Eight steps to keep a search fund transaction on course

Step 1: Ensure you have signed HoTs/LOI in place

It is vital that signed Heads of Terms (or a Letter of Intent) are in place before work commences. Even if the offer has been verbally agreed and accepted there is nothing legally preventing the seller from entertaining other offers until they have signed. 

We believe there is a sweet spot in striking the right balance with the level of detail included in the HoTs. On the one hand, anything agreed at this stage should make any negotiation further down the line more straightforward (e.g. treatment of specific items as debt or working capital). However, going into too much detail at this stage can put off potential sellers and delay progressing into exclusivity. 

Additionally, it may also be useful to include a mechanism in the HoTs showing how the headline Enterprise Value has been calculated. If the headline value is based upon a multiple of EBITDA then including this mechanism gives some scope to reduce the Enterprise Value accordingly if, after diligence, the EBITDA is found to be lower than initially expected. This is useful for getting the deal over the line as it represents you working within the original parameters set out in the HoTs rather than having to renegotiate what was previously agreed. 

Step 2: Carry out a Red Flag review to get comfortable or fail fast

Many searchers find it useful to carry out an initial red flag review, immediately after getting the LOI in place. This can normally be performed quickly with the objective of obtaining a high-level understanding of key risk areas. It is more targeted than full financial diligence, instead looking to address 5 key questions which could be immediate “deal killing” problems. 

Performing this review provides the searcher with an output to show to investors and lenders at an early stage to get them onboard with the process. Furthermore, if the deal is to fall over because of a terminal issue it is better for this to happen early to avoid unnecessary costs accumulating. 

Step 3: Maintain momentum at the full diligence stage

Once the red flag review has been completed the full financial due diligence stage can commence. It is important that momentum is maintained at this stage to ensure the deal is completed before the end of the exclusivity period. To do this effectively it is often helpful to consolidate request lists and send them out in good time. The sellers should be encouraged to provide information as soon as available (some have a tendency to want to complete the whole list before opening the dataroom which can cause delays). 

Regular catch ups with both the searcher and the seller are also useful to ensure findings are communicated efficiently and outstanding information can be chased. 

Step 4: Connect with lenders at the start of the process 

It is vital to gauge the appetite of lenders for the deal as quickly as possible. This can help to avoid delays in securing the necessary debt funding and also ensure you don’t get far down the line with a deal which cannot be supported by debt funding. Lenders may be reluctant to proceed if they don’t like the sector, have concerns around the impact of the existing owners leaving or if the debt funding requirement is beyond the level they can achieve. 

We recommend discussing with lenders around the HoTs stage. This has the added benefit of meaning that particular lender due diligence scopes and concerns can be obtained and used to fine tune the financial due diligence process to ensure that it meets the preferred lender’s requirements. Once selected the preferred lender should be kept updated as the transaction progresses. 

Step 5: Keep investors updated throughout the process to avoid surprise cap table gaps

Similarly to the lenders, it is important to keep your investors updated on progress with the transaction and any findings. We would recommend sending the red flag report and the draft FDD report to them when ready, before providing the overall finalised FDD report. 

The objective here is to ensure any investors that are going to pull out, do so early. It is fairly common that at least some of the search capital investors will choose not to follow on and contribute to the acquisition capital (resulting in a gap on the cap table). Therefore, if there is to be a gap it is useful to know the extent of this as early as possible so that a replacement investor can be found to fill in. 

Step 6: Kick the SPA (Sale & Purchase Agreement) process off in good time

The SPA process is normally primarily handled by the lawyers of each side. There is typically a fair amount of back and forth between them as key terms are agreed, particularly around Warranties & Indemnities, the Tax Covenant and non-compete clauses etc. To maximise efficiency this SPA negotiation can be run concurrently with the due diligence process. This helps to prevent there being a significant delay between completing the due diligence and finalising the SPA. 

Step 7: Seize the initiative with the EV Bridge 

The Enterprise to Equity Value bridge and completion account form is normally the area of the SPA that takes the most negotiation. If the transaction is on a cash free, debt free basis with a normalised level of working capital then this schedule details how you get from your headline offer (Enterprise value) to the amount the sellers will actually receive (Equity value). 

When negotiating this it is useful to seize the initiative, putting your schedule to the sellers first and using it as a base to work off. We find doing this makes it more likely that you will get your desired allocation between net debt and working capital items.

Step 8: National Security and Investment Act notification 

The National Security and Investment Act came into force on 4 January 2022 and gives the government powers to scrutinise and intervene in certain business transactions, including acquisitions. There are 17 sensitive areas of the economy where you are legally required to inform the government about your proposed acquisition. Some of these are more niche and unlikely to impact search transactions (such as advanced robotics, quantum technologies or space technologies) however there are others that are more common such as suppliers to the emergency services, communications and transport which a surprising number of companies fall into.  

It takes 30 working days for the government to process a decision and there is very little that can be done to speed the process up. Therefore, if your target company does fall into one of these sectors it is important to notify the government of the transaction in good time to avoid delays. We normally find that as soon as the final cap table has been decided on it is best to start the notification process. 

If you have any questions about any of the topics raised in the series and would like to discuss them in more detail, then please do get in touch. Our transaction services team has great experience in assisting search funds in making successful acquisitions.