Key Legal Matters to Understand in the Business Sale Process: An In-Depth Look into the LOI & Purchase Agreement
When selling a company, a Letter of Intent (LOI) is signed by all parties to indicate that the buyer and seller have reached an agreement-in-principal as to the substantive business points of the transaction. The LOI is essentially a “written handshake” between the buyer and seller that enumerates the high-level business points to later be incorporated into a definitive purchase agreement. Key points incorporated in the LOI are: purchase price; what is included and excluded in the transaction; transaction structure; timing of due diligence; contingencies of closing (i.e. securing continuity of certain key employees, key accounts, financing, lease, etc.); exclusive period granted to an acquirer to complete a transaction; anticipated timing of purchase agreements and closing; responsibility for fees and expenses; and, which items will be binding after termination of the LOI.
After executing the LOI, the primary areas of focus are the completion of due diligence, negotiation of the definitive purchase agreement (including ancillary agreements such as: non-competition and solicitation; employment and/or consulting), and in certain cases the securing of financing. From the time the LOI is signed by both parties, closing should occur in approximately 90 days, barring any major changes or complications, and assuming that both parties remain motivated to move the transaction toward a closing.
Stock or Asset Purchase Agreement
Once the LOI is signed and the due diligence process (financial, operational, and legal) is proceeding smoothly, the next legal document to address is the stock or asset purchase agreement. The transactional attorneys will utilize the LOI as the blue print and memorialize those points in a draft asset or stock purchase agreement. The purchase agreement will also incorporate all of the legal points that cover the scope, content, and ramifications of the various representations, warranties, and indemnifications made by both the buyer and the seller; escrow that will be set aside for a limited period of time to secure the seller’s representations and indemnifications; post-closing adjustments and true-up procedures; allocation of purchase price; fees; expenses; and, taxes. The definitive purchase agreement can range between 10 and 100 pages depending on the size and complexity of a transaction.
The attorneys will be drafting and revising this agreement; however, it is critical for the buyer and seller to fully understand the key aspects since ultimately they are the ones being impacted and protected by it. Adequate time should be allocated for your professional M&A team and legal counsel to educate you on the intricacies of this legal document that go beyond the business points that formed the initial understanding; which items may carry future consequences; those that are standard pro forma language for inclusion in all purchase agreements; and, the ramifications of each section and supporting schedule. Understanding the common sections of purchase agreements helps remove the anxiety from the process and allows you to make more informed decisions on the substantive issues that require negotiation. The better your working knowledge of the most prominent issues, the greater the likelihood of obtaining the terms you desire.
The definitions section clarifies capitalized terms, words, and concepts referenced in the agreement. This section is often overlooked because it is assumed to be boilerplate; however, it is critical to note how a particular party classifies key terms such as “Adjusted EBITDA” and “Net Working Capital,” that are subject to various financial interpretations, inclusions, and exclusions. The goal is to create a document that outlines key terms in a manner that enables any person not directly involved with the transaction to clearly and unquestionably understand the conditions and intent defined within the document. Ambiguous definitions can become a major point of future contention should the buyer and seller disagree on the post-closing meaning and mechanics of working capital adjustments, earn-out calculations, or purchase price adjustments. Some examples are:
- Definition of adjusted EBITDA that may be linked to a transaction structure that includes an earn-out.
- Definitions of working capital requirements which specify the amount of current assets net of current liabilities that will be on the balance sheet at the time of closing.
Definitions can have a major economic impact and you must have a clear understanding of their meaning and ramifications.
Purchase Price, Escrow, & Adjustments
Purchase price is often a combination of cash, buyer’s stock and/or seller financing but may include other components, such as: assumed/settled liabilities and debt; or, future earn-out payments based upon performance or other criteria. Negotiating points relevant to this section include earn-out targets, amount to be retained in escrow, and purchase price adjustments. Ancillary to this will be methodologies and criteria utilized in the various calculations. By example, you would not want corporate expense loads instituted by an acquirer’s operation or reporting requirements to be layered onto the calculation of future operational expenses, thereby artificially lowering pre-tax earnings that form the basis of an earn-out.
Escrow is a common and appropriate request by buyers to help cover potential post-closing claims against the seller during a specified period of time that may arise from the representations, warranties, and indemnifications made by the seller. The percentage of total purchase price and length of time funds must remain in escrow before being released to the seller are subject to negotiation. Escrow amounts typically range from 5% to 20% of the purchase price, and funds are typically held for periods from 6 months to 3 years depending on the issues being protected against. It is common to have varying amounts being released over time. For example, there may be $1.5 million held in escrow with the parties agreeing to releases in $500,000 increments after 12, 24, and 36 months.
Purchase price adjustments may be linked to an agreed amount of net working capital delivered at closing (i.e. collectable accounts receivable, inventory, and prepaid expenses; less current liabilities without debt), meeting future financial targets such as revenue or EBITDA (typically relating to earn-outs), or the retention of certain key customers for an agreed upon period of time.
Representation & Warranties
The representations and warranties are a requirement of each party to assure the other of the validity of certain facts presented in the transaction. The seller’s disclosures to the buyer generally far exceed those made to the seller by the buyer. It is critical to rely on your professional counsel in reviewing both this section and the indemnification section.
The representations and warranties section require supporting disclosure schedules that are attached to the agreement. These disclosure schedules will either list exceptions to certain statements being made or will list specific detail supporting or enhancing statements in the agreement. There are commonly schedules for acquired leases; financial principles; equipment lists; included and excluded assets; customer contracts; consent and notification requirements; permits and licensing; financial statements; litigation; environmental matters; etc. The schedules often involve hours of tedious research and preparation to generate the spreadsheets and materials to support them; and, even more time to closely scrutinize the results. It is worth the investment of time for the seller since it provides the opportunity to make the proper disclosures and thereby provide protection should anything arise in the future.
Indemnifications are heavily weighted towards protecting the buyer from all of the potential unknowns about the company being acquired. The buyer looks to receive protection from future liabilities resulting from seller’s past pre-closing actions. It stipulates that the seller retain financial responsibility for certain damages/liabilities that arise from the seller’s past ownership. The main areas that are negotiated include: which actions apply; who maintains responsibility; the length of time the indemnification period lasts; limitations on financial responsibility; and, materiality thresholds of claims. Examples of indemnified actions include ownership of property, payment of taxes, environmental matters, and employment matters.
Since the buyer has valued the seller’s business based upon data as of the date of the LOI an assurance must be provided to the effect that the business has not significantly changed between the time of the LOI and closing. There are also statements made that detail how the seller is expected to conduct business between the LOI or contract date and the closing of the transaction. Common examples include not paying unusual bonuses or salary increases, and limitations on major financial commitments or capital purchases unless agreed to between the parties. Many of these may be eliminated by having a simultaneous contract signing and closing.
Non-compete agreements are negotiated and vary greatly depending upon specific circumstances, such as seller’s age and future plans within or outside of the business. A non-compete agreement prevents a seller from competing with the buyer after the sale and a financial value may be allocated to it within the purchase price. The three main components of a non-compete are:
- What will the seller be prohibited from doing;
- How long will the prohibition last; and,
- The geographic footprint being prohibited.
Contract & Closing
Closing conditions are a list of items required or things that have to occur prior to closing the transaction. Common examples include employment contracts, transferring licenses, landlord consents, customer, and vendor approvals.
As mentioned above, there will either be a simultaneous signing of contract and transaction closing or there could be a contract signing followed by a closing at a future date, assuming certain post contract conditions are satisfied. For example, when there is third-party financing involved, the financing source may require review of signed contracts prior to releasing funds.
Each transaction is unique and will include important provisions or variations not mentioned in this article, but these are the core areas that are relevant to most M&A transactions. The risks, complexity, and time-intensive nature of getting this work done properly only magnify the importance of having an experienced team of advisors in place when selling your business. Assembling the right team ensures nothing is left on the table and each party is properly educated on the intricacies and impact during the business sale process.