Purchase Agreements, Positive Covenants, and Restrictive Covenants in M&A Transactions

The term ‘covenant’ rarely gets used outside of religious circles and fantasy fiction. Despite its historical connotations, the term holds very different significance in the context of mergers and acquisitions (M&A).

Imagine a lengthy journey through due diligence and negotiations between a prospective buyer and seller. After that arduous process, the closing of their transaction grows ever closer. This is when the word ‘covenant’ comes into play. It is an essential part of a purchase agreement designed to ensure the transition runs smoothly.

Covenants in M&A transactions serve as enforceable promises to either do something (i.e., positive covenants) or not do something (i.e., restrictive covenants) that will impact the company or the sale. These promises, typically made by the seller, protect the buyer before and after the deal closes.

Pre-Closing Covenants

Sometimes, there will be a delay between the signing of a purchase agreement and the closing requirements of the transaction. In those cases, the purchase agreement will include certain pre-closing covenants.

Most of these favor the buyer. They generally strive to assure the buyer that no surprises will occur during the interim period or at closing.

The buyer may also give the seller pre-closing covenants. These usually limit the buyer to agreeing to obtain all applicable governmental and third-party approvals and consent. They may also require the buyer to secure financing to fund the purchase price.

Some of the other most common positive and restrictive covenants made by the seller include:

• The seller will continue to operate the business in the ordinary course and will not take any significant action without the buyer’s prior consent.
• The seller promises to notify the buyer if any events might cause a material adverse effect on the company, its business, or its assets.
• The seller agrees to provide the buyer with reasonable access to the business, which may include the seller’s premises, personnel, and assets. This helps the buyer continue their due diligence.
• Depending on the gap between the signing and closing, the buyer may require the seller to provide monthly financial statements.
• The seller may agree to a ‘no shop’ clause. This clause states that the seller will not enter into competing negotiations with another buyer.

Restrictive Covenants and Other Post-Closing Agreements

Both parties will generally make several post-closing covenants. These may involve restrictive covenants made by the seller and owners in favor of the buyer. They may address the protection of confidential information of the target and non-disparagement agreements. Other examples include promises of non-competition and non-solicitation of employees and customers for a limited time. In most circumstances, that limit falls between two and five years.

The parties will also agree on how to file and pay taxes for the target. Post-closing restrictive covenants should include an agreement on handling any applicable transfer taxes. The agreement will generally waive compliance with any applicable bulk sales laws. In some situations, the buyer may still want to make any requisite filings with state and local authorities.

Through a positive covenant, the buyer may agree to offer employment to each of the target’s employees for at least the same compensation and benefits being paid by the seller. The buyer may require the seller to pay employees accrued and unpaid compensation and benefits before closing. If those amounts were included in the balance sheet calculations and already reflected in the purchase price adjustments, this may not apply.

Finally, the parties may agree that any press releases or other public statements should be mutually acceptable to both parties.

Specific Variations With Asset Deals

Sometimes, the transaction gets structured as an ‘asset deal.’ This varies from the four other types of M&A deal structures in that it does not involve the target company’s shareholders. Instead, the buyers identify specific assets they want to acquire. The seller’s company remains operational.

This deal structure often incorporates specific types of restrictive covenants and post-closing agreements. In an asset deal, they will also agree on how the assets will be allocated for tax purposes. The seller will generally prefer an allocation that emphasizes capital gain over ordinary income. In contrast, the buyer will generally prefer an allocation that allows it to maximize depreciation and amortization of the target assets.

In an asset deal, buyers generally require the seller to make filings to change the target’s name to match its state of formation and wherever it qualifies to do business. This allows the buyer entity to use the same name after closing.

Closing Requirements & Provisions

During closing, the execution of the purchase agreement (a ‘sign and close’) often occurs concurrently. In some cases, it may occur after some time, typically after satisfactory fulfillment of certain negotiated conditions.

Such inclusions generally protect all parties in the transaction. They may include requirements that:

• each party’s representations and warranties remain accurate as of the closing date;
• neither party is in breach of any of its obligations under the purchase agreement;
• all required governmental and third-party consents have been obtained;
• no legal proceedings affect the target or any of the parties’ ability to close;
• a buyer’s due diligence proves satisfactory;
• the buyer has obtained financing, and
• all ancillary agreements and closing deliveries have been delivered.

General Ancillary Agreements and Closing Deliveries

To ensure closing requirements have been met, buyers and sellers may require certain deliveries. This may begin with good standing certificates for each party and certified copies of each party’s organizational documents. Requested materials may also include a certificate of the secretary or manager of each party, dated the closing date as to such party, often including:

• Organizational documents in effect as of the closing date.
• Resolutions adopted by members, managers, the board of directors, and the shareholders authorizing and approving the transaction.
• Officers authorized to execute and deliver the purchase agreement and ancillary agreements.

Buyers often request evidence of the seller’s payoff of any loans requiring repayment at closing, too. This request could include copies of lien releases and other evidence of the release and discharge of any liens on the purchased assets. But if previously approved by the buyer, this would exclude some liens. All consents, waivers, and approvals from government agencies and third parties required by the purchase agreement will require verification.

If the seller is acquiring equity in the buyer as part of the purchase price, then the seller will take other specific steps. This could include executing a subscription agreement. Such agreements often deal with the number of shares sold and the agreed-upon price.

This step may also involve other documents governing the ownership of such equity, such as an operating agreement or shareholders’ agreement. Sometimes, the buyer promises to hire the owner or any of the seller’s key executives. In these cases, employment agreements for each will likely be required.

Closing Agreement Variations

Depending on the deal structure, different types of closing agreements may be incorporated into the transaction. In an asset deal, here are some common additional deliveries and instruments for transfer:

• A bill of sale for the assets being purchased.
• An assignment and assumption agreement for assumed contracts.
• An assignment of intangible property for the intellectual property being purchased (sometimes combined with the bill of sale).
• Title certificates and deeds for titled personal property, vehicles, and real estate.
• The books and records of the target.

Things may get a little more complicated in a stock deal. Frequently required deliveries include certificates of the stock or equity being purchased. This involves proper endorsements, stock powers, or other appropriate instruments of assignment and transfer. If applicable, requisite spousal consent and release will be incorporated at this step.

Any directors, managers, members, and officers of the target from all positions of authority held by each may need to provide written resignations. These often become effective immediately after the closing. These do not necessarily serve as resignations of employment. Instead, they facilitate the buyer establishing their own slate of directors and officers after they acquire the stock.

Just One Piece of the M&A Puzzle

It’s understandable if the word ‘covenant’ conjures up memories of Bible study or Indiana Jones. However, for entrepreneurs and investors, covenants operate as formal agreements critical to maintaining the value of a target company.

These restrictive and positive covenants/provisions constitute just one of the many components that make up the purchase agreement and the M&A transaction overall. By understanding their value, you can better navigate the rest.

And that’s a promise worthy of the word.

We think you’ll also like:

1. Understanding the Purchase Agreement and Risk Allocation Provisions: An Essential Overview
2. Strategic vs. Financial Buyers: Distinctive Ways of Acquiring Businesses
3. How to Conduct Due Diligence Before Buying a Business

[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. How to Read a Balance Sheet – And Why You Care!

This article was originally published in 2020 and updated on April 19, 2023. This article was most recently updated by the Financial Poise Editors.] 

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