Over recent columns, I reviewed best practices with mutual confidentiality agreements, indications of interest (IOIs) and letters of intent (LOIs). The last remaining important document used in a transaction is called the purchase agreement.
The purchase agreement is the legally binding document that outlines the transaction. It can either be an asset purchase agreement (APA) if assets are being sold or a stock purchase agreement (SPA) if it’s a stock sale. A well-drafted purchase agreement typically includes the following key sections:
1. Introduction and definitions. This sets the stage for the agreement, identifying the buyer and seller and defining key terms that will be used throughout the document.
2. Purchase price and payment terms detail the agreed-upon purchase price, the payment structure (e.g., lump sum or installments) and any adjustments based on the business’ financial condition at closing. It may also outline any earnouts or contingent payments that depend on the business's future performance.
3. Assets and liabilities specify what assets and liabilities are being sold. This section ensures that there is no confusion about what the buyer is acquiring and what obligations they are assuming.
4. Representations (reps) and warranties is one of the most critical sections, where the seller makes statements and promises about the business’s condition and the buyer verifies their authority to enter into the agreement.
5. Covenants are promises made by the buyer and seller regarding actions they will or will not take before and after closing. Covenants can include non-compete agreements, the maintenance of business operations and the handling of employees.
6. Closing conditions outline the conditions that must be met for the sale to be finalized. These might include obtaining necessary approvals, the accuracy of representations and warranties at closing and the absence of any material adverse changes since the process began.
7. Indemnification details how the parties will compensate each other for breaches of the agreement or for certain unknown liabilities that may pop up.
8. Termination outlines the conditions under which the agreement can be ended and the consequences of such termination.
9. Miscellaneous provisions include governing law, dispute resolution mechanisms and other legal boilerplate that ensures the agreement is comprehensive and enforceable.
Among all the sections described above, reps and warranties can significantly influence the outcome of the sale and they serve several important purposes.
First, reps and warranties shift risk from the buyer to the seller. If the seller makes a representation that turns out to be false, the buyer may have grounds for a claim for damages.
Second, these statements support the buyer's due diligence process. By making reps and warranties, the seller provides assurance that the business is as it has been described.
Last, if a rep or warranty is breached, it can trigger the indemnification provisions in the agreement, leading to compensation for the buyer.
Reps and warranties should be clear and detailed, covering all material aspects of the business, such as financial statements, tax matters, contracts, intellectual property, employee relations and environmental compliance. Here are some common elements you’ll find in a reps and warranties section.
Materiality qualifiers limit the scope of reps and warranties to issues that are significant to the business. They are useful in preventing the seller from being held liable for trivial matters.
Likewise, knowledge qualifiers can protect the seller from liability for issues they were genuinely unaware of. Buyers should seek to limit the use of these qualifiers to ensure they receive full disclosure.
Survival periods determine how long reps and warranties will survive after closing. A standard period is between 12 to 24 months, but this can vary. Some representations, like those concerning title to assets, may survive indefinitely.
Disclosure schedules are prepared by sellers to list exceptions to the reps and warranties. These schedules are critical for transparency and for protecting the seller from future claims. Buyers should review these schedules thoroughly to understand any potential issues.
Clearly define the breach remedies available in the event of a material breach of contract. The agreement should specify any caps on liability and any thresholds (baskets) that must be met before a claim can be made.
In a business sale, the purchase agreement is the critical document that governs the final terms of the transaction. By focusing on best practices in drafting this agreement, particularly in the area of reps and warranties, both parties can protect their interests and facilitate a smooth and successful transaction.
