This article explores where and how the purchase agreement fits into the M&A process and what to look out for in the draft. Once the buyer signs off on a satisfying due diligence, the purchase agreement can be signed before or at the closing, which can be conducted virtually or in person.
Naturally, both parties push for concessions when they’re in the greatest positions of power and seek to limit concessions when they’re weaker. The seller has the greatest leverage early in the process when they’re free to negotiate with multiple parties. But, once the LOI is signed, sellers are limited to exclusively negotiating with one buyer, assuming the LOI contains a “no-shop” clause, which most do.
The following are the general steps to a purchase agreement and beyond.
A buyer has limited information on a company before signing a non-disclosure agreement (NDA). Once a buyer signs an NDA, they’re granted access to the seller’s Confidential Information Memorandum (CIM).
Once a buyer is prepared to make an offer, they’ll submit a letter of intent. Most sellers are in a rush to sign the LOI and move on with the transaction, but the process from signing the LOI to closing can take several months or more, and less than half of deals make it all the way. Caution is advised. The LOI contains critical provisions that govern the dynamics of the relationship between the parties all the way to closing.
It’s helpful if your attorney has access to the M&A Deal Points Studies, published by the American Bar Association, to help you explore what’s customary for a transaction of your size and type. If an M&A advisor suspects that certain issues may become contentious, they’ll work to negotiate language that addresses these issues upfront.
The scope of due diligence is driven by the type and size of the business and the outcome will determine the scope of the protections afforded to the buyer in the purchase agreement.
The buyer’s due diligence may be less thorough if the seller is willing to provide more extensive reps and warranties in the purchase agreement. However, reps and warranties shouldn’t be viewed as a substitute for thorough due diligence, or vice versa. The two should work hand in hand.
The parties should bear in mind that due diligence will never uncover every problem in a business. It should also be mutual, performed on the seller and the buyer, especially if the seller is carrying a note or accepting the buyer’s stock as a form of consideration.
The buyer’s attorney normally begins drafting the purchase agreement once due diligence begins. If it’s heavily weighted in the buyer’s favor, expect negotiations to be contentious and lengthy, while a “fair” first draft is more likely to speed up the process and lead to smoother negotiations.
The buyer’s first draft of the purchase agreement also functions as a disclosure tool. If the buyer is unsure about any aspects of the business, a representation covering that point will force the seller to disclose any exceptions related to the representation. The purchase agreement can also be seen as a tool for allocating risk between buyer and seller.
Covenants are promises to do something (positive covenant) or not to do something (negative covenant). In a purchase agreement, covenants define the obligations of the parties between signing and closing, and sometimes after. The most significant covenant requires the seller to operate the business as usual before closing and not make any material changes to the business before closing without the buyer’s approval.
Pre-closing covenants are necessary only if the purchase agreement is signed before the closing. In this situation, the pre-closing covenants define how the business will be operated during the period between signing the purchase agreement and closing.
Pre-closing covenants often call for the parties to use their best efforts to obtain the required consents to close, to provide information for due diligence, or to preclude the seller from negotiating with other parties. Post-closing covenants often require the buyer to offer employment to a certain number of the seller’s employees or assist in collecting accounts receivable.
Conditions are requirements that must be met before the parties are obligated to close on the deal and are included in a purchase agreement if it’s signed before the closing. Once the conditions are met, the closing can occur. Conditions are also commonly called contingencies, and the Conditions section is sometimes called Termination.
A breach of a condition relieves the parties from the obligation to close and is unlikely to provide options for the parties to initiate a lawsuit, whereas a breach of a representation or warranty provides multiple remedies as outlined in the Indemnification Section.
The sole remedy for a breach of a condition in most cases is simply the right to walk away from the deal, also called a termination right. While termination fees are common in M&A deals involving publicly traded firms, they’re rare in the middle market where the rules are very different.
One important condition to closing is for the reps and warranties to be materially accurate. While unknowns are common in M&A, the parties must continue marching toward the finish line. Completing a middle-market M&A transaction requires a good deal of faith on both sides, and not every potentiality can be neatly buttoned up in the agreements.
A bring-down condition requires the parties to reaffirm the reps and warranties at the closing. Normally, both the buyer and seller are required to deliver a bring-down certificate to one another at closing. A bring-down is necessary only if there’s a delay between signing the purchase agreement and closing.
In other words, the reps and warranties must not only be true as of the date the purchase agreement is signed, but they must remain true in all material aspects from the time the purchase agreement was signed through the closing.
The purchase agreement sets a date for completing the transaction, the process known as the closing. Before the closing date, the seller and the buyer should resolve any remaining contingencies.
The purchase agreement is sometimes signed before closing occurs, but a change in possession of the business isn’t official until closing, when the bill of sale is signed and delivered to the buyer in the case of an asset sale, or when the stock certificates are signed in the case of a stock sale.
On the closing date, the seller and buyer may physically meet around a table, where the buyer delivers the final payment and the seller signs and delivers the closing documents. Alternatively, the closing may be virtual, where the parties sign the documents electronically or via FedEx. Once the closing conditions have been satisfied, the closing can occur.
In most cases, the closing is uneventful and anticlimactic. The more forgettable and humdrum, the better. All problems should have been worked out well in advance.
Once the closing has occurred, the parties have a vested interest in working together to complete the transition period. They’re also contractually obligated to fulfill their post-closing covenants if applicable. Both parties should also be motivated to ensure the reps and warranties remain true after the closing.
It’s tempting to put the champagne on ice when you receive a letter of intent. But wait. There are several hurdles to jump through before the sale of your business can be officially closed.
The groundwork for a successful closing happened months ago, in a well-drafted letter of intent and a frank and open due diligence. Now it’s time to pull the deal together with a purchase agreement that meets your and the buyer’s needs.
This article explores how to get to the closing with minimal disruption, which conditions and covenants keep the buyer and seller on track, and what to expect on closing day.
Here’s a description of the process from signing the NDA to closing:
Step 1: Sign the NDA – The buyer signs an NDA to receive further information about your business.
Step 2: Sign the Letter of Intent (LOI) – The buyer and seller sign the LOI, which is usually non-binding.
Step 3: Conduct Due Diligence – Due diligence begins when the LOI is accepted and typically lasts 30-60 days.
Step 4: Prepare the Purchase Agreement – The parties’ attorneys draft the purchase agreement. Negotiating the terms often takes several weeks.
Step 5: The Bring-Down – If there’s a delay between signing the purchase agreement and closing, the bring-down requires both parties to reaffirm the reps and warranties at closing.
Step 6: Closing – The closing is conducted virtually or via a round table. The purchase agreement is signed before the closing or at the meeting itself.
Step 7: Post-Closing – The parties now work together to ensure a successful transition, satisfy their obligations, and make sure the reps and warranties remain true.
When buying or selling a business, it’s important to understand the shifting positions of power between buyer and seller. Naturally, both parties push for concessions when they’re in the greatest positions of power and seek to limit concessions when weaker.
The seller has the greatest leverage early in the process before an LOI is signed, when they’re free to negotiate with multiple parties. Once it’s signed, the seller is limited to exclusively negotiating with one buyer, assuming the LOI contains a “no-shop” clause, which most do. This obligation dramatically reduces the seller’s leverage from the LOI until the closing.
Let’s examine the steps that lead to a purchase agreement and the power dynamic that develops throughout.
A buyer has limited information on a company before signing a non-disclosure agreement (NDA).
Once a buyer signs an NDA, they’re granted access to the seller’s Confidential Information Memorandum (CIM).
Most NDAs include a clause that limits the seller’s representations to those explicitly outlined in the purchase agreement. Other clauses may address the reliability of the information the seller provides to the buyer and may limit specific representations to those contained in a purchase agreement. Such as:
“You understand that the Seller has included in the Confidential Information materials which the Company believes to be reliable for the purpose of your evaluation, but you acknowledge that neither the Company nor any of its respective agents, representatives, or employees make any representation or warranty, either express or implied, as to the accuracy or completeness of the information. The only representations or warranties for which the Company is responsible are those set forth in any definitive acquisition that the Company may execute.“
Once a buyer is prepared to make an offer, they’ll submit a letter of intent (LOI).
Most sellers are in a rush to sign the LOI and move on with the deal. “Just a few more yards to go,” they think. Not so fast. When accepting an LOI, you’re still on your 30-yard line, and most sellers are woefully unprepared for just how grueling the remaining 70 yards can be. The process from signing the LOI to closing can take several months and less than half of transactions make it all the way.
This is the most critical stage of the process for the seller. Unfortunately, many are in such a hurry to sign the LOI they overlook crucial terms once they agree on a price. But those are the very provisions that govern the dynamics of the relationship between the parties all the way to the closing.
In most cases, the majority of the terms in the LOI are non-binding, except for a few, such as confidentiality and exclusivity. Most LOIs state that the parties will begin preparing the purchase agreement within a certain time frame, and that it will contain rep and warranties, covenants, and indemnification obligations customary for a transaction of its size and type.
The majority of the terms in the LOI are non-binding, except for confidentiality and exclusivity.
The LOI never includes the full scope of the clauses to be included in the purchase agreement, although the parties may choose to include potentially contentious ones in an attempt to avoid deal breakers later on. It’s helpful if your attorney has access to the M&A Deal Points Studies, published by the American Bar Association, to help you explore what’s considered customary for a transaction of your size and type.
It’s best to negotiate contentious issues during the LOI stage, not later in the deal. If an M&A advisor suspects that certain issues may cause disagreement, they’ll work to negotiate comprehensive language that addresses them before the LOI is signed. It’s better to risk losing the buyer now than to spend tens of thousands of dollars and several months negotiating only to be hit with a last-minute deal-killer.
If these issues are sat on until later, the buyer will have significant negotiating leverage over the seller, and it’s likely the seller will simply cave to the buyer’s demands, even if they’re unreasonable.
Here’s an example of language that may be included in the LOI to address the purchase agreement:
“The Purchaser will prepare and deliver to the Seller within 10 days of the conclusion of the Purchaser’s Due Diligence Review a definitive Purchase Agreement (the “Purchase Agreement”). The Purchase Agreement will contain terms and conditions customary in transactions of this type (including standard representations, warranties, covenants, and indemnifications), or which are reasonably necessary as a result of the Due Diligence Review. Representations regarding the Company will, for most items, survive closing for three years, and for other items, including without limitation environmental, taxes, ERISA, and title, the survival shall be for longer periods (and in some cases indefinite).“
The outcome of due diligence determines the scope of the protections afforded to the buyer in the purchase agreement. The extent of due diligence also depends on the scope of the representations and warranties (reps and warranties) the seller is willing to provide.
The buyer’s due diligence may be less thorough if the seller is willing to provide more extensive reps and warranties in the purchase agreement, but these shouldn’t be viewed as a substitute for thorough due diligence or vice versa. The two should work hand in hand.
Also, bear in mind that due diligence will never uncover every problem in a business. There’s always the possibility that something may slip through the cracks. Buyers rely on reps and warranties to offer them protection for issues they may not uncover.
Reps and warranties shouldn’t be viewed as a substitute for thorough due diligence or vice versa. The two should work hand in hand.
The scope of due diligence is driven by the type and size of the business. So are the protections the buyer proposes in the purchase agreement. An industrial business will require an entirely different due diligence process from a technology business, with still a different process for a chain of retail stores. Regardless, due diligence and the purchase agreement should be consistent and work in concert.
Due diligence should also be mutual, performed on the seller and the buyer, especially if the seller is carrying a note or accepting the buyer’s stock as a form of consideration.
The buyer’s attorney normally begins drafting the purchase agreement once due diligence begins. Because it’s customary for the buyer to prepare it, their first draft sets the tone of the negotiations. If it’s heavily weighted in the buyer’s favor, expect negotiations to be contentious and lengthy, while a “fair” first draft is more likely to speed up the process and make for smoother negotiations.
The buyer’s first draft of the purchase agreement also functions as a disclosure tool. If the buyer is unsure about any aspect of the business, a representation covering that point will force the seller to disclose any exceptions.
The purchase agreement can also be seen as a tool for allocating risk between the buyer and seller. Ultimately, negotiations boil down to who is willing to bear the risk of certain elements of the transaction, especially the unknowns.
For example, the buyer may ask the seller to represent that all equipment is in good working order. The seller may not know whether that’s true if they’re not on the front lines, but the purpose of this representation is that the seller bears the risk of any issues that weren’t disclosed about the equipment.
Some sellers may also attempt to control the pace of the negotiations by withholding the disclosure schedules until the last minute. This strategy can work either way – in the seller’s favor or against – and should be carefully considered before implementing.
Covenants are promises to do something (positive covenant) or not to do something (negative covenant). In a purchase agreement, covenants define the obligations of the parties between signing and closing, and sometimes after.
The most significant covenant requires the seller to operate the business as usual prior to closing. This requires the seller to not make any material changes to the business before closing without the buyer’s approval. Such changes could include purchasing new equipment, hiring staff, or changing compensation arrangements with employees.
Here’s an example of language for a covenant about maintaining normal operations:
“Until closing, Seller will operate the business in the normal manner and will use their best efforts to maintain the goodwill of suppliers, customers, the landlord, and others having business relationships with Seller.“
Pre-closing covenants are necessary only if the purchase agreement is signed prior to the closing. In this situation, the pre-closing covenants define how the business will be operated in the period between signing and closing.
Covenants are promises to do something (positive covenant) or not to do something (negative covenant).
If signing and closing occur simultaneously, then pre-closing covenants are usually unnecessary. They often require the parties to use their best efforts to obtain the required consents to close, to provide information for due diligence, or to preclude the seller from negotiating with other parties.
Post-closing covenants may also require the buyer to offer employment to a certain number of the seller’s employees and provide certain benefits, or may require the seller to assist in collecting any outstanding accounts receivable. The only covenants that survive the closing are post-closing covenants.
Conditions are requirements that must be met before the parties are obligated to close on the deal, and are included in a purchase agreement if it’s signed before the closing. Once the conditions are met, the closing can occur.
Conditions are also commonly called contingencies, and the conditions section is also sometimes called the termination section.
Most sections of the purchase agreement have no further implications once closing has occurred. This is an important distinction for the parties as certain sections, such as the reps and warranties, do survive and continue to be an important element of the agreement for a couple of years after, or for whatever the survival period is (typically 18 to 24 months).
A breach of a condition relieves the parties from the obligation to close. It is unlikely to provide them with the option to initiate a lawsuit, whereas a breach of a rep or warranty gives the parties multiple remedies, as outlined in the Indemnification Section. The remedy for a breach of a condition in most cases is simply the right to walk away from the deal, also called a termination right.
While termination fees are common in M&A deals involving publicly traded firms, they’re rare in the middle market, where the rules are very different.
One important condition to closing is for the reps and warranties to be materially accurate. Thus, each representation functions as a condition to closing. This can be a curveball in terms of timing. An important question is whether the reps and warranties are accurate if the seller discloses an exception in the disclosure schedules.
The second question is what happens if the buyer is aware of a breach before closing but chooses to close despite it. For example, if the seller represents that the inventory is all salable, but the buyer discovers that a portion of the inventory isn’t salable but decides to close anyway, can the buyer close and then later sue the seller for breach of representation?
While the purchase agreement would govern such a scenario, in most situations, the buyer would be contractually precluded from proceeding with the closing and then later suing the seller for a breach of the reps and warranties discovered prior to closing.
Conditions are requirements that must be met before the parties close on the deal. They’re included in a purchase agreement if it’s signed before the closing.
Most sellers prefer that buyers have a right to terminate the transaction only if material inaccuracies exist in the reps and warranties. Buyers prefer broader rights – even for immaterial inaccuracies in the reps and warranties.
The closing is also conditioned on the covenants. If the seller doesn’t operate the business in the ordinary way, the buyer may have a walk-away right.
Here are some examples of conditions to the parties’ obligation to close:
Following is an example of language that requires that the reps and warranties be true as of the closing:
“The representations and warranties of the Seller and the Shareholders contained herein or in any Schedule attached hereto shall be true and correct in all material respects at and as of the Closing Date as if made at and as of such time.”
If something happens to the business between signing and closing, such as a condition is breached, the simple, affordable answer is to “refer to the purchase agreement.” The complicated, or expensive answer, and the one most favored by attorneys, is “it depends.”
If something happens to the business between signing and closing, the simple answer is to “refer to the purchase agreement.” Most attorneys will say, “it depends.”
If the purchase agreement has been signed – and most aren’t signed before the closing – then it will govern the buyer’s obligation to close, particularly the “conditions precedent to closing.” Most purchase agreements include a material adverse change/effect (MAC/MAE) clause, which outlines conditions under which the buyer may terminate the agreement.
The MAC clause exists to shift risk to the seller for significant downturns, or other calamitous events, that may impact the business between signing and closing. In a nutshell, the buyer won’t be obligated to close if any covenants have been breached, the conditions for closing haven’t been met, or the reps and warranties are untrue as of the closing.
The seller should inform the buyer as soon as possible if an event has occurred that makes a representation untrue, leading to a breach. Examples include the loss of a major customer or the filing of a lawsuit.
Some purchase agreements obligate the buyer to immediately notify the seller if they discover a breach and require them to terminate or waive the breach and proceed. Without such an obligation, the buyer could withhold this information and unload it on the seller at the last minute as a negotiating tactic.
The following is example language that covers notification:
“The Seller shall promptly notify the Buyer in writing of any change in facts and circumstances that could render any of the representations and warranties made herein by the Seller materially inaccurate or misleading.“
The following is an example of termination language for the seller:
“This Agreement may be terminated at any time prior to the Closing, by the Seller, if the Buyer (i) fails to perform in any material respect any of its agreements contained herein required to be performed by it on or prior to the Closing Date, (ii) materially breaches any of its representations, warranties, or covenants contained herein, which failure or breach is not cured within 30 days after the Seller has notified the Buyer of its intent to terminate this agreement.“
While unknowns are common in M&A, the parties must continue marching toward the finish line. Completing a middle-market deal requires a plenty of faith on both sides and not every potentiality can be neatly buttoned-up in the agreements.
Trying to document every eventuality will only slow the transaction and make closing less likely. Time kills all deals. Either you waste it bickering over minutiae, or you aim to close, balancing the need for documentation and good faith. An experienced advisor can provide guidance on when to proceed based on faith, and when faith is best put into writing.
Unknowns are common in M&A. Completing a middle-market deal requires a plenty of faith on both sides and not every potentiality can be buttoned-up.
Here’s the bottom line – let your attorney do what they do best while you focus on running your business. Keep your hands on the steering wheel while your attorney tinkers with the technicalities.
A bring-down condition requires the parties to reaffirm the reps and warranties at the closing. In other words, the reps and warranties must not only be true as of the date the purchase agreement is signed, but they must remain true in all material aspects from the time the purchase agreement is signed through handing ownership to the buyer.
A bring-down is necessary only if there’s a delay between signing the purchase agreement and closing. Normally, both the buyer and seller are required to deliver a bring-down certificate to one another.
If there’s been a material change in the reps and warranties, and the purchase agreement contains a condition that the reps and warranties are true as of the closing date, then the buyer may terminate the transaction. The purpose of the bring-down condition is to shift the risk of operating the business prior to closing to the seller.
The buyer seeks assurance that the company they’re agreeing to purchase will be materially the “same” company at closing. To address materiality, a bring-down condition may include its own materiality limitations, separate from indemnification limitations. The materiality limitation may be expressed as an actual number or, more likely, qualitatively, such as:
“… except for such inaccuracies that do not and would not reasonably be expected to have, individually or in the aggregate, a material adverse effect.“
Here’s a sample clause that addresses materiality:
“Each of the Fundamental Representations and Warranties of the Target contained in this Agreement shall be true and correct in all respects, except, in the case of the representations and warranties in Section X, where failure to be true and correct would not result in an increase in the aggregate amount of consideration required to be paid by Buyer under Article X of this Agreement by more than $100,000.”
In most cases, the reps and warranties must be materially true on an aggregate basis before the closing can occur.
Materiality can be evaluated either on an individual or a collective basis. In most cases, the reps and warranties must be materially true on an aggregate basis before the closing can occur, because several immaterial inaccuracies may constitute materiality when aggregation is applied. The following language covers both:
“Each of the representations and warranties of the Sellers contained in this Agreement shall be true and correct in all respects (without giving effect to any limitation as to “materiality” or any derivative thereof or qualification set forth therein) as of the date hereof and as of the Closing Date, as though made on the Closing Date, except for any failures to be so true and correct that, individually or in the aggregate, have not had or would not have a material adverse effect.“
Is your head spinning yet? If so, that’s good. This should serve as a wake-up call to rely on the guidance, experience, judgment, and objectivity of an experienced M&A attorney in such negotiations. While you should understand the high-level mechanics of the transaction, materiality is a perfect example of the issues you should leave to your attorneys to sort out. Imagine trying to make sense of this in the whirlwind of one of the largest, most emotionally draining transactions of your life.
The degree to which inaccuracies arise in the reps and warranties is subjective, regardless of the effort your attorney puts into nailing down the language. There is a degree of uncertainty when selling or buying any company and the only antidote is faith. Even if you lack absolute faith in the other party, you should proceed with a degree of trust and willingness to move forward and be willing to accept a certain amount of risk.
The purchase agreement sets a date for completing the transaction, known as the closing. Before the closing occurs, the seller and the buyer should resolve any remaining contingencies. Once these have been satisfied, the deal may be officially closed.
The purchase agreement is sometimes signed before closing occurs. However, a change of possession of the business doesn’t occur until the last day, when the bill of sale is signed and delivered to the buyer in the case of an asset sale, or when the stock certificates are signed in the case of a stock sale.
If the purchase agreement is signed before closing, contingencies may remain, such as denial of approval by key third parties, including the lender, lessor, franchisor, or licensor. The sale is canceled if these contingencies are not satisfied before closing or before the expiration of the definitive purchase agreement (DPA).
On closing day, the seller and buyer may physically meet around a table, where the buyer delivers the final payment and the seller signs and delivers the closing documents. Alternatively, they may sign the documents electronically or via FedEx. Most closings these days are virtual, with the documents sent electronically or by next-day delivery.
In most cases, the closing is uneventful – a routine and anticlimactic affair. The more forgettable and humdrum, the better. All problems should have been worked out well in advance.
Once the closing has occurred, the parties have a vested interest in working with one another to complete the transition period. They’re also contractually obligated to fulfill their post-closing covenants, if applicable. They should also be motivated to ensure the reps and warranties remain true after the closing.
For example, the seller may have represented that the receivables are collectible. If that’s the case, the seller should assist the buyer in collecting the receivables after the closing. This means they’re incentivized to ensure the transition progresses as smoothly as possible.
For the seller, the real closing hasn’t transpired until the following:
Closing is an uneventful, routine, and anticlimactic affair. The more forgettable and humdrum, the better.
While the seller may have reason to rejoice at the closing, they shouldn’t get too caught up in the celebrations. They shouldn’t fully “let go” until the events listed above are dealt with.
Closing on the sale of your business is a story of paradoxes. You’re so close to the finish line but you’ve a long way to go. Conditions and covenants must be met but trust ultimately prevails. It’s one of the most significant moments of your professional career but it shouldn’t be memorable at all.
And when is it over? When you’ve signed the purchase agreement? When the transition period is complete? When all of the buyer’s payment has turned into cash?
There won’t be a defining moment, but one day you’ll wake up and realize you’ve completed all of your obligations. When that happens – congratulations! The biggest deal of your life is behind you.
