With the end of the stay-at-home restrictions in sight, many businesses have hung up their much welcome "We're Open" signs. But many other businesses unfortunately are hanging "We're For Sale" signs, with the hope of being able to sell while there's still some value left to the business.
But once an entrepreneur always an entrepreneur. There are always new opportunities! An owner of a once successful business will have the fortitude to sell, move on, and take on the next challenge with vigor! The seller is ready to set sights on the new and shed the old.
Shed the old? Not so fast. As the cliché "one man's loss is another man's gain," for every finalized sale transaction made by a seller there's a finalized buy transaction made by a buyer. This is a buyer's market. The buyer sits in the driver's seat and has the upper hand to drive a great bargain on favorable terms. Let's spend a few minutes to see what a buyer with the stronger negotiating position wants in a purchase agreement and what a clever seller can do to soften the blow.
One of the first issues that the parties will need to resolve is whether the deal will be an asset purchase or a stock purchase. In an asset purchase deal, the buyer buys specific assets and liabilities and the seller keeps the legal entity with any assets and liabilities that the buyer doesn't pick up. In a stock purchase deal, the buyer buys the seller's ownership shares and ends up owning the entire company, including all assets and liabilities. The buyer and seller of course have different goals and it can make a lot of difference which way they go.
For example, asset sales may allow a buyer to "step-up" the company's depreciable basis in its assets. A buyer can allocate a higher value for assets that depreciate quickly (like equipment) and allocate a lower value on assets that amortize slowly (like goodwill). This allocation has distinct benefits to the buyer, and can also be geared to reduce taxes sooner and improve cash flow during the vital early years. Stock transactions often favor the seller if the deal is set up to be taxed at capital gains rates.
A buyer may prefer an asset deal because it more easily avoids inheriting potential liabilities. There are many twists here. While basically the buyer in an asset deal doesn't automatically assume the liabilities of the seller, there are situations where a buyer may end up with "successor liability" and be responsible for liabilities of the seller no matter what the buyer does. The problem is especially fraught where there is environmental pollution or where creditors can make a case that the deal doesn't treat them quite right. Even in a stock deal, there's often an arm wrestle where the buyer wants the seller to sign indemnity clauses, which say no matter stock or assets, the seller will be personally responsible for problem x for up to $y and until date z. More about this later.
Also, an asset sale sometimes presents difficulties in transferring intellectual property, contracts, leases, and permits that need third-party consents, while in a stock deal there's no need to separately transfer any assets. The buyer steps into the shoes of the seller and continues to run the company as the new owner.
Let's assume that our buyer insists on buying assets and that the buyer wins this battle. Despite these Covid days it's now time to 'take off the gloves' and look at the nuts and bolts of the paperwork in these deals. Both the stock purchase agreement and the asset purchase agreement have similar basic structures.
There are the operative terms of the transaction that spell out the deal; what's being bought and what's being paid and when. The first-time seller will need to learn new terms like "escrow" and "holdbacks" and "normalized working capital." A buyer will often require a portion of the purchase price to be put into escrow and be available to reimburse or indemnify the seller for "stuff" that surfaces up to so many months or years(!) after the deal is finalized – this may include liabilities that surface after the closing that the seller knew nothing about. In some deals the buyer holds back a portion of the purchase price and payment is only due if the purchased business hits certain milestones. It's a complicated business to get these so-called earn-outs to make sense.
It is also fairly common for a buyer and seller to adjust the purchase price by the amount that the working capital as of the date the deal closed exceeds or falls short of the normalized working capital target. Sometimes this calls for an audit to be done effective with the closing.
A buyer will also want the seller to make "representations and warranties" and make certain statements of fact. For example, the seller will typically have to formally state that the seller has legal power and authority to act; that none of the seller's shareholders or others can interfere or complain; that the seller has good title to the assets being sold and that these assets are in good working order and free and clear of liens; and there hasn't been and there is no litigation, including no claims of IP infringement if relevant. The seller may need to indemnify the buyer for a representation or warranty that is not true.
Even more important, the buyer will insist that the seller stand behind financial statements for the past several years.
Agreements have covenants. A covenant is a fancy word for an agreement made by a party on how they will act in the future and are sprinkled throughout the asset purchase agreement. As an example, the agreement may require the seller to keep information that the buyer is buying in confidence and not to compete or solicit. These restrictive covenants (restrictive in the sense that the seller cannot say, or take certain activities) are carefully negotiated in scope, time and geography. A buyer does not want to find a court striking these provisions as overbroad and against public policy and the seller does not want to be bound too tightly. Tax people like to get involved on the tax aspects of these agreements.
The agreement will also have a conditions section that spell out certain conditions that must be met before a party is required to close. For example, a buyer can walk away from the deal, or, more likely, renegotiate the deal, if the buyer's accountant reviews the seller's financial situation and determines that the assets, liabilities and earnings are not what the seller promised they would be. A heavy-handed buyer may impose onerous conditions on the seller, while at the same time adding conditions to limit its obligations to the seller.
Let's get a bit technical on "indemnification" provisions that can be among the most highly negotiated and critical deal points in acquisition transactions. If not done right there's a good chance of litigation in your future. First, what is it. Indemnification provisions allocate the risk of known and unknown liabilities between the parties (i.e. buyer and seller); one party agrees to "defend, indemnify, and hold harmless" another party. An obligation to "indemnify" typically requires the indemnifying party to reimburse the indemnified party for losses, damages, or other costs it incurs from an underlying claim. A hold harmless (sometimes "save harmless") obligation is sometimes used interchangeably with an "indemnify" obligation; it is however a distinct commitment that requires that, in addition to reimbursing the indemnified party's costs, the indemnifying party will not hold the indemnified party liable for the underlying claim even if it arises from the indemnified party's own negligence or fault. Finally, the duty to defend is broader than the duty to indemnify - the duty to defend arises before the indemnified party's liability is adjudicated and can be triggered even if the underlying claim has no merit.
If the indemnity provision is drafted very broadly, it may appear to cover any claim at all - not just claims asserted by third parties, but even breach of contract claims between the parties to the contract themselves (known as "direct claims"). The indemnifying party may take the position that an indemnity for direct claims is unnecessary because a party can almost always be sued for the direct loss under contract or tort theory. However, indemnification for direct claims can give the indemnified party remedies that are greater than or additional to those provided under other contract provisions or the law. For example, indemnified parties can typically recover attorneys' fees under indemnification, which state law may otherwise prohibit without an express agreement.
Some of the key indemnification terms that are typically negotiated are, (1) de minimis thresholds (this threshold prevents indemnified parties from bringing immaterial claims), (2) baskets and deductibles (some deals include a deductible. Both the basket and the deductible require that the aggregate amount of all claims exceed a specified dollar threshold before the indemnifying party becomes obligated to compensate the other party for the claims. With a basket, once the threshold is reached, the indemnifying party becomes liable for the full amount of claims. With a deductible on the other hand, once the threshold is reached, the indemnifying party becomes liable for only the amount in excess of the deductible. Sometimes a transaction will contain a combination basket in which once a certain claim threshold is reached, damages may be recovered in excess of a different deductible amount), (3) caps (that is, a limit on the total amount of claims for which an indemnifying party will indemnify the other party. This limit, or cap, is generally calculated as a percentage of the overall deal price. In some deals the indemnified party will insist that there is no cap on indemnification for specified types of claims, such as fraud, willful misconduct, or breaches of certain representations and warranties), and (4) survival period of representations and warranties (some indemnifying parties may be able to limit their indemnification obligations by imposing a time period during which the other party may bring a claim for indemnification for a breach of a representation or warranty. Many deals will include multiple survival periods, including a shorter period for breaches of general representations, with longer periods for claims arising out of breaches of what are commonly termed "fundamental representations" such as due formation, authorization, capitalization, and for tax and environmental representations).
A word of caution: There are the miscellaneous things that usually hide in the end of the document but are still plenty important and should be understood.
While a buyer may in this environment be in the stronger negotiation position, many dealmakers will tell you that the win-win transaction is one in which both parties walk away with the feeling that the other party drove a good deal.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
