Chapter 15
Documenting the Final Deal: The Purchase Agreement
In This Chapter
Putting the final purchase agreement together
Examining the parts of a purchase agreement
Looking at important representations, schedules, and exhibits
Concurrent with conducting due diligence (see Chapter 14), Buyer and Seller draft a purchase agreement to memorialize the deal. Although most documents during the M&A process are nonbinding (that is, generally unenforceable in a court of law), the purchase agreement is a final, binding document.
Exciting, isn’t it?
In this chapter, I introduce you to the purchase agreement, what to watch for while writing and reviewing it, and what you should leave to your lawyer.
In most cases, the purchase agreement passes the baton from the investment banker, who negotiated the business deal, to the lawyer, who settles all the nits and gnats of the legal issues. Find a good attorney; you’re going to have to trust that person!
Drafting the Deal
The purchase agreement is the final, binding contract between Buyer and Seller. In layman’s terms: This is the deal. In written correspondence, the purchase agreement is often referred to as the SPA (stock purchase agreement) or the APA (asset purchase agreement).
The purchase agreement can seem like a large, cumbersome document, but most of the document is boilerplate legalese that’s in most agreements. The following sections give you an overview of the writing and refining process.
Purchase agreements like verbs. For example, you don’t simply write sell or buy. You write sell, convey, assign, transfer and deliver or purchase, acquire and accept. Be prepared for some very long and exacting sentences!
Writing the first draft
Purchase agreements don’t float in the ether, alighting to terra firma after being summoned to memorialize a deal between Buyer and Seller. Instead, someone has to write the darn things! Although both sides contribute to writing the document, someone has to provide the first draft; conventionally, that’s the Buyer, but in reality, either side can write the first draft of the purchase agreement.
In other words, Sellers shouldn’t feel compelled to wait for Buyers to provide a draft of the purchase agreement. As with most legal documents, the side that writes the agreement usually has a leg up on the other side. In fact, you may want to have a draft of a purchase agreement written well in advance of signing a letter of intent (LOI — see Chapter 13). That way, your side can quickly claim the high ground by submitting the initial draft, and you cut down on how much you have to wade through someone else’s work.
See, the side who writes the first draft sometimes (but not always) writes an incredibly one-sided document that the other side needs to spend an inordinate amount of time fixing, tweaking, and adjusting. That is, lawyers spend that time fixing, tweaking, and adjusting, and lawyers don’t work for free (or even cheap). Submitting a draft that’s fair and reasonable can help cut down on how long the refining process takes (see the following section) and reduce the associated legal fees.
Although I encourage Sellers to submit a draft, a highly motivated Seller may be wise to agree to use the Buyer’s draft if the Buyer balks at the Seller’s draft. In this case, the Seller needs to get the deal done and isn’t in much of a position to try to force the Buyer’s hand.
Redlining the initial draft
No matter who provides the initial draft, the next step in the writing process is something I call redline ping pong, where both sides send marked up (or redlined) versions of the purchase agreement back and forth as the lawyers work through as many issues as possible.
Keep an ear out for the term turns, which also describes the process of sending a redlined draft to the other side. You may hear something like “When will we see your turn of the purchase agreement?” in conversation with the other side.
Amazingly enough, redline ping pong often allows the lawyers to settle many of the legal issues in a purchase agreement. However, the lawyers invariably end up at loggerheads on certain issues, usually of the business variety; at this point, the deal-makers (investment bankers) need to reconnect to settle those remaining issues.
Don’t let the lawyers play redline ping pong too much. Stay on top of their process; after you clearly see that they’re unable to settle an issue, make sure the deal-makers speak or meet to settle the remaining open issues.
Navigating the Final Purchase Agreement
Purchase agreements are lengthy, detailed documents that can make your eyes bleed if you don’t know how to read one properly. Seriously. They’re dreadful.
Joking aside, knowing how to read a purchase agreement is as important as what’s in the purchase agreement. It’s a two-step process:
1. Review the document to make sure it accurately represents the main (and major) facets of the deal.
2. Take a deeper dive into the minutiae of the document.
For that in-depth review, you may want to rely on your attorney.
Defer to your lawyer for matters concerning legal issues. Most purchase agreements contain legal boilerplate that doesn’t differ much from one document to the next. You need to pay attention to this legalese, of course, but leave it to your lawyer to deal with it.
When first reviewing the document, deal-makers should focus on the key, very specific areas in the agreement. Because you’ve already negotiated these aspects, you’re making sure the agreement conforms to those negotiations. These main points are
Purchase price: This point includes any conditions to the Seller getting the full purchase price. Does the Seller have to jump through any hoops to get her dough — in other words, does the deal include contingent payments such as a note, earn-out, and so on? Check out Chapter 12 for more on these structuring options.
What’s being sold: Confirm that the purchase agreement adheres to the deal type (stock or asset) that you’ve negotiated. I explain these deal types more in the later section “Determine what’s being sold, for how much, and when.”
Escrow: The agreement lays out the amount of escrow, how long that money stays in escrow, and what the Seller needs to do (or not have happen) to obtain that money.
Cash at closing: This figure is the actual amount the Seller receives in cash after escrow, debt, advisor fees, and taxes come out of the purchase price.
Post-closing adjustments: Post-closing adjustments (see Chapter 17) are usually relatively straightforward. However, the mechanisms for delivering a post-closing balance sheet (in order to calculate those adjustments), the ability to dispute, and what happens if Buyer fails to deliver necessary information to Seller after close can take multiple paragraphs or even pages, so be sure to review them carefully. If you’re a Seller, consult with your attorney!
That’s it! Those are the main issues you should be initially concerned with as you make your first review of the purchase agreement. These are the big issues, but they aren’t the only issues.
Some M&A deals involve transactions outside the scope the purchase agreement. If the Buyer is assuming some or all of the Seller’s debt, is also buying real estate the Seller owns, or is taking over leases from the Seller, those transactions involve other agreements. However, the purchase agreement itself may mention or refer to them.
The following sections outline the highlights of a typical purchase agreement. These agreements often run 50 to 100 pages and up; I’m covering them in a far shorter span than that, so buckle up!
Confirm the name, rank, and serial number of the deal
I call this part, which is usually toward the beginning of the document, the “whereas” section because most paragraphs start with the word whereas. This preamble sets the tone for the rest of the document. Here are a few items to verify:
Legal names and addresses of the entities (Buyer and Seller) are correct.
Deal is either clearly defined as an asset sale or a stock sale.
If it’s a stock sale, make sure the share information (number of shares issued, outstanding, and authorized) is correct.
Definition of the business is accurate.
Intents of Buyer and Seller are clearly stated — Buyer desires to buy, and Seller desires to sell.
Determine what’s being sold, for how much, and when
The purchase agreement also very clearly defines what is being sold: the company’s stock or the company’s assets. Sellers usually prefer stock deals because of tax reasons. Buyers typically prefer to buy assets because assets can help reduce the worries of successor liabilities, or problems caused by the Seller (such as wrongful termination lawsuits) that may pop up after the deal closes. The agreement should also specify the purchase price, the structure of that price (cash, notes, stock, earn-out, and so on), and the amount that goes into escrow.
This section also details the anticipated closing date and location. Usually, the closing occurs in the lawyers’ offices. In the old days, the closing took place in a specific office, but because of today’s technology, most closings are virtual closings conducted via e-mail, fax, and phone. See Chapter 16 for more on closing.
Know what to bring to the closing
The purchase agreement defines certain items the Buyer and Seller may need to physically bring to the closing (or deliver ahead of time, if the closing is virtual as I describe in the preceding section).
Seller’s deliveries may include
Stock certificates or other documents providing evidence Seller actually owns what she’s selling
Resignations of any or all officers or board members, if Buyer requires that info
Stock books, ledgers, minute books, other corporate records, and corporate seals
Documentation that Seller has complied with all conditions required by the purchase agreement
The company’s articles of incorporation and bylaws
Written documentation that all outstanding options, warrants, or other instruments that can claim ownership in Seller have been extinguished or exercised prior to closing
Written opinions from Seller’s lawyers that all the necessary legal documents are in order
Signatures from both parties for the escrow agreement, confidentiality agreements, noncompetition and non-solicitation agreements, and employment agreements
A closing financial statement (generally as of the close of business from the previous day)
Buyer’s deliveries may involve the following:
The money! This delivery is the single most important one (at least in the eyes of Seller). Buyer brings the money in the form of a wire transfer, not a check.
Some sort of documentation, signed by an authorized officer, that Buyer has performed all necessary due diligence
Approvals by Buyer’s board of directors
Legal opinion by Buyer’s attorney
Signed counterparts to various agreements, including the escrow agreement, noncompetition and non-solicitation agreements, employment agreements, confidentiality agreements, leases, and any other agreement between Buyer and Seller
Review the representations and warranties
The purchase agreement spends an inordinate amount of space dealing with the issue of representations and warranties, or reps and warranties for short. Reps and warranties are basically promises and fall into three camps: promises the Seller makes, promises the Buyer makes, and promises both sides make. These guarantees tend to be pretty similarly worded from deal to deal; in fact, many lawyers simply use the language from an earlier agreement they worked on!
In most deals, the reps and warranties are far more onerous for the Seller than for the Buyer. Seller, prepare thyself for a slew of schedules and tables and a huge amount of work!
You can provide representations and warranties on the past (in other words, on known events). Don’t provide reps and warranties on the future (unknown events). For example, a Seller can provide a representation that the books are accurate but shouldn’t offer a representation that her largest customer will still be the largest customer in one year.
Seller’s reps and warranties
The Seller typically provides the Buyer with a bevy of representations and warranties to proclaim that everything that she says (or represents) about the company in the purchase agreement is true to the best of her knowledge.
The gist of all these promises is that Seller has run the company in the normal course of business (that is, a clothing distributor suddenly hasn’t entered the music business), that she has the right to sell the business, that the company hasn’t experienced any adverse material changes since the LOI was signed, and that she’s being completely truthful — Buyer won’t discover any unpleasant surprises after the deal closes.
Representations and warranties, although full of legalese, should be taken very seriously. These representations will come back and haunt Seller if she lied or misrepresented any of them. In that case, Buyer has recourse to be reimbursed from the money in escrow and possibly through a lawsuit against Seller.
In an actual purchase agreement, each bullet consists of a lengthy paragraph chock-full of legalese. In brief, these promises can include
Seller is the owner of the shares or assets and that those shares or assets are free from liens.
Seller has the authority to legally sell those shares or assets.
The sale of the assets or stock doesn’t violate or conflict with any laws, rules, or regulations of any governmental authority.
The company is a corporation duly organized, validly existing, and in good standing.
The company has full corporate power, legal right, and corporate authority to execute and deliver this agreement.
Change of control will not trigger some sort of material change, such as an agreement with a major customer that allows the customer to cancel an important contract.
Seller represents the capitalization of the company — that is, how many shares are authorized, issued, and outstanding and any other specific details about that stock. Details on the capitalization may be included on a schedule.
No options, warrants, or other agreements pertaining to a claim of the company’s ownership are outstanding.
The company has filed all required tax returns, and no taxing authority has any liens against the assets of the company.
Seller has made all corporate documentations (articles of incorporation, bylaws, and so on) available to Buyer.
The company has full corporate power, legal right, and corporate authority to operate its business.
Seller has provided a complete list of all arrangements, contracts, and agreements between the company and other parties to the Buyer. This information is usually in the form a schedule.
Seller doesn’t need the approval of a domestic or foreign governmental authority to execute the transaction. If Seller does need any approvals, she lists them in a schedule.
Seller actually owns all of the property and assets being sold.
Any property involved in the deal has no pending condemnation proceedings, lawsuits, or administrative actions relating to it.
The company has filed all required tax returns under applicable laws and regulations.
Seller has withheld or paid all taxes.
No tax problems with any governmental entity exist. Details of any issues that do exist appear in a schedule.
Seller represents that financial statements (balance sheet, income statement, and cash flow statement) from the most recent year-end, often audited by an accounting firm, are accurate.
Seller has provided the closing date balance sheet, and that document fairly presents in all material respects the financial condition of the company as of the closing date.
The company has performed appropriate procedures to ensure the year-to-date financials are accurate and correct.
Seller has presented Buyer with a list of all material contracts, including credit and loan agreements, mortgages, leases, collective bargaining agreements, employment agreements, severance plans, employee benefit plans, and supplier and vendor agreements.
Seller has provided Buyer with a listing of all bank accounts, certificates of deposit, safe deposit boxes, and credit cards issued to employees.
Seller doesn’t know of any litigation or pending litigation involving the company.
Seller has presented Buyer with a schedule containing each employee plan, including, but not limited to, bonus; deferred compensation; incentive compensation; stock purchase; stock option; severance pay; medical, life, or other insurance; profit-sharing; and 401(k), pension, or retirement plans.
All employee benefit plans have been operated and administered in accordance with the plans’ terms.
Seller knows of no labor problems (strikes, slowdowns, lockouts, work stoppages, and so on).
The company is in compliance with the requirements of the Worker Adjustment and Retraining Notification Act (WARN) and is in compliance with the Occupational Safety and Health Act of 1970 (OSHA).
Seller has provided all patents, patent applications, trademarks, trademark applications, trade names, service marks, service mark applications, customer lists, copyrights, and copyright applications to Buyer.
The company owns all intellectual property it’s selling to Buyer.
All computer software and proprietary databases owned or licensed by the company are paid for or owned by the company.
The company takes reasonable measures to protect the confidentiality of trade secrets and proprietary data (including any customer lists and record of financial information constituting a trade secret).
Seller has provided all environmental reports and permits to Buyer.
The company is in compliance with environmental laws.
The company hasn’t received written notice that the company is in violation of the requirements of any environmental law or the subject of any lawsuit arising from any environmental law.
The company hasn’t transported, stored, or disposed of any hazardous material.
Seller has given a listing of all insurance policies to Buyer.
All insurance policies are legal, valid, binding, and enforceable.
Inventory is usable and saleable.
The company isn’t in possession of any inventory it doesn’t own.
Seller is responsible for paying any intermediaries she hires during the sale.
Seller has provided Buyer with a complete list of all accounts receivable.
The company doesn’t have any prepayments or deposits from customers for products to be shipped or services to be performed after the closing date.
No officer or director of the company (while in the employ of the company) has filed bankruptcy or been convicted of a crime.
Seller has given Buyer a purchase order list (the commitments the company has made to buy from suppliers and vendors).
Seller doesn’t know of any customer who is requesting to buy less than previous levels.
Seller has provided a list of customers and vendors to Buyer.
Buyer’s reps and warranties
Although the Buyer provides far fewer reps and warranties than the Seller, he does still make a few promises:
Buyer represents that his company is a duly organized entity, validly exists, and is in good standing. In other words, Buyer promises that his company is a going-concern.
Buyer has authority and legal right to execute the purchase agreement.
Buyer pays the fees for any intermediary he utilizes during the sale.
Mutual promises between Buyer and Seller
Most purchase agreements have at least a couple of mutual representations and warranties that both sides agree to. These may include
Buyer and Seller agree to refrain from making any public announcement of the deal until after the deal closes.
Buyer and Seller agree on the method to calculate taxes for the pre-closing period.
Both sides take reasonable best efforts to fulfill their obligations of the agreement.
Secure against loss with indemnifications
All the representations and warranties (see the earlier section “Review the representations and warranties”) are meaningless unless one side has some sort of recourse against the other. Indemnification means one side is providing security against a loss for the other side. The term you see in legal documents is hold harmless. One side agrees to hold the other side harmless in the event something happens (or doesn’t happen).
As with the representations and warranties, Seller generally provides Buyer with many more indemnifications than Buyer provides to Seller.
Indemnification is why the Seller usually places some of the proceeds from the sale in an escrow account. In case of a breach of a rep or warranty, the Buyer has recourse to recover damages by obtaining money from escrow.
The purchase agreement defines how long the representations and warranties are in effect. Generally, this period ranges from one to two years.
In addition to time limits, the purchase agreement also spells out the limits on the amount of damages from indemnity. This figure depends on the specifics of your deal, of course. A good rule of thumb is to limit the damages to the amount of money in escrow, but as with all legal issues, speak to your attorney to determine damage limits (as well as indemnity periods) for your deal.
Instead of nickel-and-diming each other with relatively small damage claims, M&A parties often agree not to seek money from each other until the net damages reach a certain amount, called a basket. In other words, if the basket is $100,000, Buyer won’t ask for reimbursement if he suffers $500 in damages from some sort of breach of representation. However, if the net damages reach that $100,000 threshold, Buyer can seek reimbursement from Seller (usually from the escrow money).
Whether you’re buying or selling, don’t agree to a limitless indemnity because you may be on the hook for a limitless amount of money.
Agree on how to handle a rep and warranty breach
The purchase agreement defines the process for one party to pursue a claim against the other. Usually, the process involves submitting a written complaint and trying to settle the issue with the other party. If the parties can’t settle the issue, the agreement lays out how to settle a dispute, often through mediation or the courts. As with most agreements, the specifics depend of the deal, so talk to your legal advisor.
The purchase agreement defines which state’s laws govern the agreement. If the parties fail to agree on which side’s home state to use, Delaware is a good compromise because it’s considered a business-friendly state and even has a separate court system for business issues.
Get acquainted with the exhibits and schedules
As I note earlier in the chapter, purchase agreements are long, and that doesn’t even address the exhibits and schedules. For any given agreement, you may see 50 to 100 exhibits and schedules that run the gamut from the escrow agreement to legal and accounting opinions to employment contacts and a lot more!
Many of these exhibits and schedules are part of Seller’s representations and warranties. The burden of producing these schedules falls on the shoulders of Seller. Flip to the earlier section “Review the representations and warranties” for more detail on those promises.
The following list gives you a partial view only. Depending of the specifics of a deal, a purchase agreement may have more or different schedules than those I list here. Check with your lawyer to see which documents your deal requires; I can’t provide a one-size-fits-all approach.
Escrow agreement
Flow of funds at closing
Adjusted EBITDA calculation table
Real estate leases and deeds
Confidentiality agreements
Noncompetition agreements
Non-solicitation agreements
Employment agreements
Calculation of net working capital
Products in development
Shareholder list
Liens
Owned properties
Rights of use or occupancy arrangements
Real estate options/rights of first refusal
Leased properties
Capital leases
Annual financial statements
Interim financial statements
Closing date balance sheet
Material contracts
Bank accounts
Litigation
Employee benefit plan
Labor relations and employees
Intellectual property lists
Computer software and proprietary databases
Environmental reports, disclosures, and notifications
Storage of hazardous materials
Material changes
Compliance with laws
Insurance policies
Inventory list
Open purchase orders
Brokers and finders agreements
Accounts receivable
Product design
Prepayments and deposits
Change of control obligations
Reimbursable expenses
Open sales orders
Customer order changes
Customers and vendors
Buyer consents and approvals