The terms of sale are the heart of the purchase and sale agreement. They define:
The parties to the purchase and sale agreement will be (i) the “Buyer”, which is usually a new entity created by the principal buyer, (ii) the “Seller,” and (iii) the target company (the “Target”).
In a stock transaction, the company’s owner (the “Owner”) will be the seller. In an asset transaction, the target will be the seller, with the proceeds of the sale being distributed from the target to the owner.
If the buyer operates a similar business, then it is referred to as a “strategic” buyer. It may be purchasing the target to enter a new territory, to expand its market share, to expand its business, or for other strategic reasons.
If the buyer is a private equity fund, family office, or other private investment group, then it is referred to as a “financial” buyer. A financial buyer typically will seek to realize some investment objective through its ownership of the target, which will usually be over a five- to seven-year period. However, there are some liabilities that a buyer may not be able to avoid, even when the purchase and sale agreement provides that the buyer is not assuming them.
In the sale of a business, the buyer takes control by either purchasing all (or substantially all) of the assets or the equity of the target. In a stock or equity transaction, the buyer will purchase all of the owner’s rights, titles and interest in all equity in the target, free and clear of all liens, encumbrances and rights of third parties. If there are multiple owners, then there will typically be a schedule attached to the purchase and sale agreement describing the equity interests owned by each of the owners. The buyer will want to make sure that it is buying all of the issued and outstanding equity interests of the target. Additionally, in an equity transaction, all of the assets and liabilities will remain with the target. Only the ownership of the target will change.
In an asset transaction, the target will be selling all or a select portion of its assets to the buyer, depending on the underlying deal terms and what the buyer feels is material to operate the business after closing. These assets are usually sold free and clear of all liens, except for certain permitted immaterial liens arising by law. Even when all of the assets are being purchased, the purchase and sale agreement will still usually include an exhaustive list of the assets being purchased. While this is not technically required, it is helpful, because it memorializes the intent of the parties.
Additionally, although a transaction might be for “all of the assets,” there are usually certain assets that are excluded, including:
With respect to pre-closing liabilities, the buyer will generally only assume a limited amount, including to-be-performed obligations under assumed contracts for post-closing periods. Assumed liabilities might also include certain accounts payable and accrued expenses arising in the ordinary course of business if those items were included in the calculation of any closing date purchase price adjustments. All other liabilities of the target would generally remain with the seller. These liabilities would either be paid off at the closing or satisfied by the seller in the ordinary course.
In an equity transaction, the legal existence of the target will continue – only its ownership will change. In an asset transaction, a new entity will be purchasing the assets necessary to operate the business. This means that the buyer will also need to hire those employees of the target that it believes are necessary to continue the operations. Often, all of the existing employees will be hired as new employees of the buyer. The buyer may also want the owner to continue on as either an employee or consultant. This may be either for a short transition period of up to a year, or for multiple years.
If the buyer believes that the owner is critical to the continued growth and success of the business after closing, then it might structure the transaction so that a portion of the overall payment to the owner includes salary and bonus and, perhaps, equity in the buyer. The buyer may also condition a payment of a portion of the purchase price on the performance of the business after closing. These types of “earn-out” provisions in the terms of sale are discussed below.
The parties will likely have agreed on the purchase price at the letter of intent stage. However, the gross purchase price stated in the letter of intent will be different from the net proceeds received by the seller after taking into account contingent payments, holdbacks, payoffs and taxes. This sometimes comes as a surprise to sellers, so it is important that the seller discusses the financial and tax implications with its tax and financial advisors as early as possible. If the buyer will be assuming certain liabilities or requiring payoff of existing debt, then the cash portion of the purchase price will be reduced accordingly.
The terms of sale will then clarify how the buyer will pay the seller. The purchase price may be paid entirely in cash, but more likely will be paid with a combination of cash (at closing) and seller financing. In this case, the buyer gives the seller a promissory note for a portion of the purchase price.
Additionally, the buyer might require that a portion of the purchase price be held back for a period of time after the closing (a “holdback”), or that the target hit certain financial targets in order for a portion of the purchase price to be paid (an “earn-out”). If there are certain contingencies that the buyer will want satisfied after closing in order for the seller to receive the balance of the purchase price, then the buyer will hold back a negotiated portion pending satisfaction of those contingencies.
Holdbacks are used when there is an uncertain liability, obligation or other matter outstanding that could potentially negatively affect the value of the target. In order to avoid potentially overpaying, the buyer will require a holdback generally in an amount that would cover the contingency or equal to the potential lost value. In lieu of a holdback, the parties may agree to hold a portion of the funds in a third party escrow account. This would be preferred by the seller. A third party escrow agent holds the funds until all of the required contingencies have been satisfied or the release dates have passed.
Earn-outs are a form of contingent consideration that delays the full determination of the purchase price until post-closing after certain milestones are hit. A common earn-out milestone is the target achieving certain EBITDA targets for certain post-closing periods. Earn-outs are often used when the parties cannot agree on the price or when the buyer cannot obtain sufficient third party financing to fund the purchase.
Earn-outs can be heavily negotiated, as there are a number of potential variables and contingencies that could affect the target’s ability to achieve its earn-out targets. If the buyer will operate the target after the closing, then the seller will want to require the buyer to continue to operate the target in the ordinary course and not take any actions that might cause the target to miss its targets. Buyers often resist this.
The purchase price may also be subject to adjustment based on the target’s working capital as of the closing date, which is usually calculated between one and three months after closing. It is important to make sure that the terms of sale in the purchase and sale agreement sufficiently describe how the purchase price adjustment will be calculated and how disputes will be handled.
The dispute resolution should require deadlines for delivering objections. It should also require that the parties first negotiate disagreements in good faith for a period of time. The disputing party should be required to provide reasonable supporting documentation for such disagreement, and for those items not in dispute, the disputing party should be deemed to have agreed with all other items and amounts set forth in the closing working capital statement.
If the parties are able to resolve disputed items within a negotiated written agreement, then that should be deemed to be final, binding and conclusive on the parties. If the parties cannot agree to resolve the disputed items by negotiation, then they should be required to submit the dispute to an independent public accounting firm for resolution.
In addition to cash and the satisfaction of liabilities, a portion of the purchase price may include equity in the buyer. For instance, if the buyer wants to retain the seller to continue to run the target after closing, then it may give the seller a certain amount of equity in the buyer. This “roll-over” ensures that the seller still has skin in the game, so that he or she has the incentive to continue to help grow the company. Private equity buyers will often structure their deals in this manner so they can leverage the seller’s expertise and leadership (although strategic buyers may also use this structure when entering new markets). The equity interest may be voting or nonvoting and subject to redemption if the seller quits or is terminated for cause.
These business terms of sale, as well as the terms discussed throughout this article, create the foundation of the purchase and sale agreement. Once established, the buyer and seller will then negotiate further provisions, including closing requirements, disclosure provisions and more.
[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.
Rob is a senior associate in Levenfeld Pearlstein’s Corporate & Securities Group where he focuses on mergers and acquisitions, securities transactions, startup companies, technology agreements, and general corporate matters: M&A: Rob works with privately held businesses and investment funds across a broad range of industries in the middle market in negotiating and consummating acquisition and…
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