Common Pitfalls in UK Mergers & Acquisitions and How to Avoid Them

Navigating a merger or acquisition can be complex, with many stages where common errors and pitfalls may result in costly delays, adding further challenges to the transaction. Here, we aim to simplify the key stages and common pitfalls in UK M&A transactions and provide practical steps that are important to be aware of to mitigate these risks.

1. Heads of Terms (HoT) Stage

What are Heads of Terms?

Heads of Terms (“HoTs”) are a preliminary document that outlines the key points both parties agree upon in principle before negotiating the main transactional document (either a Share Purchase Agreement or an Asset Purchase Agreement). While HoTs are not legally binding overall, they provide an essential framework, clarify the main terms, set the transaction timetable, and may include binding clauses such as confidentiality and exclusivity.

Common Pitfalls at the HoT Stage

Overly General or Vague Provisions: If the HoTs are drafted too generally, they may lead to misunderstandings in later stages of the transaction. Key details such as price, payment conditions, or closing dates must be clear. Vague terms can result in disagreements and renegotiations between parties, delaying the transaction.

Neglecting Legal Obligations: Certain clauses in the HoTs – for example, confidentiality and exclusivity, can be legally binding. Overlooking these obligations or failing to enforce them can expose either party to legal risks. For instance, if a seller violates an exclusivity provision by negotiating with another buyer, they may be liable for damages.

Underestimating Due Diligence Issues: The HoT stage typically occurs before full due diligence. If the document doesn’t allow room to adjust terms based on later findings, one party might be forced into an unfavourable deal. Including conditions that enable renegotiation once due diligence is complete can help protect both sides.

Negotiating Falling Through: Where appropriate, a break fee may be included in the transaction documents to compensate the buyer if the deal does not complete due to certain actions or failures by the seller or target company. A break fee is a pre-agreed amount payable to the buyer in specific circumstances, such as the seller accepting a competing offer, breaching exclusivity or no-shop clauses, or failing to obtain required shareholder or regulatory approvals, which effectively derail the transaction. These fees are intended to cover the buyer’s incurred costs, such as legal and due diligence expenses, and provide a level of deal protection against the risk of the transaction falling apart after substantial investment of time and resources.

How to Avoid These Pitfalls:

• Draft HoTs with clear and specific terms.
• Identify which clauses are legally binding.
• Build in flexibility for renegotiation based on due diligence findings.

2. Due Diligence

Due diligence is where buyers examine the target company in detail. Two streams of Due Diligence are important to execute in an M&A process:

• Legal Due Diligence: Focuses on contracts, compliance, and ownership of assets; and
• Financial Due Diligence: Examines financial health, tax exposures, and accounting practices.

Financial due diligence is typically carried out by accountants or tax professionals acting on behalf of the buyer. It involves the assessment of various financial and economic aspects of the target company, including (but not limited to) revenue trends, profit growth, working capital requirements, and balance sheet analysis.

For this section, however, we will focus on and explore legal due diligence in greater detail.

Key Due Diligence Areas

Undisclosed Liabilities and Tax Inefficiencies: Hidden debts or tax issues can become costly problems if discovered too late. Early identification and addressing these risks are essential.

Weak Supplier or Customer Contracts: Strong contracts with key suppliers and customers protect business operations post-acquisition. Weak or unclear contracts may jeopardise these relationships, affecting revenue and operations.

Unresolved Disputes and Compliance Failures: Ongoing legal disputes or compliance issues can lead to penalties or litigation after completion. Identifying these during due diligence allows for better risk management.

Intellectual Property (IP) Ownership: Ensuring that the target company holds clear ownership of its vital IP assets is crucial. Any ambiguity could lead to legal challenges later.

Regulatory Risks and Employee Disputes: Non-compliance with industry regulations or unresolved employee issues can cause significant operational disruptions and added costs.

Financial Misstatements: A detailed review of financial records is necessary. Any inaccuracies or misstatements could lead to overvaluation or unexpected liabilities.

How to Avoid Pitfalls in Due Diligence:

• Use warranties, indemnities, undisclosed liabilities, and tax covenants to safeguard against unexpected issues in the main transactional document.
• Consider setting up escrow accounts or deferred payments to hold part of the purchase price until potential issues are resolved.
• Ensuring warrantors have warranty and indemnity insurance in place.
• If you have a buyer, do not be afraid to renegotiate a deal where significant issues are uncovered.

3. Negotiating the Purchase Agreement

The Purchase Agreement is the definitive contract that sets out all terms of the transaction. Many pitfalls arise at this stage, particularly concerning price adjustments, warranties, and restrictive covenants.

Price Adjustment Mechanisms

Completion Accounts: This method adjusts the purchase price based on the target’s financial position at completion. If the methodology or timing is unclear, disputes can arise. Buyers might argue that the adjustments were unfair or miscalculated.

Earn-Outs: An earn-out ties part of the purchase price to the future performance of the target company. Without clear performance targets and measurement criteria, earn-outs can become a significant source of conflict.

How to Avoid These Pitfalls:

• Clearly define the methodology for any price adjustments.
• Set objective, measurable performance targets.
• Include dispute resolution mechanisms to quickly settle disagreements.

Warranties and Indemnities

Warranties: Warranties are promises regarding the state of the target company. Buyers often require comprehensive warranties to protect against undisclosed risks. If too limited, buyers may face post-completion liabilities. If they are too broad, sellers may be unduly exposed.

Indemnities: Indemnities provide targeted protection against identified risks, such as tax or legal liabilities. Failing to include the right indemnities can leave buyers vulnerable, while sellers typically seek to cap their liability or limit the claim period.

How to Avoid These Pitfalls:

• Negotiate warranties that provide sufficient protection without overburdening either party.
• Tailor indemnities to cover material risks.
• Clearly define limits on liability and time periods for claims.

Restrictive Covenants

These clauses prevent the seller from establishing a competing business post-sale. They need to be carefully defined in terms of scope, duration, and geography to be enforceable. Overly broad restrictions may not hold up in court, while too narrow restrictions may leave the buyer exposed.

How to Avoid These Pitfalls:

• Craft specific and reasonable restrictive covenants.
• Ensure the duration and geographic limits are practical and enforceable.

Asset Sale vs. Share Sale

The structure of the deal, whether it is an asset sale or a share sale, can significantly affect tax liabilities and the assumption of risk.

Share Sale: In a share sale, the buyer acquires the company’s shares and takes on all its assets and liabilities. This approach may be cleaner for the seller but exposes the buyer to potential hidden liabilities.

Asset Sale: Here, the buyer picks and chooses the assets and liabilities they want. While this can limit exposure to unwanted liabilities, it may be more complex regarding the transfer of contracts, employees, and other assets. Tax implications can vary between the two structures.

How We Help Clients Choose the Right Deal Structure

We take a tailored, strategic approach to deal structuring, recognising that every transaction involves a unique set of commercial, legal, and tax considerations. Here’s how we support in deciding between a share sale and an asset sale:

• Assessing Risk Appetite and Liability Exposure
  We identify clients’ risk tolerance and appetite for assuming liabilities. In a share sale, buyers inherit the company’s entire legal and financial history. We help conduct thorough due diligence to uncover any hidden risks, such as unresolved litigation, potential litigation risks, tax exposures, or compliance issues, that may make an asset purchase more prudent.
• Evaluating Tax Implications
  Tax treatment can vary significantly depending on the transaction structure. For instance, sellers may prefer a share sale due to potential eligibility for Business Asset Disposal Relief (BADR) (formerly Entrepreneurs’ Relief), which reduces Capital Gains Tax. Buyers, on the other hand, may prefer an asset purchase for potential tax deductions on depreciable assets. We collaborate with our internal corporate tax solicitor and tax advisers where required to model and compare the tax impact of both structures.
• Analysing Operational and Commercial Objectives
  We understand our client’s end goals and commercial objectives – whether that’s acquiring key assets, retaining staff, or continuing business operations seamlessly. An asset sale might be better suited for acquiring specific parts of a business, whereas a share sale may be more appropriate where continuity (e.g. with customer contracts or regulatory approvals) is crucial.
• Future-Proofing the Transaction
  We will consider not only the immediate outcome of the transaction, but also how the structure will impact future business plans. For example, post-acquisition integration, potential restructuring, and the effect on existing group structures all contribute to shaping our advice.

4. Issues at Completion

Even when negotiations go smoothly, the completion stage can still present challenges that delay or derail the deal.

Delays and Financial Disputes

Completion Accounts Disputes: Last-minute disagreements over the final accounts can delay completion. Buyers might dispute the valuation of assets or liabilities, leading to prolonged negotiations.

Failure to Meet Conditions Precedent: Conditions precedent – such as obtaining third-party consents, regulatory approvals, or settling outstanding debts – must be met before completion. Failure to do so can result in delays or even jeopardise the entire transaction.

Ensuring both parties take independent advice at the outset will allow both parties to determine what the favourable sale/purchase type will be beneficial for them, before the undertaking of a significant due diligence exercise.

Transitional Arrangements

Post-completion, the acquired business must be integrated into the buyer’s operations. Key transitional issues include:

Management Handover: A clear plan is necessary to transfer management responsibilities. Without this, operational disruptions and confusion can occur.

Access to Business Systems: Immediate access to IT systems, customer databases, and financial software is crucial. Any delay in system handover can impact business continuity.

Interim Support: Sometimes, the seller may need to provide temporary support during the transition. A well-defined agreement (usually in the form of a consulting agreement or an employment contract) on roles, responsibilities, and timelines can prevent misunderstandings.

How to Avoid These Pitfalls:

• Prepare a detailed transitional plan during the negotiation stage.
• Outline clear responsibilities and timelines for the handover.
• Ensure immediate access to critical systems and data post-completion.

5. Post-Completion Challenges

Even after a deal has closed, several post-completion issues can affect the success of your merger or acquisition.

Integration Challenges

Merging two businesses is more than just signing a contract – it’s about successfully integrating operations, cultures, and systems.

Warranty and Indemnity Claims

Post-completion, disputes may arise if a buyer discovers that certain warranties were breached or liabilities were not disclosed. These issues can lead to drawn-out disputes and litigation.

How to Avoid These Pitfalls:

• Ensure the Purchase Agreement includes robust dispute resolution mechanisms, such as mediation or arbitration.
• Consider warranty and indemnity insurance as an extra layer of protection.
• Clearly document and agree upon the process for handling any claims.

Earn-Out and Deferred Consideration Disputes

When part of the purchase price is based on future performance (through earn-outs or deferred payments), disputes may arise over the achievement of targets. Ambiguities in how performance is measured can lead to conflict between buyer and seller.

How to Avoid These Pitfalls:

• Use independent auditors to verify financial targets.
• Clearly define performance metrics and calculation methodologies in the Purchase Agreement.
• Establish a clear, fair dispute resolution process.

Conclusion

Navigating the M&A process in the UK requires a deep understanding of the potential pitfalls at each stage, from the early Heads of Terms to the post-completion phase. By: a) drafting clear and detailed Heads of Terms; b) conducting robust legal and financial due diligence; c) negotiating a well-drafted Purchase Agreement that clearly sets out price adjustments, warranties, indemnities, and restrictive covenants; d) preparing for a seamless completion through detailed checklists and transitional arrangements; and e) planning for effective post-completion integration and compliance; both buyers and sellers can mitigate risks and avoid costly mistakes.

At the Jonathan Lea Network, we specialise in simplifying complex M&A processes. We help clients understand these pitfalls and provide practical strategies to ensure that every deal is structured for long-term success. Whether you need tailored advice on transitional arrangements for a specific sector or guidance on managing earn-out disputes, our experienced team is here to help you navigate these challenges.