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

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

While these transaction structures have various technical and legal differences, all these agreements share several provisions. For the sake of simplicity, this discussion will refer only to the agreement as the ‘purchase agreement.’

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 direction and results of the negotiations.

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
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 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 the standard length of time for this period. Certain specified representations and warranties may survive for a longer period. Warranties for tax, environmental, health and safety, and employee benefits often last for 3 to 5 years after closing. They survive until the statute of limitations expires. Certain ‘fundamental’ representations and warranties will survive indefinitely. These include authorization, capital structure, 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 indemnify the purchaser for:

• Violations of the purchase and ancillary agreements,
• Any seller-retained liabilities, and
• Any undisclosed, unpaid debts and liens not paid off at closing.

Also, the purchaser may require specific indemnities from the seller if there are risks. For example, this applies if the seller must secure key customer consent or settle litigation.

The purchaser will indemnify the seller for their own breach of the purchase agreement’s representations, warranties, and covenants. They will also indemnify the seller for any liabilities 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 buyer will be indemnified for all losses from the first dollar. Tipping baskets would entitle the buyer to indemnification only for amounts above the threshold. The parties may negotiate a ’minimum claim’ requirement, depending on the transaction size. It means the seller has no indemnification obligations for claims below a certain amount.

On the other hand, there will be a ‘cap’ on the total indemnification obligations. Sellers want to limit their liability and seek the lowest cap. But, it’s wiser to focus on getting the highest deductible. 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 exclude non-direct damages in an indemnity claim. These include consequential, special, indirect, or punitive damages. But, it does not apply to damages awarded to a third party in a third-party claim. The purchaser will want the agreement to say that this limit does not exclude indemnification for damages due to a decline in value.

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

The purchase agreement might explain how to calculate losses for indemnification. Losses will be calculated net of (i) any recovery by the indemnified party from a third party, (ii) any tax benefit from the losses, and (iii) any insurance proceeds received by the indemnified party, excluding self-insurance. Also, deduct any costs incurred in collecting the insurance proceeds.

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

Terms should 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 indemnified party’s consent.

Additional Securities

Suppose there are amounts to be paid by the purchaser to the seller. These could be contingent consideration or note payments. In that case, the purchaser will want set-off rights. This will secure any losses the seller must indemnify.

The seller will want the agreement to state that the indemnity provisions and any rights to equitable relief, including specific performance, are the only remedies. This excludes claims for fraud or intentional misrepresentation. The purchaser will want to clarify that this limit won’t restrict any rights under the ancillary agreements.

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

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[Editors’ Note: 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):

1. Understanding Risk Management Basics for Business Owners
2. Structuring and Planning the M&A Transaction
3. Preparing for an Arbitration

This is an updated version of an article originally published on April 3, 2015 and previously updated on June 10, 2019 and on July 21, 2022. This article was most recently updated by the Financial Poise Editors.] 

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