Understanding the Purchase Agreement and Risk Allocation Provisions: An Essential Overview

In any sale of a business, there are a number of documents negotiated and delivered by the parties. The most important of these is the purchase agreement. This is the contract that contains the “guts” of the deal, and it is a primary vehicle for negotiation. The name and format of the purchase agreement depends on the transaction structure. Typically, sales of businesses are structured as assets sales, stock sales, or mergers, so the agreement may be called an “Asset Purchase Agreement,” “Stock Purchase Agreement,” or “Merger Agreement.”

While there are various technical and legal differences among these transaction structures, all these agreements share a number of provisions. For the sake of simplicity, this discussion will refer only to the agreement as the “purchase agreement.”

[Editors’ Note: If you are interested in how ESOP transactions might benefit a seller and their company, read The Benefits of an ESOP Transaction for the Seller and Company]

The Purchase Agreement Dissected

The buyer will prepare the first draft of the purchase agreement and submit it to the seller and their advisors. As with any negotiated transaction, the relative bargaining power of the parties, their respective goals, and their advisors’ experience and sophistication will drive the negotiations’ direction and results.

The purchase agreement can be broken into five categories:

1.  Business Deal Terms;
2. Closing Requirements and Mechanics;
3. Disclosure Provisions;
4. Risk Allocation Provisions; and
5. General “Boilerplate” Provisions.

If the transaction is not the “sign and close” type, the purchase agreement will contain risk allocation provisions regarding how a party may terminate the contract. It is standard for the purchase agreement to provide the following conditions for termination:

• By mutual written consent of the parties;
• By either party if there is a court order permanently restraining or otherwise prohibiting the transaction;
• By either party if the closing has not occurred by an agreed upon date, unless the failure to close by such a date is because of a failure to fulfill any obligation under the agreement by the party seeking to terminate;
• By either party if the other party is in material breach of the agreement and such breach is not cured after notice and a reasonable cure period;
• By the purchaser at any time, except that the seller might require a termination payment from the Purchaser in exchange for agreeing to this right.

Survival Periods

The representations and warranties of the parties will survive for a negotiated period after the closing. This usually ranges from 12 to 24 months; 18 months is a common length of time for this period. Certain specified representations and warranties may survive for a longer period. Representations and warranties for taxes, environmental, health and safety, and employee benefit matters often survive for 3 to 5 years following the closing or until the applicable statute of limitations has expired. Certain “fundamental” representations and warranties will survive indefinitely. These include authorization, capital structure and ownership, title, and brokers.

Indemnification

The purchaser will expect the seller to stand behind their representations and warranties by providing indemnification—in the form of financial compensation—to the purchaser if there is a breach. The seller will also indemnify the purchaser for other breaches of the purchase agreement and ancillary agreements, along with any seller-retained liabilities and any debt and liens not previously disclosed and paid off at closing. In addition, the purchaser may require specific indemnities from the seller if there are risks or concerns—for example, where the seller is required to secure key customer consent or settle existing litigation.

The purchaser will likewise provide indemnification to the seller for their own breach of representations, warranties, and covenants covered by the purchase agreement, as well as for any liabilities of the seller that they are assuming.

Limitation of Liability

The seller will likely negotiate certain limitations to the indemnification obligations. These can take the form of a deductible, or “basket,” and a “cap.” The deductible, or basket, sets a floor on the amount of losses that the purchaser must sustain before the seller is required to compensate them for the loss. Baskets fall into two categories:  “first dollar” or “tipping.” First dollar baskets mean that, once the threshold is met, the purchaser will be entitled to indemnification going back to the first dollar of loss. Tipping baskets would entitle the purchaser to indemnification only for amounts above the threshold. Depending on the size of the transaction, the parties may also negotiate a “minimum claim” requirement, whereby the seller will not have any indemnification obligations for claims below a certain minimum amount.

At the other end, there will be a “cap” on the total indemnification obligations. While sellers want to limit their liability and seek the lowest cap possible, it is more prudent to focus on receiving the highest deductible possible. The types of catastrophic losses that would necessitate an indemnity cap are rare. Much more likely are the smaller claims that may be avoided if the deductible is high enough. The American Bar Association and other industry groups regularly produce market reports that provide data on the various terms negotiated by parties to purchase agreements. These reports serve as helpful negotiation tools for both parties so that the terms stay within an acceptable market range.

Non-Direct Damages

The purchase agreement may also exclude non-direct damages (i.e., consequential, special, indirect, or punitive damages) in an indemnity claim, except to the extent awarded to a third party in a third-party claim. The purchaser will want the agreement to specify that this limitation will not rule out indemnification for damages based on a decline in value.

The limitations on indemnification will apply to both parties, though these limits generally only apply to indemnification obligations of non-fundamental representations and warranties. The limitations will not apply to breaches of representations and warranties, taxes, or any other indemnification obligation. They will also not apply in the case of fraud or intentional misrepresentation.

The purchase agreement might provide for how losses are calculated for the purpose of a party’s indemnification obligations. Losses normally will be calculated net of (i) any amount actually recovered by the indemnified party from a third party, (ii)  any tax benefit actually realized with respect to such losses, and (ii) any insurance proceeds actually received by such indemnified party, excluding self-insurance arrangements and net of any deductible or other expenses incurred by the indemnified party in collecting any such insurance proceeds.

The purchase agreement should contain a provision as to how third-party claims will be handled. Terms include:

• notice of the claim;
• that the indemnifying party can generally control the defense, and that the indemnified party can take over if the indemnifying party refuses to or does not adequately handle the defense;
• that the indemnified party will reasonably cooperate with the indemnifying party;
• that the indemnifying party will not settle the case without the consent of the indemnified party.

Additional Securities

If there is contingent consideration, note payments, or other amounts still to be paid by the purchaser to the seller, then the purchaser will want set-off rights to provide additional security for any losses for which the seller is obligated to indemnify the purchaser.

The seller will want the purchase agreement to state that the indemnification provisions and any rights to equitable relief (including specific performance) will be the exclusive remedies of the parties, except for claims arising from fraud or intentional misrepresentation. The purchaser will want to clarify that this limitation will not restrict any additional rights and remedies they may have under the ancillary agreements.

Keep in mind that purchasing insurance is one way to minimize risk in the event that a representation or warranty is breached.

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[Editors’ Note: If you want to read more about how to sell or otherwise exit a business, be sure to read Business Transition and Exit Planning: Welcome to the Jungle! It will lead you step-by-step through what you need to know.

To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• Roadmap to Selling a Business or Taking on Outside Investors
• Key Provisions in M&A Agreements
• Negotiating an M&A Deal]

This is an updated version of an article originally published on April 3, 2015 and previously updated on June 10, 2019]

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