When it comes to due diligence in buying a business, Benjamin Franklin said it best in that an ounce of prevention is worth a pound of cure. In the same light, the more that a buyer can learn about a business before they actually acquire it, the better the position they will be in when negotiating the key terms of a purchase agreement.
Regardless if the purchase agreement is to buy shares or assets, there are several key terms of any purchase agreement that buyers and sellers should take time to negotiate carefully. Key terms include, but are not limited to, the following:
The Purchase Price:
Preliminary negotiations will allow the parties to come to a tentative agreement on the purchase price of the business, however, a buyer may need to negotiate the purchase price payment structure based on the results of the buyer’s due diligence on the business.
If any risks in acquiring the business are discovered in the due diligence process, buyers will normally want to hold back some part of the purchase price to mitigate their risk and as security to ensure they have recourse against the seller should something occur (or not occur) following the closing of the sale.
A buyer’s strategy will be to hold back a significant portion of the purchase price, whereas sellers will want most, if not all, of the purchase price payment on closing. Ultimately, it will be up to the parties to negotiate how the purchase price is to be structured and paid.
Representations and Warranties:
Representations and warranties of the purchase agreement is all about risk allocation. It is in this section of the purchase agreement where the seller formally describes the condition of the business and makes disclosures about any issues or problems that the seller is aware of. Typical representations and warranties would include that the business has no litigation, no environmental issues, no labour issues, has paid all taxes and has no issues with any of the business’ customers, clients and suppliers except as otherwise disclosed to the buyer. Once these representations and warranties have been made, a buyer can negotiate who will assume various risks for any issues disclosed by the seller. An example of such negotiation would be that the parties will agree who is responsible for paying damages if a lawsuit is brought against the business or if an existing environmental issue of the business should arise after closing of the purchase agreement.
Covenants are the actions that the buyer and seller agree to take both before and after closing of the purchase agreement. For example, the seller will agree to operate the business as usual until the sale closes and to avoid any significant changes like making new capital expenditures or major employment modifications to the business. The buyer will also likely want the Seller to agree to a non-compete agreement whereby the seller promises not to participate in a competing business for a certain number of years after the closing.
In most acquisitions there is a period of time between signing the purchase agreement and the closing of the transaction, which is the date a buyer takes possession of the business. Closing conditions are tasks the seller agrees to complete during this interim period in order for the purchase agreement to close. For example, there may be contracts or leases that the seller must obtain consent from third parties to transfer them to the buyer as the new owner. There may also be remedial action to take such as cleaning up corporate or environmental issues flagged during the buyer’s due diligence.
This is an important section where buyers and seller negotiate who will be responsible to pay if the disclosures about the business turn out to be inaccurate or if covenants are not respected. An example would be that a seller represents that there are no litigations or threatened ligations against a business, but the buyer discovers after closing that a litigation is about to be filed against the business that the seller was aware of. Properly drafted indemnities will protect a buyer from these unforeseen situations.
Ancillary agreements are agreements that accompany the main purchase agreement and often play a critical role in the success of the main purchase agreement. These may include a non-compete agreement for the seller and a transitional service agreement where the seller agrees to provide service after closing.
Proper due diligence and negotiating clear contractual terms to mitigate risk are critical for the ongoing success of a business being sold. Properly negotiated terms will also protect both buyers and sellers and can lead to a win-win for both parties.
If you are thinking about buying or selling a business, please call Peter Gottschlich at 416-682-7064 or at email@example.com and he will be happy to help.
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