compliances under the Goods and Services Tax Act, 2017
The Goods and Services Tax does not apply to a slump sale where the entire business undertaking is transferred as a whole. This is because the tax is only applicable to goods and services and a business undertaking does not classify as a good. Slump sales have been further exempted from the applicability of the tax vide Notification No. 12/2017. Furthermore, the Goods and Services Tax does not apply to share transfer as securities because securities are excluded from the definition of goods and services. However, the tax is levied on different aspects of an asset sale like movable assets which make it an expensive option in comparison to the others.
Legal Compliances under the Income Tax Act, 1961
According to section 50B of the Income Tax Act, 1961, a slump sale is taxable as a capital gain. Where the undertaking is held and owned by the transferor for 36 months or less it would be classified as a short-term capital asset, whereas if it is held and owned for more than 36 months, it will be classified as a long-term capital gain and will be taxed at 20%. However, in an asset sale, the acquirer only purchases certain assets which do not amount to the transfer of a business undertaking on a going concern basis. Ergo, a specific value is attributed to each item based on the period that each asset was held for by the seller.
Legal Compliances under the Indian Stamp Act, 1889
The amount of stamp duty to be levied on transactions differs throughout States. Furthermore, whether the slump sale is carried out through a conveyance deed or agreement to sell also matters while computing the cost of stamp duty. In the case of a business transfer agreement, clients are generally advised to opt for an agreement to sell instead of a conveyance deed because the stamp duty is considerably lesser for an agreement compared to a conveyance deed. In the case of a share transfer, unlisted securities in dematerialized or physical form are subject to a stamp duty of 0.015% of the purchase consideration, whereas, for listed securities, it varies from 0.015% – 0.003%.
The second wave of COVID-19 has extensively affected small businesses and left them increasingly vulnerable to corporate dissolution. This article proposed acquisition as a recourse to this problem. While explaining how acquisitions work in India, various acquisition structures like share transfer, slump sale, and asset purchase have been discussed in the article along with the effect of the acquisition on various categories. Furthermore, the article has also looked into the steps to be followed, precautions to be taken and the regulatory compliances that the companies would have to adhere to. Getting acquired is a wonderful strategy for small companies to save their businesses post the second wave of COVID-19. In order to make sure that they benefit from the transaction, the companies will have to carefully negotiate and structure the deal as all the acquisition structures have their own particular merits and demerits. However, the final decision to opt for a specific structure would rest with the companies and would vary tremendously based on their needs, aims, and objectives.
Authored By: Adv. Anant Sharma & Priya Gala