In June of 2017, I began a series of blogs regarding the most important legal considerations in the mergers and acquisition process. The first blog discussed the mergers and acquisition process at a global level generally laying out the six most important legal considerations in the process. In the second blog of the series, I dove deeper into the first step of the process, engaging a financial advisor and drafting the engagement letter. The third blog discussed the drafting of the nondisclosure agreement. The fourth blog detailed the negotiation and drafting of the term sheet or letter of intent. The fifth blog was a quick summary of the due diligence process.
This sixth installment focuses on a general overview of drafting and negotiating the definitive agreement. In the context of a sale or purchase of a company, the “definitive agreement” is usually an asset purchase or stock purchase agreement. To follow will be three blogs diving deeper into the three most important sections of the agreement: (1) economics; (2) representations, warranties, and disclosure schedules; and (3) indemnification.
First, the drafting and negotiating of a purchase and sale agreement necessitates a lawyer and an accountant. This is so because a lot of negotiations take place during and after the drafting of the agreement. The agreement is where many of the most important decisions are made, including pricing and payment.
The first draft of the agreement will generally be prepared by buyer’s counsel and will be divided into several separation sections, such as the following:
- Description of the transaction
- Representations and warranties of the seller
- Representations and warranties of the buyer
- Pre-closing covenants
- Conditions to closing
- Post-closing covenants
- Survival and indemnification
- Miscellaneous or general provisions
Being aware of the contents is not the same as understanding them from a legal standpoint. Please do not assume the descriptions below are sufficient for handling a deal on your own, especially because this blog cannot possibly address every detail.
Basics: The agreement will first list things such as the parties involved and the closing or effective date of the agreement. If there is any place where formalities are strictly followed, it is a purchase and sale agreement.
Closing price: A separate clause will list the purchase/sale price. Larger deals will include prices allocations, as well, for determining tax implications.
Price adjustments: The closing price is often not the final agreed upon price. Adjustments are typically made to account for the specific place in time the transaction takes place, in which case the price can be prorated or inventory and final account balances can be adjusted.
Assets: The list of assets can be quite lengthy. Certain sales will include details concerning everything being transferred by the final sale price. The most valuable assets will be listed: accounts receivable, cash, clients, patents, inventory, equipment, real estate, buildings, machinery/automobiles, etc. One should also cover all the bases and include clauses covering the furniture and fixtures in the buildings.
Liabilities: Naturally, liabilities will follow close behind the assets. Liabilities are largely accounts payable because a buyer is not likely to agree to a deal in which the seller gets to sell off dangerous/complicated liabilities. For this reason, you would be wise to include a clause stating that the buyer is not responsible for any liabilities except those explicitly accounted for in the purchase and sale agreement.
Payment and payment security: Payment is often more complicated than just instantaneous cash reimbursement. It often includes a plan in which the payment is going to be made at intervals in the future. In the case the payment is not made in one up-front lump sum, a payment security clause should be added. This protects the seller by including verified assets owned by the buyer. These are used as a safeguard or guarantee of sorts. Similarly, the buyer wants to be protected and this is accomplished through business operation requirements. In other words, once the agreement is signed, the seller is not allowed to waive its obligations and allow the business to fall apart.
Buyers and Seller Representations and Warranties: While I am including these as one clause, the buyer and the seller will each have their own space in the agreement. Each party will make a statement guaranteeing their ability and legal right to enter into the agreement. In other words, the seller is not posing as a fraudulent owner of a business (the seller actually owns it and has the right to sell it) and the buyer is not posing as a fraudulent buyer (the buyer can legally purchase the business and has the necessary means).
Employee termination: In many cases the seller must be willing to terminate those employees that are not contractually transferable. This is not a personal vendetta whatsoever or even the end of the employee’s tenure. It simply means the seller will pay its employees’ wages, benefits, etc. until the transfer actually takes place. Then the employees who are “terminated” might be “re-hired” by the buyer. This is necessary for tax purposes. Wages, commissions, benefits, etc. must be transacted under the buyer’s federal employer identification number, or its FEIN.
Post-closing provisions, transfers, fees: The end of the agreement may or may not be filled with a number of small clauses. A post-closing obligations means the buyer can make final adjustments after the sale for unforeseen expenses or liabilities. A default provision sets forth means for handling disputes if either side is unable to fulfill the agreement obligations. The transfer agreements simply cover things like transferring assets, stocks, etc. Finally, the fees clause protects the lawyers, accountants, and brokers involved by making methods for their payment explicit.
The actual sections included will depend, in part, on whether the deal is structured with a signing date followed by a later closing, or, alternatively, as a “sign and close” transaction where both events happen simultaneously. In the latter case, the purchase agreement is generally simpler and will not include the pre-closing covenants or conditions to closing sections.
But before the agreement can be finalized, there are numerous, often challenging issues to be worked out between the acquirer and seller regarding: (1) the economics of the transaction; (2) representations, warranties, and disclosure schedules; and (3) what rights the acquirer will have if it is determined that representations and warranties were untrue in any way (indemnification). Stay tuned for follow up blogs on each of these important issues.