Mergers and Acquisitions (M&A) in simple terms is the process by which one party buys — whether in whole or in part —someone else’s business. Although M&A can be simply defined, the process is anything but easy. There are dozens of legal implications, seemingly innocuous clauses that can sneak up on even the most careful entrepreneur, and potentially significant sums of money to be made or lost.
This field guide is a five part series and will discuss in detail the five phases of M&A:
- Part One – The Letter of Intent
- Part Two – Due Diligence
- Part Three – The Definitive Agreements
- Part Four – Closing
- Part Five – Post-Closing
Part Three – The Definitive Agreements
Everything thus far has been building up to this moment. Whether you are a buyer or a seller, the time for the substantive legal work on the deal is at hand with the development of the definitive agreements to document the deal. Definitive Agreements is a fancy term that lawyers often use when referring to legal documents. These purpose of these document are to record the terms and conditions agreed to by the parties, via the Letter of Intent and any modifications from the Due Diligence phase. These documents are generally represented by the purchase agreement (as well as the ancillary agreements, instruments, and schedules that come with it) are the final pieces of the puzzle. Once negotiated and fully executed, if all goes well and the closing conditions are met, you’ll be legally bound to close.
Of course, putting the definitive agreements together is no simple task. A good deal of work goes into preparing just the initial drafts to fit the deal before delivering them to the other side for review and negotiation.
The Purchase Agreement
Of all the agreements and documents involved in the M&A process, the purchase agreement is the primary controlling agreement upon which the entire transaction is based. As its name suggests, the purchase agreement sets forth the final terms, provisions, and details for effectuating the deal. Both the buyer and seller have an equally important stake in ensuring that it protects their conflicting interests subject to the risks each party may be willing to take. This goes far beyond merely trying to get the price right — so it pays to understand the finer points of the agreement as well as the entire transaction, including the pre and post-closing risks.
After establishing the parties to the transaction and recitals describing the structure of the transaction, the purchase price and terms for the payment and types of consideration is typically the first set of substantive provisions addressed in the agreement. These are the provisions where the total consideration for the transaction will be detailed, including the amount of cash paid at closing, whether any equity in the purchaser or its affiliate is included as part of the purchase price, whether any amounts are subject to payment over a period of time, whether seller financing is involved, as well as possible earnout payments for additional consideration.Earnouts serve to protect the purchaser post-closing. An earnout is an additional sum of money that the purchaser agrees to pay to the seller if certain objectives are met based on post-closing operations. It’s a way for the purchaser to hedge its risk by paying less at closing, while rewarding the seller if sales or profits, for example, hit certain minimum levels at defined periods after closing.
The purchase agreement will often include target and closing working capital terms and provisions. These provisions outline a minimum amount of capital that must be on-hand upon closing so that the business can continue to operate in its ordinary course after the sale. If actual operating capital at closing is higher than the target closing working capital, the seller can expect to receive an additional amount of funds on top of the purchase price. The converse, however, is also true where the seller can expect a negative adjustment to the funds paid or payable to the seller in the amount that the closing working capital is less than the target. Often, this may be addressed through the purchaser receiving the funds from a closing escrow account or offsetting the negative adjustment against a future payable to the seller such as an earnout.
Other common elements in purchase agreements are accounting principles and dispute resolution clauses as a corollary to the target and closing working capital as well as any earnout provisions. The provisions addressing accounting principles will establish the method of accounting (e.g., GAAP) and other terms by which the parties (or more specifically, the purchaser) will calculate the actual closing working capital. If the seller does not agree with the purchaser’s calculation, typically there will also be provisions specifying the process for resolving the dispute, which often is accomplished through an independent accounting firm identified in the purchase agreement. These same accounting principles and dispute resolution procedures may be used to address calculations with respect to earnouts as well.
The purchase agreement also may establish one or more categories of escrow where a portion of the total consideration or purchase price is placed into escrow with a third party escrow agent-often a commercial bank. However, Purchasers will generally prefer seller holdbacks, which is similar to escrow except that the purchaser gets to hold the funds, not an independent third party escrow agent. Sellers though will resist this alternative as it creates an uphill battle to dispute a claimed breach and subsequent offset against the holdback by the purchaser since the party making the claim and offset (i.e. purchaser) holds the funds.
While escrow provisions may be used to address disparities in the target and actual closing capital, more often it is established to cover a portion of the seller’s indemnity obligations. The amount of an indemnity escrow will vary from deal to deal, typically based on the size of the deal. Calculating an amount as a percentage of the purchase price is not uncommon because both the amount and the length of time of the escrow tend to follow the agreed upon cap on liability for a breach of non-fundamental reps and the period of time the non-fundamental reps survive after closing.
Representations and Warranties
Outside of the total consideration, one of the most critical aspects of the purchase agreement are the representations and warranties. In most cases, the representations and warranties are the largest set of provisions in a purchase agreement making up a substantial portion of the overall document. They consist of a number of comprehensive statements related to the seller, the state of the business or assets being sold, their history, structure, legal compliance and other matters. Most sellers or buyers, glaze over these sections, not realizing the impact these reps and warrants will have on limiting their liability or exposing them to additional liability. If any of these statements turn out to be false, the seller may be subject to liability to the purchaser through indemnity and breach of contract.
Except in small transactions where no distinction is made, representations and warranties usually are broken up into two categories of fundamental (“Fundamental Reps”) and non-fundamental (“Non-Fundamental Reps”). Sometimes, a deal may involve a third category that falls somewhere in between Fundamental Reps and Non-Fundamental Reps. These intermediate representations and warranties tend to have a longer survival period post-closing and greater liability exposure to the seller if breached than Non-Fundamental Reps, but a shorter survival period post-closing and lesser liability exposure to the seller if breached than Fundamental Reps.
Fundamental Reps are characterized as the representations and warranties of the seller that are critical to the purchaser and the deal in general. Fundamental Reps are so important to the deal that the purchaser would not enter into the purchase agreement if it knew that a Fundamental Rep was false. If any of the Fundamental Reps turn out to be false, it could have a significant negative impact on the purchaser and its ability to own and operate the business as intended. Accordingly, Fundamental Reps will have a much longer survival period post-closing and much broader liability for the seller if any are breached such as a liability cap of 100% of the purchase price or no cap at all.
While the Fundamental Reps may have some variations from deal to deal, they generally include affirmation of the following: (1) organization and good standing of the seller and the target entity being sold, if a stock or membership interest sale; (2) authorization of agreement or power and authority of the seller to enter into and consummate the transaction; (3) capitalization or capital structure of the seller or the target entity being sold, if a stock or membership interest sale; (4) subsidiaries of the target entity being sold if a stock or membership interest sale; (5) title to securities in a stock or membership interest sale; (6) title to assets in an asset sale; (7) brokers and finders’ fees if any are involved or otherwise stating that none or no others are involved; and (8) tax matters stating timely filing of all returns and paying all taxes in compliance with applicable laws and regulations.
Non-Fundamental Reps, on the other hand, while still important, are not as critical and tend to have a lower risk of a significant negative impact on the purchaser if any turn out to be false. Accordingly, liability for a breach of Non-Fundamental Reps will typically have a cap that is a percentage of the purchase price such as 10% to 15% for larger deals or 20% or more for smaller deals, but in either case with a much shorter survival period post-closing than Fundamental Reps. The survival periods typically range from six months to two years. Further, the list of possible Non-Fundamental Reps is substantially longer than Fundamental Reps, and may include many or all of the following:
- Conflicts; Consent of Third Parties
- Financial Statements
- Events Subsequent to Most Recent Fiscal Year End
- No Undisclosed Liabilities
- Legal Compliance
- No Illegal or Improper Transactions
- Real Property
- Intellectual Property
- Tangible Assets
- Material Contracts
- Litigation and Claims
- Labor and Employee Matters
- Employee Benefits
- Environmental, Health, and Safety Matters
- Affiliate Transactions
- Bank and Brokerage Accounts
In addition to the indemnity provisions, the representations and warranties are typically the most heavily negotiated sections of the purchase agreement by the parties’ legal counsel. The purchaser will want the seller to make comprehensive representations and warranties about the business or assets it is acquiring to help protect its substantial investment if future unexpected issues arise. Conversely, the seller will want to limit and qualify all of the representations and warranties as much as possible to prevent and avoid future liability after closing. To accomplish this, the seller’s counsel will usually seek to include materiality and knowledge qualifiers that make a possible breach more difficult unless the seller should have known the statement was incorrect or the inaccuracy of the statement must be “material”. Without getting into the possible issues related to what is “material” and what isn’t, the qualifiers have the effect of watering down the representations and warranties of the seller. Yet, even if seller’s counsel successfully negotiates inclusion of a number of qualifiers, the purchaser still has an avenue for expending protections with indemnity “scrapes” that remove the qualifiers for indemnification as discussed below.
If the representations and warranties weren’t enough, developing the corresponding disclosure schedulesis a substantial task but a very important component to the representations and warranties. Disclosure schedules often can quickly turn a 45-page purchase agreement 300 pages or more. But what’s a disclosure schedule exactly? Disclosure schedules are annexes provided as supplements to the representations and warranties (or anything else that requires further elaboration in the purchase agreement). Generally, disclosure schedules provide additional information and details that would be too much to be included in the main body of the purchase agreement. For this reason, the seller needs to carefully examine the representations and warranties so that they can fully understand what they are required to disclose in the schedules.
In addition to providing lists of contracts, assets, litigation and claims, employees, or the financial statements, the items and matters disclosed on the disclosure schedule may constitute an exception to the representations and warranties to which the disclosure makes reference. The disclosures may qualify the representations and warranties by disclosing matters that if not disclosure would cause the statements to be incorrect. For example, within the representations and warranties addressing legal compliance, the seller might represent that is has not violated any laws, rules, regulations, or ordinances — except for those set forth on Schedule X.
Disclosure schedules are long and laborious documents to assemble and complete. This is because they are rife with all kinds of information. Even if something has only a minute chance of being relevant in the future, both parties have an interest in it being included to be aware of potential issues that could arise. And for that reason, this is often one of the most tedious parts of the purchase agreement. But, for both buyers and sellers, disclosure schedules may have significant consequences if not complete or correct. For the seller, failing to provide a pertinent piece of information in the disclosure schedules could result a breach of a representation and warranty resulting in substantial liability. And for the buyer, failing to take note of the information disclosed could result in having to deal with a liability that was carved out from express indemnity.
In a stock or membership interest sale with a larger number of shareholders or members as the sellers, the sellers typically appoint a sellers’ representative to act on behalf of the sellers as a group for any post-closing matters and issues that may arise. The sellers’ representative usually has the power to make decisions regarding claims against escrow, disputes, and similar post-closing matters. For example, if there is a claim of breach of a representation, the sellers’ representative is authorized to make decisions and represent all the sellers’ interests in settling the matter with the purchaser. Further, the sellers will agree to indemnify the sellers’ representative and often obtain an insurance policy to protect them in their capacity as the sellers’ representative. Sometimes the cost of the policy is shared with the purchaser as the sellers’ representative allows for much more efficient resolution of post-closing matters than having to deal with a large number of sellers, many of whom may have their own legal counsel.
Purchase agreements typically include protective covenants. The purpose of a protective covenant is to protect the purchaser and the business after closing from any type of competition or interference from the seller. With this in mind, the purchase agreement will usually include: (1) covenant not to compete; (2) non-interference and non-solicitation of customers; and (3) non-solicitation of employees.
The covenant not to compete is designed to prevent the seller and their affiliates from competing with the purchaser and the acquired business after closing. The reason for this is simple: the seller, in many cases, may be in a better position to conduct business than the buyer given the seller likely has developed substantial goodwill with its “former” clients, and this could be used to harm the purchaser if allowed to compete.
Non-compete covenants usually have three limiting qualifiers placed on them as required by applicable law. These limitations are connected to a specific geographic area, a specific duration of time, and the overall scope of the restrictions. For example, the non-compete clause might bar competition with the purchaser or the business sold within a certain municipality(ies), county(ies), or state(s) and last for five years after the closing. The geographic scope needs to cover at least where the seller currently conducts business and perhaps areas where the purchaser operates and intends to expand the acquired business. The duration of non-competes tend to be from three to five years with more deals trending towards five years.
The non-interference covenant is sometimes included to bolster the covenant not to compete. It’s a provision that bars the seller from “interfering” with the acquired business’s customers, vendors, and other relationships. The non-interference covenant also may include wording that protects the business and purchaser from disparagement. In other words, it may bar the seller from speaking negatively about the company or the purchaser after the deal is complete. Another extension of the covenant not to compete is a seller’s covenant not to solicit any past, current, or protective customers. Arguably, however, even without a specific non-solicitation of customers or non-interference covenant, the covenant not to compete will protect the purchaser from these matters if drafted well.
The purpose of the non-solicitation of employees covenant is to prevent the seller from taking employees away from the business after closing and stealing any potential new employees. It also may include a no hire provision, which provides that the seller is not allowed to employ any former employees of the purchaser for a certain period after they leave the purchaser. This covenant prevents the seller from potentially harming the purchaser and the acquired business by stealing former key employees of the seller that the purchaser needs to successfully transition and operate the acquired business.
Once the closing has occurred and the purchaser has paid the purchase price to seller, which party should bear the cost when unexpected liabilities arise? Of course, the seller wants to move on with the entire benefit of the consideration paid to it and not bear any risk for future liabilities that could arise related to the company or assets it sold. The purchaser, however, does not want to bear any liability for matters that arose under the seller’s watch or for liabilities that arise from inaccurate statements about the business in the purchase agreement (i.e., breach of a representation and warranty).
Without express provisions in the purchase agreement to address these concerns, however, a purchaser’s sole recourse would be a general claim for breach of contract. Therefore, indemnification provisions bridge the gap by providing both parties more certainty as to which party will bear the burden of liabilities that arise post-closing. Indemnification is like an insurance policy that allocates risks among the parties to provide a contractual remedy for certain claims, liabilities, and losses that may occur after closing. With the seller’s and the purchaser’s conflicting interests and objectives, and the possible impact that indemnity may have on the deal’s economics, indemnification provisions tend to be one of the most heavily negotiated parts of a purchase agreement. Typically, indemnity provisions target losses that may arise from breaches of representations, warranties and covenants in the purchase agreement, but the purchaser often will seek to expand the scope to address damages that may arise from certain matters identified during its due diligence investigations. In general terms, the purchaser will negotiate for broad indemnification provisions seeking to cover as many scenarios as possible. The seller will seek to narrow their scope as much as possible to limit the number of possible claims and total damages that may follow.
In M&A, there are many terms of art associated with the indemnification provisions such as a “basket,” “materiality scrape,” or “anti-sandbagging”. A “basket” is a threshold amount of damages or losses that the purchaser must incur before the seller is obligated to “indemnify” or pay the losses incurred by the purchaser. It’s essentially a deductible like those associated with most insurance policies. A basket falls into two general categories, a “tipping basket” or a “true deductible.” A basket that is a true deductible is self-explanatory and means that the seller will be liable for losses that exceed the amount of the basket. A “tipping” basket, on the other hand, means that the seller will be liable for all of the losses suffered by the purchaser but only if the total losses exceed the amount of the basket. Of course, sellers prefer a true deductible basket and purchasers want a tipping basket if they have to agree to a basket at all. Baskets typically apply only to a breach of Non-Fundamental Reps and do not apply to other indemnity scenarios. The purpose of a basket is to allocate the risk among the parties and prevent the purchaser from asserting “immaterial” claims. However, allocation of risk is purely a business point, which the purchaser will consider when agreeing upon the purchase price for the business or assets.
A “materiality scrape” is a provision that for purposes of indemnification, removes all of the materiality qualifications that the seller negotiated into the representations and warranties. The materiality scrape may be a “single” or “double” scrape depending on the bargain power of the respective parties and the amount and types of basket(s) negotiated. A “double” scrape removes all materiality qualifications for determining whether or not a breach or a representation and warranty occurred and with respect to calculating the amount of losses for which the seller will be responsible that result from the breach. As for a “single” materiality scrape, the materiality qualifications are disregarded only for purposes of determining the amount of seller’s exposures for indemnity losses, but will still apply determining whether or not a representation and warranty was breached.
An “anti-sandbagging” provision restricts the purchaser from asserting a claim for the seller’s breach of a representation and warranty that the purchaser already knew about prior to closing the deal. The rationale from the seller’s perspective is that the purchaser should not be able to take advantage of an issue it knew about but chose to proceed anyway. The purchaser, on the other hand, will argue that it can’t be expected to “know” about an issue that the seller claims was referenced or alluded to in one of thousands of pages of documents provided to a data room during due diligence.
As discussed above with respect to representations and warranties, the seller will seek and typically obtain limitations or caps on damages depending on type of representation and warranty breached or other issue subject to indemnification. In addition to a breach of Fundamental Reps having much larger liability exposure to the seller, the purchaser often will seek to exclude fraud from any cap on liability. While the seller tends to find it difficult to argue that there should be a cap on its liability if it committed fraud and so is generally amenable to such carve-out, the definition of fraud varies from state to state. In some states, it’s more broadly interpreted, such that a false statement of a material fact, made without any intention to deceive, but upon which the purchaser relies to their detriment and is injured, is fraud. Whereas in other states, the requirement that the seller had intent to deceive is included. Therefore, even though the seller is amendable to carving out fraud, the seller will want to negotiate a definition for fraud to include intent regardless of the state law governing the transaction.
Ancillary Agreements and Instruments
Beyond the purchase agreement and the disclosure schedules there are other agreements and instruments that are necessary help bring everything together and otherwise consummate the transaction.
If the purchase agreement is for a stock or membership interest purchase, typically an assignment of membership interest or stock powers is needed to effectuate the transfer of the securities from the seller to the purchaser. In terms of an asset sale, a bill of sale is needed to convey ownership in most of the assets sold with some categories of assets being conveyed through other instruments such as conveyance deeds for real property, assignment of intellectual property, or assignments of contracts. The bill of sale is simply a document that transfers titles to personal property.
If the seller has certain employees who are considered by the purchaser to be key to the successful performance of the business or are at least needed for some period of transition, employment and consulting agreements are commonly ancillary agreements.
Financing instruments are sometimes involved when the seller is financing a portion of the purchaser price itself. Accordingly, the seller may require the purchaser to sign a promissory note that is secured by the business or assets being sold as collateral to protect the seller if the purchaser defaults on the repayment of the note.
Although ancillary agreements and instruments are not the meat and potatoes of M&A, they do affect the status and structure of the deal. Understanding how each of these agreements and instruments works can help you plan how to navigate the deal.
Definitive Agreements: The Final Step Before Closing
The entire mergers and acquisition process has been building up to this moment. When you go through a tedious due diligence phase, getting to definitive agreements might feel like the time to take things easy. But that’s far from the truth.
Many people believe if the price looks good, they can simply sign a piece of paper and it’s over. This is not the case, as you can see. Each of the provisions in the purchase agreement, the information contained on the disclosure schedules, and the ancillary agreements and instruments can have immense power over both the buyer and seller for years to come. This is why we recommend hitting the pause button and involving an experienced M&A legal counsel and financial advisors before you ink the deal.
In Part Four of this series we will discuss the next phase of M&A – the closing. If you have any questions or if you would like to learn more about the M&A process, email us at firstname.lastname@example.org.