1. INTRODUCTION
As opposed to acquiring 100% (one hundred percent) of the share capital of a company incorporated in India upfront or with an element of deferred consideration, acquiring a company by way of a staggered/ tranched acquisition also remains a popular method of structuring merger and acquisition ("M&A") transactions in the Indian legal landscape.
Simply put, a staggered acquisition is one where a strategic investor acquires a majority stake upfront, leaving (in most instances) the promoters with a minority stake and obligations to run the operations of the company until the acquisition of the entire share capital of the company. As an incentive to continuing their engagement with the company and partnering with the strategic investor, the consideration payable for these staggered acquisitions is typically linked to the performance of the company during the interim period.
A staggered acquisition ensures that the strategic investor has sufficient time to understand the business operations and relationships before finally taking over the day-to-day control over the affairs of the company. For the promoters and any remaining investors, a staggered acquisition ensures access to working capital, processes and network of the strategic investor, thereby enhancing the scale of operations in a streamlined manner culminating in growth for all stakeholders.
While finalising this structuring option, there are a number of factors which require to be navigated in a nimble manner, including considerations during the interim period and the intent and objective of the respective parties involved. As such, the negotiations and discussions involved in the drafting and finalising of the definitive documents become an intricate task. This article sets out certain key aspects that come up and need to be considered during structuring a staggered acquisition of an unlisted company incorporated in India.
2. CONSIDERATIONS
2.1 Power Sharing
Balancing 'control' of the company between the acquirer and the (promoter) sellers in a staggered acquisition is a complex process since it involves the rights of a majority shareholder vis-à-vis the rights and obligations of a minority shareholder in running the day-to-day operations of the company. In this context, it becomes relevant to note that the Indian Accounting Standards ("IndAS") only permits an acquirer to consolidate its financial statements with the target company upon the acquirer establishing necessary 'control' over the target company, as required under IndAS (which includes retaining the ability to take decisions on certain relevant activities significantly impacting the returns of the acquirer)1 . Whereas, from the sellers' perspective, control over the operations of the company becomes an important aspect since the consideration for the next tranche of shareholding is linked to the performance of the company.
Accordingly, in addition to agreeing to a list of affirmative vote matters, having in place a well thought through business plan and an authorisation matrix, clearly defining the rights and obligations along with the scope of authority of the respective parties, in an agreed form upfront is a useful means to balance the interest of the parties.
Additionally, while in most staggered acquisitions, it is observed that the remaining shareholders are promoters or the key management personnel of the company, in some instances institutional investors retain a portion of their shareholding. Managing the rights and protection desired by such existing institutional investors subsequent to the majority acquisition, is also, therefore, another aspect that needs to be considered and addressed along with balancing control between the acquirer and the promoter sellers. For settling this aspect, the parties are often required to provide the institutional investors with a lean list of affirmative vote matters linked to protecting the value of their investment, along with information rights and/ or a right to appoint a non-voting observer at the board level.
2.2 A Firm Handshake
The initial and ultimate goal of a staggered acquisition, for all parties, is to complete the acquisition in pre-agreed tranches. The acquirer and sellers are therefore required to pre-agree the circumstances under which the closing of a particular tranche may get impacted. Typically, the grounds for termination prior to the completion of the first tranche are easier to navigate since the change in control is yet to occur. These grounds include termination for breach of covenants and representations and warranties, failure to complete identified conditions prior to the agreed long stop date and occurrence of matters having a material adverse effect or significantly impacting the reputation of the company or the sellers. Matters having 'material adverse effects' are linked to events in relation to: (i) being unable to consummate the transaction on account of applicable law; or (ii) having a material adverse effect on the company (including the financial or operational condition of the company).
However, once the change in control has occurred and the acquirer obtains the majority shareholding, the sellers desire certainty on the nature of events which could lead to the acquirer walking away from completing the next tranche of the staggered acquisition. Simultaneously, it is also crucial for the acquirer to ensure that the sellers do not have the ability to forge a faux circumstance forcing the acquirer to walk away without completing the entire acquisition. Accordingly, an understanding needs to be reached between the acquirer and the sellers regarding the certainty of the transaction after the first tranche of acquisition is complete. As opposed to completion of the first tranche of the acquisition, the acquirer is typically required to bear the burden of the financial risk associated with doing business post acquiring the majority shareholding and control. Additionally, the consideration for the remaining shareholding is closely linked with the performance of the company during the interim period.
As such, the parties are required to consider limiting the termination events to instances where the transaction becomes impossible to consummate on account of a change in the applicable laws (in contrast to the wider definition of material adverse effect which takes into account the financial and operational performance of the company), fraud, breach of fundamental warranties/ covenants and non-completion of identified conditions precedent relating to the title and ownership of the shares. It is also crucial to ensure that no defaulting party has the right to terminate the definitive documents at any stage. Even in such instances, the parties may devise options under the definitive documents to agree to an alternative structure to consummate the transaction or agree to cause a strategic sale to protect their investment.
2.3 Warranties and Indemnities
The definitive documents for share acquisition transactions, more often than not, contain detailed 'business' representations and warranties (in addition to fundamental warranties) running into several pages, being provided by the sellers to the acquirers. These representations relate to the business operations of the target company and its compliance with laws, and are provided to protect the acquirer from any past liability. The sellers (the promoter sellers) are comfortable in providing the long list of business warranties at the signing stage and at the stage of completion of the first tranche since they appreciate that they were responsible for carrying out the day-to-day operations of the company and had the power and authority to take necessary decisions in this regard.
However, post the completion of the first tranche, while the sellers retain the control over the day-to-day operations of the company based on a pre-agreed mechanism, they (in most instances) hold minority shareholding and lesser representation in the board of directors post the completion of the first tranche. This change in control impacts their ability to take conclusive and independent decisions regarding the business operations of the company. Accordingly, and since the acquirer exercises control over the direction (while the promoter sellers remain in the driving seat) of the business operations, the parties can consider identifying and restricting the business warranties to matters where the sellers would practically be exercising sufficient control.
Furthermore, the monetary limitations of liability with respect to indemnification events are negotiated and linked/ capped to a certain percentage of the entire purchase consideration being provided to the sellers, but these need to be commercially discussed where the entire purchase consideration is not remitted at the closing of the first tranche.
2.4 Thinking through the Consideration
Among other reasons, acquirers and sellers adopt to structure a transaction as a staggered acquisition, to accommodate for the promoter sellers ability to receive the desired consideration linked to the future projections (for their remaining shareholding), and the acquirer's concern in allocating a valuation based on future projections.
While staggered acquisitions (where the tranched purchase consideration is linked to a portion of the shareholding being transferred at the relevant time) do not have to deal with some of the issues in a transaction involving payment of deferred consideration (where all the shareholding is transferred upfront), namely: (a) payment being required to be made within 18 (eighteen) months from signing; (b) not more than 25% (twenty five percent) of the consideration being eligible for being deferred; and (c) the sellers being liable to pay tax for the entire consideration without much certainty on the extent of the actual deferred consideration which may be paid to them, subject to pricing guidelines; however, the determination of consideration in case of a staggered acquisition, needs to be carefully examined, including from the perspective of applicability of the foreign exchange regulations in case where foreign residents ("NRs") / foreign owned or controlled entities incorporated in India ("FOCCs") are involved.
The Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the "NDI Rules"), require that any transfer of securities from a resident Indian to an NR should be at a price which is at or above the fair market value of the securities. In case the resident Indian is purchasing the securities from an NR and FOCC, the consideration for the shares should be at a price which is at or below the fair market value of securities.2 Accordingly, the formula or criteria agreed between the parties for deriving the tranched consideration should be in compliance with the pricing guidelines set out in the NDI Rules, especially in the event of occurrence of any default by the sellers (where typically parties agree to a discounted consideration).
2.5 Protecting the Shares
M&A deals in India commonly require the consideration to be deposited in an escrow account with a third party, to depict the commitment of the acquirer to successfully close the transaction. In staggered acquisitions, another crucial aspect for closure of the tranched leg of the transaction becomes the ability of the (remaining) sellers to transfer the title and ownership of the (remaining) shareholding to the acquirer free and clear of any encumbrances. For protection of the acquirer from a legal perspective, the definitive documents should be drafted to ensure that the acquirer can specifically enforce its contractual rights of purchasing the remaining shareholding, be entitled to indemnification remedies for any loss suffered by it and deem any transfers in contravention of the documents and the articles of association of the company void ab initio.
To further mitigate the risk of the acquirer, a share escrow arrangement may also be discussed between the parties. Share escrow arrangements for a comparatively longer term (as typically seen with staggered acquisitions), of companies having shares in physical form are much easier to achieve and implement in contrast to escrow of dematerialized shares. However, with the recent amendment to the Companies (Prospectus and Allotment of Securities) Rules, 2014, a private company3 is also required to dematerialise its shares on or before September 30, 2024 and therefore, it is likely that nuanced negotiations in relation to structuring the escrow arrangements for dematerialized shares will also have to be undertaken in any new M&A deal where a share escrow arrangement is contemplated.
With the assistance of the escrow agent, parties are required to select the appropriate model suited for the transaction to implement the escrow for dematerialized shares, whether inter alia in the form of transferring the beneficial ownership of the shares to the escrow agent upfront on day one, or through submission of the depository instruction slips and granting of a power of attorney to the escrow agent (and retaining the beneficial ownership of the shares with the sellers till the tranched closing date(s)). The escrow documents should take into account the understanding regarding the transfer of shares as envisaged under the other transaction documents, setting out clearly the roles and responsibilities of the escrow agent in such instances. The escrow agreement should act as the bible for the escrow agent to limit future disputes in relation to the treatment/ transfer of shares.
3. CONCLUDING REMARKS
In addition to the considerations set out above, commercial teams should ensure a post-acquisition integration between the acquirer and the target company to be able to favourably achieve the result of a staggered acquisition. As an alternative to navigating around the issues of staggering the acquisition, structures such as deferring a portion of the consideration and linking it to the performance of the target company can be discussed. Further, an earn-out structure where the sellers' payout is linked to their employment / engagement with the target company can be considered. The parties should evaluate these options from a foreign exchange regulations', tax and accounting perspective as well.
Footnotes
1. Indian Accounting Standards (Ind AS) 110, Consolidated Financial Statements, such as at paragraphs 5-8 and 10 and paragraphs B11- B13 in Appendix B.
2. Rule 21 and 23 of the NDI Rules
3. Note that Rule 9B of the Companies (Prospectus and Allotment of Securities) Rules, 2014 exempts small companies and government companies from having to comply with the requirement of a mandatory dematerialization. Section 2(85) of the Companies Act, 2013 defines a "small company" based on thresholds linked to the paid-up share capital and turnover of a company which is not a public company
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