This contributed article by Allistair Booth and Charles Waddell, partners of leading law firm Fasken Martineau LLP, examines some of the key aspects to be considered when entering into such a transaction.
In recent years there has been an increasing trend in the use of deferred consideration in share sale transactions in the life sciences sector. A relatively small proportion of the consideration is paid “up front” on completion with the remainder of the consideration being payable on achieving certain milestones in a manner not dissimilar to a lot of licensing transactions.
Two of the reasons behind the increased use of deferred consideration provisions in share sale transactions are value and risk. Since the onset of the recession, share valuations have on the whole been depressed and purchasers have become more risk averse. The attraction of a deferred consideration provision for vendors is that, rather than accept a valuation they believe to be too low, they can use deferred consideration mechanisms to increase the overall potential consideration payable. The same mechanism is attractive to the purchaser, as they are paying a smaller amount up front and only pay the remaining element on “success”.
Passing of Title
The key difference between selling a company for deferred consideration and a licensing transaction with milestones and royalties is that title to the shares passes to the purchaser on completion. On a licencing transaction, a licensee who does not pay milestones and royalties risks having the licence terminated.
The mere fact that deferred consideration is potentially payable on share sale transactions does not automatically imply an obligation on the purchaser to use commercially reasonable endeavours to carry out the activities that would give rise to the deferred consideration. Diligence obligations on the purchaser are the norm in agreements of this nature. As with licensing transactions, one needs to be careful about the uncertainty around a “commercially reasonable endeavours” type clause.
The question of what remedy is available to the vendor in the event the purchaser elects not to continue with the development of the asset of the target company (and thus achieve the milestones that will give rise to the deferred consideration) is one of the more complicated considerations. Whilst it is possible to hand back ownership of an asset on an asset sale transaction, it can be difficult to hand back ownership of shares, not least because many target companies in the life sciences sector are biotech companies with a disparate shareholding base of venture capital and angel investors.
One of the things the vendors will be very keen to avoid is the embarrassment of the purchaser selling on the target company shortly after purchasing it from the vendor for a significantly larger sum than they paid to the vendor. Deferred consideration provisions often contain an anti-embarrassment clause entitling the vendor to a percentage of the sum the purchaser obtains for an onward sale. These clauses are, more often than not, time limited so that they cease to apply after 12-18 months of the original transaction.
Vendors are unsecured creditors of the purchaser in respect of deferred consideration payable under a share purchase transaction. Where a large element of deferred consideration is payable and the financial covenant of the purchaser may not be strong, vendors should consider taking a charge over the target’s assets or the shares in the target. Taking security over the target’s assets has to be carefully structured to avoid infringing prohibitions against target companies providing unlawful financial assistance. From the vendor’s point of view, a charge over the buyer’s or target’s assets has the benefit that it can be registered at Companies House and, in the case of patents, against all of the patents in the various patent offices, which makes it very difficult for the purchaser to subsequently deal with the assets without the consent of the vendor.
General anti avoidance
The share sale agreement should provide that the purchaser will not and will procure that the target company will not undertake any transaction that has its primary purpose, effect or intent, the avoidance of the obligation to pay the vendor the deferred consideration in the event of the successful achievement of any milestones.
Sale preference “cascades”
Many target companies in the life sciences sector have majority shareholders which are venture capital investors. The articles of association of the target company need to be reviewed to check how future flows of deferred consideration will interact with sale preference cascades which allocate sale proceeds as between the holders of different classes of shares.
Tax and stamp duty
Capital gains made by sellers will be chargeable to tax. It is important for sellers to understand how they will be taxed on the right to receive deferred consideration. HMRC will charge capital gains tax on what it determines is the value of the right to receive the deferred consideration.
The purchaser has to pay stamp duty on the purchase price at an effective rate of 0.5%. Stamp duty is payable on deferred consideration to the extent that it is ascertainable. If the deferred consideration is stated to be capped, HMRC will charge stamp duty on the maximum sum payable regardless of whether that sum is ever actually payable.
Allistair Booth is a partner at Fasken Martineau LLP and is a member of the technology and intellectual property and life sciences practice groups.
Charles Waddell is a partner at Fasken Martineau LLP and is a member of the life sciences practice group.