One of the more common engagements for our firm is to assist with business sales and acquisitions. This article is the third in a series of articles which will walk through and generally discuss the steps typically associated with the sale of a business. In Part 1, we discussed the breakdown of the business, the identity of the relevant parties, the role advisors play, and brief discussion of the two primary types of sales that take place. In Part 2, we discussed preliminary negotiations and the letter of intent. In Part 3 we discussed the due diligence process. Now, we move on to definitive agreements. Before doing so, however, let’s step back and look at the picture from beginning to end.
- Initial Negotiations;
- Letter of Intent/Term Sheet;
- Due Diligence;
- Definitive Agreements;
- Transitional and Post-Closing Matters; and
- Tax Reporting.
What are the Definitive Agreements?
The definitive agreements are the documents which represent the actual binding agreement between the parties and contain the terms of the sale. The form of the definitive agreement depends on the nature of the transaction. For asset sales, the definitive agreement is an asset purchase agreement. For equity acquisitions, the definitive agreement is usually referred to as a membership interests purchase agreement or stock purchase agreement, depending on the type of equity involved. It usually takes a couple of rotations and some negotiation between the parties to finally come to terms, but generally speaking, the more material provisions of the definitive agreements will mirror the terms outlined in the letter of intent such as purchase price and indemnification provisions.
Additionally, one may also see license agreements, employment agreements, consulting agreements, and the like among the definitive agreements. The are usually referred to as ancillary agreements because they are executed pursuant to the terms of the definitive agreement. This article will focus on the sale agreement, be it asset or equity.
Primary Provisions of the Definitive Agreement
While this provision may seem silly, it should come as no surprise that parties must be properly identified. This becomes crucial when special purpose entities are at play. Special purpose entities are entities created solely for certain transactions that serve to segregate liabilities and uncertain risks. If you are selling, you need to know who is buying, their history, and that the requisite due diligence was performed with respect to the appropriate party. For the buyer, this can become even more important, particularly with respect to due diligence as well as indemnities Did you perform your due diligence on the proper entity? How deep are the seller’s pockets if it comes time to settle up on an indemnity? While special purpose entities are commonplace in business sales, it is important to ensure the parties to the agreement, and which are bound by the agreement, are the parties expected to participate in the transaction.
The assets exchanged are key. Are the assets just equity interests or are the assets the underlying business assets? While asset identification may be easy in an equity sale, it is appropriate to ensure the business purchased includes the assets expected and needed to operate the business. Usually, there will be representations, warranties, and covenants ensuring that a buyer’s expectations are met.
While the assets exchange are usually considered to be the physical and intangible assets of the business or the business itself, another relevant item common in business sale transactions is debt. If a prospective buyer is assuming indebtedness of either the seller or the company purchase, is the buyer not in essence paying additional purchase price? Therefore, indebtedness must be accounted for.
In the asset purchase context, asset identification is is of the utmost importance. Sometimes, there will be a schedule of assets purchased. Other times (and more often in my experience), the asset purchase agreement merely states “all assets, less excluded assets.”
Whichever method is utilized, specific identification or all-except, it is important from the buyer’s perspective to clearly identify the items being purchased. Following execution of the definitive agreement and prior to closing, the buyer will want to verify existence, condition, and ownership of the assets acquired in the transaction.
Representations, Warranties, and Covenants
Sometimes, representations, warranties, and covenants can be the most negotiated provisions in business sale transactions. Representations are just that, representations made by a party is a presentation of the existence or non-existence of certain facts, usually relied upon by the other party so as to enter into the transaction in question. Typical representations would be valid existence of entities, authorization to act for an entity, or no lawsuits pending. A warranty is an express or implied promise that something in furtherance of the contract is guaranteed by one of the contracted parties. A typical warranty would be the title status of an asset, for instance that no liens encumber the assets or the assets will be transferred free and clear of such encumbrances. Lastly, a covenant is an obligation of a party to either act (positive covenant) or refrain from acting (negative covenant) in a certain manner. An example of typical covenants would be a non-competition covenant or a non-solicitation covenant.
In sum, representations, warranties, and covenants are matters of facts, guaranties, and future actions that act to induce the parties to enter into agreements.
Purchase Price, Adjustments, and Allocations
The purchase price is an item generally identified in the letter of intent and is usually discussed even prior to the letter of intent as the purchase price is a threshold question. Purchase price usually comes in one of two forms, stated price or a formula price. A stated price is simply a fixed value for the purchased assets. A formula price is exactly what it sounds like, a formula. The formula price can come in numerous varieties. It is common to hear 3x revenues, 5x trailing 12-month EBITDA (earnings before interest, tax, depreciation, and amortization), or 5x the number of points the Ole Miss defense allowed against Louisiana Directional Technical College in the second football game of the season. In short, a formula purchase price is an unfixed price based on fixed terms. Customary forms of purchase price can vary based on the industry, but by and large, a price is a price.
It is not uncommon for a purchase agreement to include adjustments to purchase price based on certain events such as subsequent sale, increased or decreased performance, collection of purchased accounts receivable, equipment condition upon receipt, or as a result of an indemnification obligation. One must be cautious with adjustments because if performance is at issue, the seller may be betting its money that a prospective buyer operates the business in a profitable matter. In essence, the seller is still in the business to an extent.
Lastly, but not last in importance, it is imperative to consider the tax consequences surrounding the allocation of the purchase price. The tax consequences can make or break a deal. Particularly, a buyer may desire to lean more heavily on allocating to furniture, fixtures, and equipment, accounts receivable, and other tax-advantageous property in lieu of allocating to land or intangibles. Another item receiving allocations at times that may have significant importance is personal goodwill. In the c-corporation environment, an allocation of personal goodwill results in a sale between a shareholder and buyer, thus eliminating double taxation by means of corporate and dividend tax.
While allocations may be more commonplace in asset purchases and stock acquisitions involving certain elections (ex. Section 338(h)(10) elections for an asset basis step-up), a commonly missed transaction where an allocation can carry great weight is the sale of tax-partnership interests (partnership, limited partnership, or default classified multi-member limited liability companies). Section 751 can rework the tax effects for the seller such that a seller, having plenty of basis, can get whipsawed on a sale. While a discussion of the effects of Section 751 are beyond the scope of this article, it is important to know the consequences of the tax allocation before entering into a definitive agreement.
To ease a buyer’s mind, the buyer may wish that the seller make right if something is not as described. For instance, if there is a lawsuit that is not disclosed in due diligence and the company sold gets sued post-closing, the buyer will likely take great issue with this event. In most cases, the definitive agreement will provide that the seller will have a duty to defend and indemnify the buyer for pre-closing business matters. In the event of an asset sale, liabilities are generally stripped from the going concern purchased.
The seller usually negotiates for indemnities as well to ensure any post-closing items that may arise which could cause liability for the seller are the eventual the responsibility of the buyer. Additionally, these indemnity provisions will extend a reasonable period of time to ensure that the representations and warranties of the parties hold true at and post-closing.
At least from the buyer’s perspective, the buyer may require that a portion of purchase price stay in escrow. For instance, it may be that there is a question regarding collectability of accounts receivable purchased by the buyer. The buyer may insist that there be a 10% set-aside in escrow for a period of 90 days to ensure collection of the accounts receivable and that in the event a specified amount is not collected, the purchase price is adjusted accordingly and the buyer receives a partial refund from the escrow balance.
The deliverables section of the purchase agreement will specify the requirements on the parties and is an outline of the items required to close. A typical deliverables section would require that a buyer deliver the purchase price at closing together with countersigned signature pages of the relevant closing documents. The seller will usually be required to bring bills of sale, certificates of title, payoff letters, and proof of satisfaction of outstanding liens. In short, the deliverables section can act as a mini-outline for a closing checklist. If a deal is going to close, the parties must know unequivocally what each must bring to the closing table.
Conditions defines what facts must exist prior to or at the time of the closing. Conditions may be release of liens or mortgages, financial performance requirements, or guaranty releases (ex. release of a seller-owner from a long-term lease guaranty). The buyer usually structures its conditions on assuring that the buyer is getting what the buyer actually intends. The seller on the other hand usually is seeking a clean and complete break from the business risks associated from the business being sold.
The last item usually included is the identification of the closing timeline. At this point in the transaction, the buyer is about to (or already has) incurred expense related to the acquisition of the business. The definitive agreement will usually identify what is happening next (further due diligence) and when to expect the buyer and seller to execute the transaction.
In the next part of this series we will discuss the closing and the closing documents. Closing is usually a game of logistics and can occur quite informally to the surprise of many. While most people in these types of transactions have bought or sold a house and been through the formalities associated with the transaction, a business transaction can occur a lot less (or more) formally.