A PRIMER FOR BUSINESS OWNERS
When selling your company, you typically will sign a Letter of Intent (LOI) which gives you and the buyer an opportunity to complete due diligence and grants the buyer exclusivity among other things. You can learn more about the IOI (Indication of Interest) or the LOI in other articles in FAQs.
Once you have signed the LOI, typically the next major legal document for you to navigate is the Purchase Agreement. This document incorporates all the terms agreed to in the LOI, adds terms and conditions not generally included in the LOI (e.g. indemnification provisions) and will be the reference point used in any post-transaction questions or issues. You should be leaning heavily on your attorney for help interpreting, navigating, and understanding the details of this document, but ultimately you as the seller are bound by the Purchase Agreement’s terms, so you must not “delegate” this one out. You need to be actively involved in the process of taking the first draft and turning into the final draft. This will involve a lot of time, some education from your M&A Advisor and your M&A attorney, but it’s crucial to a successful outcome.
The following sections and the issues they address represent most of the common material terms found in most Purchase Agreements. Since each transaction is unique, yours may include other provisions that are no less important than those outlined here. The sections are ordered as they are generally found them but it varies by legal counsel and the other authors of the agreement.
This may be the most important section of the Purchase Agreement, but it often receives too little attention from the seller because it appears to be basic standard boilerplate. Every term or word found in the Purchase Agreement that is capitalized (e.g. Purchase Agreement) is considered a defined term and will be found in the Definitions. Material terms such as “Adjusted EBITDA” and “Net Working Capital” that are especially subject to multiple and highly varies interpretations should be clearly and concisely written. Ideally any person reading the document, who was not involved in the transaction and who may not really understand the underlying business, could read the definition and have no doubt as to its meaning. You should know that poorly written definitions can and will become a major future problem should buyers and sellers disagree on the amount of a post-closing working capital adjustment, earn-out calculation or need for a purchase price adjustment. For example, does “Net Working Capital” include only trade receivables? Does “Adjusted EBITDA” include or exclude “market” adjustments to retained seller’s salaries? If you don’t nail these issues down here, and your transaction is subject to post-closing adjustments, you can expect some potentially major disagreements.
This section details the purchase price, payment mechanics, earn-out targets and timing of earn-outs, escrows and purchase price adjustments. Some or all of these may be applicable to your transaction. Preferably they were first introduced and agreed upon in the LOI but it is not uncommon for one or more to appear post-LOI.
Purchase price is often a combination of cash, buyer’s stock or seller financing but could include other items. If the buyer is a public company, then it is here where the mechanics of how the buyer’s stock will be valued is found (e.g. average closing price on NYSE for the 10 days prior to the closing date).
Three sources of negotiating friction found here are earn-out targets, escrows and purchase price adjustments. If earn-out targets were not included in the LOI, and it is not unusual for an earn-out to be a post-LOI addition if due diligence has surfaced concerns for the buyer, then discussions over how to calculate the target, calculate the future result (e.g. seller no longer controls company and hence expenses thus what is in or out of EBITDA), and the amount of the earn-out can delay closing or halt the process altogether. Escrows are requested by buyers to cover potential future claims against the seller post-closing. Escrow conflicts are generally over the amount (standard is to express as a percentage of total purchase price) the escrow period, the frequency of fund releases from escrow (may allow staggered release) and definitions related to materiality of claims and types of claims. The latter is negotiated within the indemnification provisions of the Purchase Agreement. Purchase price adjustments may be tied to agreed net working capital delivered at closing, meeting future financial goals (EBITDA did not decline more than 5% in first twelve months post-closing) or other benchmarks.
Again, the common thread throughout these preceding issues is the need for well-authored definitions.
Representations, Warranties and Schedules
sellers and buyers ask each other to state that certain conditions and facts are true at the time of sale; however, the seller’s disclosures to the buyer far exceed those made to the seller by the buyer. It is in this section of the Purchase Agreement, and the following on indemnification that seller’s will rely heavily on their counsel to protect their interests as most sellers will not be familiar with the terminology. These sections are also intertwined (i.e. a change in one may section may only be palatable if a relating term is changed in the other).
There are at least three material issues your attorney will be negotiating for you: who will make the representations on behalf of the seller, for what period(s), and definitions of “materiality” and “knowledge”. For example, buyers will often name the “whom” as the company, C-level executives and material shareholders. Sellers should try to cut this back as much as possible as this language opens individuals in management or shareholders to personal liability post-closing. As might be expected there are few non-management shareholders willing to accept that risk.
Arguably, your counsel and your intermediary is also helping you reduce the number of required disclosure schedules and level of detail provided on them.
While any section may require that a supporting schedule be attached to the agreement, it is the representations and warranties sections that generally require the majority of the supporting disclosure schedules. Generally a Purchase Agreement will include a “Schedules” list or table of one to two pages. To the uninitiated this appears to be a rather benign request. For the seasoned veteran, this is the source of hours of tedious research and dozens, if not more, spreadsheets and volumes of materials to place into due diligence to support the schedules - another source of negotiating friction as each side discusses materiality of data requested and oftentimes for the seller many more thousands in legal fees.
For many sellers who have been through the process, the demands placed on them from this process alone made them vow to never sell another business without third-party help.
Indemnifications define what actions of one party or events caused by that party damage the other and are heavily weighted towards protecting the buyer. Generally speaking the buyer is trying to protect against future liabilities resulting from seller’s actions pre-closing and is contractually requiring the seller to agree to compensate the buyer for damages. Friction points in negotiating indemnifications are found in the breadth of actions covered, who must provide the indemnification, how long the indemnification period lasts, caps on damages, relationship to escrow and materiality of claims. Examples of indemnified actions include intellectual property, taxes, employment matters and securities issues. Buyers and sellers may negotiate a discrete indemnification period and damages cap for each of these items (though some areas such as tax are almost always uncapped). Buyers may ask that management and material, or even all, shareholders are held accountable for paying indemnified damages. Sellers will generally work to limit who is making the indemnification, ask for a cap on damages of no more than the escrow amount and limit the indemnification period to no more than the escrow period. Lastly, indemnified items may be subject to a deductible and to a materiality standard. In other words, a basket is created where the first $xxx of claims is held and if the basket amount is never exceeded the buyer pays the claims. Disagreements over indemnification provisions can and have scuttled transactions so best to address this section early on in reviewing the first draft.
Interim and Post-Closing Covenants
Interim and post-closing covenants detail how the seller and buyer promise to conduct business before and after the transaction. One surprise many sellers face upon reading the first draft of the Purchase Agreement is the number and specificity of the interim covenants. Standard requirements include not hiring any new employees, not granting any bonuses or salary increases and no purchases greater than $10,000. Effectively the buyer has valued the seller’s business based on the operations and numbers as-of the LOI date, or earlier, and expects to receive a business very little changed from that decision date. Post-closing covenants may include non-competes, providing transition services and seller’s providing ongoing D&O insurance for former management and directors. Non-competes are highly negotiated and may vary greatly between individual sellers. Non-competes are also highly variable in allowable terms depending on the seller’s state of residence.
The simplest description of closing conditions is a list of items to be delivered or events to have occurred before each party exchanges signatures on all of the deal documents. It sounds so simple. Closing conditions may include regulatory approvals (e.g. business requires government-issued licenses or permits which are often non-transferrable or require long lead times to transfer), written consents from all seller landlords (even for stock sales), written consents from customers and vendors where the seller’s agreement with them did not include a change-in-control provision or still requires written consent, etc. The seller’s attorneys and intermediary generally are coordinating activities needed to meet closing conditions by the targeted closing date are met. It is possible to close without satisfying all conditions but at the complying parties discretion and expect that to cost something.
The above is just a snapshot of the pitfalls, issues and key terms that make up the Purchase Agreement with a few examples to highlight why this is such an important document and must be drafted and negotiated rigorously. Each of these sections could be a multi-page article in its own right and the risks, complexity and time-intensive nature of getting this work done properly further points to the importance of having an experienced supporting deal team of attorneys and M&A Advisors in place when selling your business.