The Purchase Agreement- Inking the Deal
Handshake deals are a wonderful concept. However, given the risks involved in today’s world, especially that the person with whom you have an agreement may not be the one you end up dealing with later, they are simply not tenable in most circumstances. This is especially true for something as complex as buying someone’s business, even a very small one. While acquiring a going concern is often a very good solution for someone, there are several ways this can go very wrong. A comprehensive, well-written purchase agreement need not be a treatise, but it should encompass several things.
The terms of the agreement- what exactly is being sold, for how much, and how will that amount be paid/delivered? This includes what is excluded from the sale, and may also include some post-sale expectations such as a consulting arrangement or non-compete agreement. The agreement should address any closing timelines, whether bulk sale is applicable, and other industry specific considerations.
The purchase price may be an all-cash payment, or it may involve some seller financing, an earnout provision, or some other variation. Because the structure of the payment may impact financing options, the proposed structure should be discussed with the buyer’s lender prior to final agreement.
In an asset sale, the buyer and seller will need to allocate the purchase price among the assets, including such assets as equipment, inventory, goodwill, intellectual property, and a non-compete agreement. The determination of this allocation has both backward and forward reaching tax implications- meaning the seller will be impacted by it, and the buyer’s basis on a go-forward basis as well. Additionally, if the buyer is obtaining financing for the purchase, the amount attributed to goodwill may be important. It is important to agree up front on the allocation, at least on a rough basis. When inventory is a significant asset, often the purchase agreement will provide for a modification of the final price based on an inventory taken at or near closing. Unless each item has significant value, this often provides for inventory levels being within a predetermined allowance rather than an exact number.
The level of working capital to be left in the business is critical in a stock sale, and expectations should be discussed early to avoid the deal disintegrating later, after the buyer has invested time and money in due diligence, and the seller has taken the risk of disclosing the sale to third parties and employees.
Representations, warranties and covenants- mostly these are one-sided and provided by the seller. The seller is representing that the business is viable, that the financial statements are an accurate representation, that there are no undisclosed claims or disputes, and so forth. The seller warrants these and other things to be true when made, and at closing, and covenants to deliver things promised. The buyer may also make representations, especially if it is an entity- as to its capacity and authority to contract and will covenant to deliver the purchase price and other promised items.
Typically representations and warranties will survive closing for a specified period of time. That is to say that the buyer will have recourse if it is discovered later that a representation was untrue, either when made or at the time of closing. Often these are bifurcated between more substantive items, such as having the authority to enter into the transaction, title to the assets or stock, which survive until the statute of limitations has run, and others which may have shorter periods of survival. For instance, financial representations may be crafted to survive until the buyer would reasonably have the opportunity to discover them in an annual audit, or tax preparation and the like.
The knowledge required in order to trigger liability for a representation is important as well. A seller may warrant regarding something to the best of its knowledge, after due inquiry, or may limit the seller’s liability if the fact was known by the buyer prior to closing. In larger deals this may be heavily negotiated, and in smaller deals it is often not given a lot of attention, sometimes to the later chagrin of the less sophisticated party.
Because a deal is hammered out based on the most recent information, and typically some time elapses between then and actual closing, the wise buyer will include a requirement that the seller maintain disclosures. This usually involves disclosure of a material adverse change, which is often specifically defined in the agreement.
There may be conditions to the obligation to close on both sides, such as a financing contingency for the buyer. While the buyer has an obligation to pursue financing in good faith, if it fails, a financing contingency will allow the buyer to terminate the agreement and limit the buyer’s exposure to damages.
Indemnification clauses give teeth to the reps, warranties and covenants. A well-written indemnity clause allows the buyer to pursue recourse from the seller when claims arise later based on actions or omissions prior to closing- whether from a taxing agency, a customer, employee, or some other source.
If the business has any potential exposure for environmental claims, for instance, the buyer should ensure that the seller is required to indemnify them for actions prior to closing- and also establish a baseline via testing or another source, so that it is easier to determine later whether the environmental issue arose pre- or post- closing.
The seller will generally concede the need to offer indemnity, but often wants to limit their exposure- in terms of time period limitations, dollar caps, minimum thresholds (buckets), or other caps. The seller and buyer may negotiate different buckets for various risk exposures as well.
The indemnification should address the right to notice of a claim very early in the process, and establish whether the indemnifier (usually the seller) has the right to defend the matter themselves, or direct legal counsel.
The agreement should address what remedies are available. On a larger scale, the choices are generally to litigate, or to make use of alternative dispute resolution means, such as mediation and arbitration. However, no matter which of these is chosen, the buyer should be sure to carve out the right to injunctive relief in enforcing any non-compete or non-solicitation clauses in the agreement. It is far more useful to be able to prevent a seller from opening up a competing business than to try to prove damages three years down the road.
General provisions are seen as boilerplate by most people - until they take effect. An integration clause that provides that this is the entire agreement will generally foreclose introduction of a prior verbal side agreement in a later dispute, for instance. These clauses help reduce later confusion or uncertainty about what was intended at the time of contract, and therefore provide more certainty for both parties.
And last, but far from least, the buyer and seller need to sign the purchase agreement, preferably well before the actual closing.
Flack Law, PC
703 2nd Street, Suite 323
Santa Rosa, CA 95404