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The Process of Buying or Selling a Business: M&A Purchase Agreements

This is a continuation of a series of posts about buying or selling a business targeted to those less familiar with the process. This post provides a high-level overview of the purchase agreement.

Overview

The purchase agreement is the principal legal document used to effect a merger, acquisition, or sale transaction (an “M&A transaction”). Depending on the transaction structure and the types of entities involved (e.g., corporations, limited liability companies, etc.), it may be styled as an “asset purchase agreement,” a “stock purchase agreement,” a “merger agreement,” or something else. It is the most important document in the transaction, playing the following roles:

(1) it serves as the roadmap for closing the transaction, setting forth all conditions required for closing and the closing deliverables,

(2) it sets forth the business terms of the transaction, such as the purchase price, how and when the purchase price will be paid, and the terms of any contingent purchase price or escrow, etc.,

(3) it sets forth and delineates the assets or equity interests (referred to herein as “stock”) being purchased and any excluded assets or interests,

(4) it serves a diligence function for the buyer (and, in some cases, the seller),

(5) it serves as a basis for post-closing recovery of damages for the buyer (and, in some cases, the seller) in the event there are breaches of representations, warranties, or covenants by the sellers (or the buyers) and

(6) it may set out post-closing covenants and transition agreements.

The purchase agreement is typically drafted by the buyer’s counsel after the letter of intent has been signed and the buyer has done enough due diligence to feel confident that it wants to pursue the transaction. The length and complexity of a purchase and sale agreement can vary widely, but in most lower middle market deals we work on, we see agreements that are 50 to 100 pages in length.

Purchase Agreement Provisions

Most purchase agreements follow a typical pattern, with the agreement setting out the following provisions:

  1. The parties to the agreement – in a stock deal, this will be the purchasing entity and the selling stockholders; in an asset deal, this will be the selling entity, the purchasing entity, and the stockholders of the selling entity.
  2. The assets or stock being purchased and any excluded assets – in most deals, the buyer is taking most or all assets, but there may be some personal use assets the seller side wants to exclude (e.g., personal vehicles, phones, and phone numbers, etc.) and there may be some assets the buyer simply doesn’t want (e.g., a contract for a service the buyer already has).
  3. Any assumed and excluded liabilities – in an asset purchase structure, the parties can contractually allocate liabilities, which is one of the benefits of this structure. The buyer often only agrees to take current accounts payable and the obligation to perform contracts it assumes after the closing. The remaining liabilities can be designated as excluded liabilities and remain with the seller.
  4. The purchase price, how and when it’s paid, and any contingent purchase price – the purchase price can be very simple (e.g., $20M in cash at closing). However, that’s rarely the case, as most deals have some portion of the purchase price paid in cash, some via a promissory note, and potentially some held in escrow. Also, some deals have some portion of the purchase price tied to the performance of the business being purchased after the closing.
  5. The closing process – most deals are now closed on the signing date; the parties finalize all documents and exchange signatures to be held in escrow. Then, when both sides are ready, there is either a closing call or an exchange of emails to release signatures. At that time, the deal is closed, and the buyer wires the cash portion of the purchase price.
  6. Representations and warranties of the parties – representations and warranties in an M&A transaction are extremely important and are highly negotiated. For the buyer, they have two primary functions: (1) they serve as a basis for the buyer to conduct due diligence on the seller (i.e., by making the seller make representations and warranties and disclosures, the buyer is uncovering and evaluating risks); and (2) they serve as a basis for post-closing recovery from the seller if the buyer has damages.
  7. Tax matters – in asset purchases, the primary tax matters involve (1) how the purchase price is allocated among the assets (higher allocations to certain assets may produce more or less capital gain for the seller and thus more or less income tax on the transaction), and (2) which party pays for transfer taxes (e.g., retitling vehicles). In a stock purchase or merger, the responsibility for filing pre- and post-closing tax returns and the responsibility for taxes due has to be addressed.
  8. Other covenants and agreements – this can vary widely, but common ones are terminating employees and making them available to the buyer in an asset purchase and transition services to be provided by the seller side.
  9. Indemnification –indemnification provisions in an M&A transaction are extremely important as well. They serve as the basis for one side to recover funds from the other side if there is a breach of a representation, warranty, or covenant by one side and the other side is damaged by the breach. These provisions are highly technical and highly negotiated. 
  10. Miscellaneous provisions – this can include things like governing law and venue (i.e., where a lawsuit will be held in the event of litigation, payment of expenses associated with the transaction, and so forth).

Future posts will explore each of these provisions in more detail.

Simultaneous Closing versus Sign and Close Later

Broadly speaking, purchase agreements come in two different varieties in terms of when the closing will happen in relation to the signing of the agreement. The agreement will either be:

  1. signed and closed on the same day (the “simultaneous closing” variety) or
  2. signed on one date and closed on a later date (the “sign and close later” variety).

Most lower middle market deals we see use the simultaneous closing variety unless there are important approvals or consents required from third parties (e.g., important customers or governmental agencies), and it’s either not possible or not advisable to seek these consents and approvals prior to having a signed agreement.

However, in either case, it’s important for both the buyer and seller to realize that there is no “deal” until the purchase agreement is signed and closed. We often see both buyers and sellers acting as if the deal is closed and taking actions that may damage one of the parties if the deal falls apart.

Transaction Structure

The underlying transaction structure will drive how the purchase agreement is styled (e.g., asset purchase, stock purchase, etc.). But what drives the transaction structure? There are typically competing interests on the buyer and seller sides.

The buyer most often wants to purchase the assets of the business for two principal reasons – (1) purchasing assets minimizes the risk of the buyer bearing the burden of unknown or contingent liabilities because, for the most part, those liabilities can be contractually allocated to the seller in an asset purchase, and (2) purchasing assets gives the buyer a fair market value income tax basis in the assets, which can increase future depreciation and amortization deductions and reduces gain on a future sale by the buyer.

However, the seller side typically prefers to sell stock because this may result in more favorable income tax consequences (more capital gain, less depreciation recapture and other ordinary income, and potential state income tax savings in states like Tennessee that impose an entity level tax but not an individual income tax).

We typically see a merger transaction when both the buyer and seller are operating similar businesses, and the buyer wants to combine the two entities.

The actual transaction structure in a particular deal will be a negotiated term, and it should be considered at the letter of intent stage. We have seen situations where a transaction structure was not adequately considered and addressed at the LOI stage, with the result being additional time and expense to restructure the deal and one side requesting adjustments to the purchase price.

Riggs Davie Deal Team Note

If you have additional questions, please reach out to the mergers and acquisitions practice group at Riggs Davie PLC. We counsel clients through deals on the buy-side and sell-side in a wide range of industries, including technology, health care, HealthTech, FinTech, professional services, financial services, real estate, business services, manufacturing, and distribution. For more information about our services, please visit www.riggsdavie.com or contact our practice group by email at dealteam@riggsdavie.com.


This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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