If you are considering selling your business, getting familiar with the key aspects of a purchase agreement is important. A purchase agreement is the document that governs the legal aspects of an M&A transaction. The document is lengthy, with legal language that can seem unfamiliar and complex. At its core, the purchase agreement provides information such as purchase price, what is being sold, the guarantees that are made, and consequences for potential risks occurring.
Salient terms in the purchase agreement and their meaning are outlined below.
1. Definitions
The definitions are key words and terms that are used in the purchase agreement in a formal manner and convey an agreed upon meaning between the buyer and seller. Each defined term appears capitalized throughout the document.
2. Purchase Price and any Adjustments
The purchase price is the base figure, but it will be adjusted according to typical convention by adding closing cash, subtracting closing debt, and adjusting for working capital (which may be positive or negative). Additionally, the net cash received will be reduced by any rollover equity reinvested into the business or any earn-outs that are predicated upon future performance and could be paid out at a future date. The benefit of hiring an M&A lawyer and an investment banker is how they will work with the seller to negotiate the adjustments and structure in a seller-friendly manner.
3. Representations and Warranties
One of the most consequential elements of the purchase agreement is the section with representations (“reps”) and warranties. To protect the buyer from undisclosed risks, the seller states the legally binding certainties of the business (the reps) and guarantees their accuracy (warranties). If any of the reps end up not being true, it may be valid for the buyer to seek compensation. There are two main types of reps – general and fundamental. General reps deal with operational matters such as tax, environmental, IP, and employee benefits. These reps typically have a capped liability and survive 12-18 months. On the other hand, fundamental reps relate to topics that would call off the deal if false. There is often no cap, and the survival period is several years, if not indefinite. For sellers, it is paramount to be accurate when making the reps and related disclosures.
4. Indemnification
A critical element of the purchase agreement is the indemnification section that details the recourse a party may have if something goes wrong after the deal closes. Specifically, the indemnification section states the amount the breaching party needs to compensate the other party for costs relating to the breach. A breach can relate to reps, warranties, and covenants as examples. Both parties negotiate the limits of the potential damages in terms of dollar value and survival period. Sellers typically deposit a portion of their proceeds in an escrow to compensate buyers for potential losses.
Representations and warranties insurance (RWI) policies have become increasingly common in M&A transactions. The intent of the policy is to transfer the risk from the seller to the insurance company. The coverage can be customized by each deal to account for specific concerns that arose during due diligence.
5. Covenants
Within the purchase agreement, there are agreements regarding actions the parties will either take (affirmative covenants) or not take (negative or restrictive covenants). The time period for these covenants can either be effective prior to closing or after closing. A couple of examples include non-compete or non-solicit agreements or others relating to business operations. It is important to be reasonable and practical in determining the covenants as they will guide future actions.
6. Conditions to Closing
Buyers typically require certain conditions to be satisfied before closing – or they may walk away from the deal. Some potential conditions to closing may include achieving business performance targets, securing regulatory approvals, obtaining third-party consents, and that no material adverse changes occur prior to closing.
7. Terminations
When the purchase agreement is signed prior to closing – which is common – there are termination provisions that allow parties to back away from the deal. For example, there may be closing conditions that must be met prior to closing and, if not, the buyer can decide to terminate the deal.
In Summary
The purchase agreement is one of the most consequential documents you will ever sign. Working with experienced M&A attorneys and investment bankers is not optional. It is how you navigate the complexity, protect your interest, and maximize your proceeds at closing.
