Acquiring a Manufacturing Business in India – Red Flags
Contributed by Amrit Mehta of Majmudar & Partners
India is an attractive market for foreign companies as it offers long term growth prospects, highly potential domestic market, and inexpensive labour and manufacturing capabilities. While many foreign companies (“Acquirers”) are attracted by these benefits, they often stumble over the legal or transactional hurdles. This paper attempts to give a broad overview of the key issues that an Acquirer must keep in mind while investing in India.
ENTRY INTO INDIA
Acquirers can enter the Indian market by creating joint ventures with Indian or foreign parties, or establishing wholly owned subsidiaries, whether as a greenfield or a brownfield
business. An acquisition of an existing business (the “Target”), either through purchase of shares of the company conducting the business, or acquisition of the business as a going concern
or acquisition of identified assets of the business is more preferred than setting up a new manufacturing business. An acquisition can help the Acquirer gain immediate market share or
an exclusive distribution channel while also avoiding misappropriation of knowledge, and significant investment of time and capital required to set-up business from scratch.
MODES OF ACQUISITION
An Acquirer should opt for a mode of acquisition so as to optimise tax and operational benefits, as also mitigate exposure to pre-acquisition liabilities. For instance, although a share acquisition can be completed fairly quickly, it requires a higher level of due diligence. On the other hand, in a business purchase the Acquirer can disassociate with pre-existing liabilities of the Target.
Due diligence is crucial in acquisitions in order for the Acquirer to understand the history of the business, including the liabilities it will inherit. It is important for an Acquirer to do a detailed legal, financial, business and environmental due diligence. Some key areas to focus on are:
- Title of shares or business assets
It is important to ensure that the shares or the business assets being acquired by an Acquirer are clear from encumbrances, and are validly held by the sellers. Moreover, in case of a share acquisition, the Target must have completed corporate formalities for issuance of shares validly.
- Labour law compliance
In a manufacturing business, labour is of utmost importance. Therefore, Acquirers should ensure that the Target has complied with applicable labour laws, and most importantly, the Factories Act, 1948, and has paid adequately paid dues to its employees in a timely manner.
- Environmental issues
Acquirers should ensure that the Target has the approvals from the concerned State Pollution Control Board to set up a manufacturing facility, especially if the establishment is
likely to discharge sewage or trade effluent (whether hazardous or not) or emit air pollutants. Further, legislations on the use of toxic gases or explosives may also be applicable depending
upon the manufacturing process, the materials and equipment used, and the by-products created. Where necessary, the Acquirer must insist on soil and ground water investigations to mitigate risks of unsanctioned discharge and pollution of the water table.
- Real property
In India, typically, manufacturers operate on land acquired from state owned
infrastructure agencies on a long-term lease. The Acquirer must be aware of the Target’s title,
any encumbrances and permitted use of the land.
For the Acquirer, it is equally important to seek adequate protection under the transaction documents, such as share purchase agreement (in case of share acquisition), or a business
transfer agreement (in case of transfer of business), or an asset purchase agreement (in case of transfer of assets). Certain clauses that are important and that often take up majority of the
negotiation time are:
Representations are statements towards the past and present facts and circumstances of a business from the seller. A breach of a representation amounts to misrepresentation and can entitle the Acquirer, a claim for damages and/or a right to terminate the transaction. Sellers often insist on extensive exceptions to representations in the form of disclosures, which Acquirers must negotiate carefully and limit only to key disclosures.
Warranties are promises with regard to the future condition of the business. Acquirers should use these to ensure that the state of the Target continues to remain as satisfactory as promised post closing for the term of the warranty period. For instance, acquirers may include warranties for the state of the plant and machinery.
Non-compete covenants, including the time and scope, are very important in case of a complete buy-out although enforceability of these covenants is questionable. If the transaction is structured as business or asset transfer with goodwill, non-compete covenants may be held enforceable under Indian law.
Indemnities are used to protect an acquirer from losses suffered due to a breach by the Target of its representations, warranties, covenants and/or other obligations. Currently,
indemnities up to a value of 25% of the purchase price and for a period of eighteen (18) months from the date of the transfer agreement can be given in a cross-border share purchase transaction without the need for India’s apex bank’s approval. Other contractual carve-outs may be agreed upon depending on the Acquirers’ business appetite for risk.
- Standstill covenants
Standstill clauses can be used by the Acquirer to ensure that the condition of the Target remains constant in the period between the signing and closing of the transaction. These
covenants are crucial in deals with significant time lapse between signing and closing of the transaction on account of the conditions precedent.
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