Purchase Agreement Essentials – Positive Covenants and Restrictive Covenants in M&A Transactions

More Assurances, Fewer Surprises

Both Buyer and Seller are nearing the closing of their transaction. There is still another element of the purchase agreement that needs to be addressed to ensure that the transition runs smoothly: covenants. Covenants in M&A transactions are 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 covenants, typically made by the seller, are meant to protect the buyer prior to and after the deal closes.

Pre-Closing Covenants

If there will be a delay between the signing of the purchase agreement and the closing requirements of the Transaction, then the purchase agreement will include certain pre-closing covenants. Most of these will be made by the Seller in favor of the buyer, and are generally intended to give assurances to the buyer that there will be no surprises during the interim period or at closing. The buyer may also give the seller pre-closing covenants. These are usually limited to the buyer agreeing to obtain all applicable governmental and third-party approvals and consents, and perhaps to secure financing to fund the purchase price.

Below are the most common positive covenants and restrictive covenants made by the seller:

• The seller will continue to operate the business in the ordinary course and will not take any major actions without the prior consent of the buyer.
• The seller promises to give the buyer notice if there are any events that might cause a material adverse effect on the company, its business or assets.
• The seller will agree to provide the buyer reasonable access to the seller’s premises, personnel and assets to allow the buyer to continue its due diligence.
• The seller will covenant to obtain all required governmental and third-party approvals and consents.
• Depending on the amount of time between the signing and closing, the buyer may also require the seller to provide monthly financial statements.
• The seller may agree to a “no shop” clause where the seller agrees not to enter into any competing negotiations with another buyer.

Restrictive Covenants and Other Post-Closing Agreements

Both parties will generally make a number of post-closing covenants. These include restrictive covenants made by the seller and owners in favor of the buyer regarding confidential information of the target, non-competition and non-solicitation of employees and customers for a limited number of years (usually between two and five) and non-disparagement.

In an asset deal, the buyer may agree, through positive covenant, 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 accrued and unpaid compensation and benefits to employees prior to closing, unless those amounts were included in the balance sheet calculations and already reflected in the purchase price adjustments.

The parties will also agree on how taxes for the target will be filed and paid. If the transaction is an asset purchase, 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, while the buyer will generally prefer an allocation that allows it to maximize depreciation and amortization of the assets it is acquiring.

Post-closing restrictive covenants should include an agreement on how to handle any applicable transfer taxes. The agreement will generally waive compliance with any applicable bulk sales laws (although the buyer may still want to make any requisite filings with state and local authorities).

In an asset deal, the seller will generally be required to make filings to change the target’s name with its state of formation and wherever it may be qualified to do business, so that the buyer entity can use the same name after closing.

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

Closing Requirements & Provisions

The closing of the transaction may either be concurrent with the execution of the purchase agreement (a “sign and close”), or it may occur after a period of time, typically after certain negotiated conditions are satisfied.

These closing conditions generally include requirements that: (i) each party’s representations and warranties remain accurate as of the closing date; (ii) neither party is in breach of any of its obligations under the purchase agreement; (iii) all required governmental and third party consents have been obtained; (iv) there are no legal proceedings affecting the target or any of the parties’ ability to close; (v) the buyer is satisfied with its due diligence; (vi) the buyer has obtained sufficient financing; and (vi) all ancillary agreements and closing deliveries have been delivered.

Regardless of whether the transaction is an asset or a stock deal, the ancillary agreements and closing deliveries will usually include:

• Good standing certificates with respect to each party;
• Certified copies of each party’s organizational documents;
• Certificate of the secretary or manager of each party, dated the closing date as to such party’s (i) organizational documents in effect as of the closing date; (ii) resolutions adopted by members, managers, board of directors and the shareholders authorizing and approving the transaction; and (iv) officers authorized to execute and deliver the purchase agreement ancillary agreements;
• Evidence of the seller’s payoff of any loans required to be repaid at closing, along with copies of lien releases and other evidence of the release and discharge of any liens (other than permitted liens previously approved by the buyer) on the assets being purchased;
• All consents, waivers and approvals from government agencies and third parties that are required by the purchase agreement;
• If the seller will be acquiring equity of the buyer as part of the purchase price, then the seller will execute a subscription agreement and whatever documents will be governing the ownership of such equity, such as an operating agreement or shareholders’ agreement;
• Additionally, if the owner or any of the key executives of the seller will be hired by the buyer, then there will likely be employment agreements for each of them.

If the transaction is an asset deal, there will be a number of additional deliveries and instruments that are required to transfer the assets:

• A bill of sale for the assets being purchased
• An assignment and assumption agreement for assumed contracts
• An assignment of intangible property for intellectual property being purchased (this is 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

If the transaction is a stock deal, deliveries will include:

• Certificates of the stock or equity being purchased, with proper endorsements, stock powers or other appropriate instruments of assignment and transfer, including any requisite spousal consent and release (if applicable);
• Written resignations of any directors, managers, members and officers of target from all positions of authority held by each, effective immediately after the closing. These are not necessarily resignations of employment, but rather to facilitate the buyer establishing their own slate of directors and officers after they acquires the stock.

These restrictive covenants and positive covenants/provisions are just one part of the many components that make up the purchase agreement and the M&A transaction overall. But despite the antiquated connotation we have with the word “covenant,” these are formal agreements that are important in maintaining the value of the company, and should not be overlooked by the seller.

[Editor’s 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 find definitions for some of the terms in this article, you may also visit the Business Transition and Exit Planning Glossary. To learn more about this and related topics, you may also want to attend the following webinars: Post-Closing Issues: Integration & Potential Buyer/Seller Disputes 2019 and Key Provisions in M&A Agreements. This is an updated version of an article originally published on April 3, 2015.]