Your client, the owner of a successful company, has decided to sell his business. He tells you that the buyer is someone he has known in the industry for many years; they have agreed upon the purchase price and expect that the transaction can be structured "rather simply." Fast forward a few weeks or months later. You are now explaining to a frustrated client why he just received a fifty page agreement (with ancillary agreements) memorializing that simple deal. This article offers a broad overview of the major components of an asset purchase agreement ("Agreement") and explains why it is often more complex than the "simple agreement envisioned by the client.
Structure of Transaction
There are several different ways to structure an acquisition. The threshold question is usually whether the transaction will be a sale of stock or a sale of assets. This decision reflects the nature of the industry and the identity and tax status of the buyer and seller. This issue is often the most significant factor affecting the after tax return to the seller under the current tax rate structure that generally taxes net long term capital gains at the preferential rate of 15% 1 Private company acquisitions more often involve the taxable purchase of assets based upon the desire of the buyer to amortize the purchase price for tax purposes and to be selective about the specific assets purchased and liabilities assumed. This article assumes that the purchase price is significant enough to justify a more comprehensive agreement.2 Many of the concepts involved in this type of transaction, particularly the nontax factors, are common to all acquisitions.
Is there a Letter of Intent?
A letter of intent ("LOI") or term sheet is a nonbinding agreement between the buyer and seller and possibly the seller’s owner setting forth the business terms for the transaction. The significant terms include the structure of the transaction (stock or assets) the purchase price, the mechanism for adjusting the purchase price, purchase price payment and other terms specific to the transaction such as real property leases and covenants not to compete. The LOI may also contain binding provisions such as a "no shop" clause which prohibits the seller from soliciting or entertaining offers from other suitors for a specified period or non-solicitation covenants prohibiting the buyer from hiring any of seller’s employees or soliciting its customers for a specified period if the transaction is not consummated. An LOI is not required in order to draft an Agreement, but it is often helpful to avoid later disagreement over business terms and can regulate the conduct of the seller and buyer during and after the acquisition process if the transaction does not close.
The Major Components of the Acquisition Agreement
While every transaction is unique, the Agreement is usually structured in Sections or Articles according to the following chronological order:
· Description of the Transaction
· Representations and Warranties
· Conditions to Closing and Closing Deliveries
· Post Closing Covenants and Indemnification
The size and complexity of the transaction demands that the attorney determine the need for a particular section and the associated content. For example, an Agreement for the sale of a manufacturer will contain representations and warranties that may be quite different than those of a seller in the service industry. Though technology has leveled the playing field for law firms of all sizes to produce incredibly lengthy and sophisticated agreements, clients demand that the Agreement fit their transaction and avoids unnecessary verbiage. The remainder of this article examines the common components of the Agreement in more detail.
The introduction section and the presence and length of any preamble reflect the personal style of the drafting attorney. If the transaction is small, the preamble may describe and define many if not all of the transaction terms. More often, the preamble will merely recite the core transaction in a few brief sections. If the parties intend for the preamble to have legal effect, the Agreement should clearly state this, although any significant legal or business terms should be in the body of the Agreement. In a larger transaction, the preamble may be brief, because significant terms are defined in a separate section.
The definitions section performs several essential functions in the Agreement, but can be misused. Definitions will usually appear after the introductory terms, although some attorneys prefer defined terms at the end of the Agreement, or even appended to the Agreement as a stand alone document. Definitions permit the drafting attorney to achieve consistency in the Agreement so that if the parties change a definition, the changes apply consistently throughout the Agreement. The buyer and seller attorney may negotiate extensively over definitions such as "purchased assets" "excluded assets" "assumed liabilities" "purchase price" "working capital" and "knowledge" and "materiality." The drafting attorney should be careful to avoid defined terms that are not relevant to the transaction. The Agreement negotiation will start off on the wrong foot if the seller attorney receives a five page definition section from the buyer’s attorney that is filled with superfluous defined terms from a template agreement not relevant to the transaction.
The transaction structure section describes the basic business transaction that the parties have agreed to. This section details the purchase price for the purchased assets, prorations and other adjustments to the purchase price, escrowed amounts, assumed liabilities, and allocation of purchase price. Often the buyer and seller believe they are fully aware of the economics of their transaction until they see it memorialized in this section of the Agreement.
If the transaction involves the purchase of an operating business, the parties will often agree upon a working capital3 adjustment that occurs after the closing date. If the transaction closes on December 31, but the parties used the balance sheet of seller from September 30 for their closing date figures, the working capital adjustment can significantly increase or decrease the purchase price. If there is a purchase price adjustment in the Agreement whether based upon working capital or some other benchmark, the parties should specify who is responsible for preparing the closing date balance sheet. The Agreement should also include the mechanism for resolving any disputes over any purchase price adjustment. The parties may include the name of an independent accounting firm that will resolve all disputes.
In a similar vein, the allocation of the purchase price among the purchased assets will affect the net purchase price the seller and ultimately the seller’s owner receive after taxes. The allocation negotiations reflect the tension between the desire of the seller and its owner to maximize after tax return and the buyer’s desire to amortize the purchase price as quickly as possible. The tax status of the seller affects this analysis. Limited liability companies and Subchapter S corporations offer the parties greater tax flexibility in structuring the deal than "regular" or Subchapter "C" corporations. 4 However, all tax structures present purchase price allocation issues.
Example: Subchapter S Corporation
A seller that is taxed as a Subchapter S corporation may own assets that include machinery and equipment with significant economic value that the seller has fully depreciated for tax purposes. The buyer may want to allocate a substantial part of the purchase price to these purchased assets because it can depreciate that part of the purchase price quickly. The seller however, realizes that every dollar of purchase price allocated to machinery and equipment triggers depreciation recapture5 and ordinary income rather than the preferred treatment as long term capital gain. Therefore the parties need to negotiate the amount of purchase price to allocate to equipment relative to other assets of the seller.
Example: Subchapter C Corporation
The purchase price allocation for a Subchapter "C" corporation also presents issues which can change the effective after tax proceeds. The preferential capital gains rate is not available to the Subchapter C seller. This often prompts the parties to allocate part of the purchase price to assets or services outside of the seller corporation For example, the seller’s owner may advocate allocating some of the purchase price to a consulting agreement, covenant not to compete, or goodwill that the owner asserts is not owned by the seller, but rather personally by the seller’s owner.6 This type of allocation in turn competes with the buyer’s desire to quickly amortize the purchase price.7
The Agreement should specify the agreed allocation of purchase price, which is usually appended to the Agreement as a schedule, the method of determining the allocation and the requirement that the parties consistently report the allocation for Federal income tax purposes. 8
Representations and Warranties
The representations and warranties, particularly those of the seller, are often the largest section of the Agreement. Although the terms are lumped together, the more accurate term is "seller representations." 9 The representations are "statements of past or existing facts."10 These representations usually address the seller’s legal status, authority to transact business, representations about the quality of the purchased assets, operations, financial statements, taxes, litigation, environmental issues, retirement plans, employees and labor matters. Buyer representations, particularly if the purchase price is all cash, are often limited to the status of the buyer, its organization and its authority to enter into the Agreement. If the buyer is a newly created entity or thinly capitalized, the seller will also usually seek a solvency representation. The representations and warranties section can also suffer from overuse of a form agreement. For example, if a seller maintains a simple prototype 401(k) plan, the Agreement may not need several pages of representations about the seller’s qualified plans. If the seller is a service business, the Agreement may not need extensive environmental representations.
The representations and warranties section reflects the due diligence efforts of the seller and buyer. During the due diligence process, the seller usually provides extensive information about its operations to buyer, including financial statements, information about its assets, significant obligations, environmental reports, personnel information, and the status of any litigation or claims. This information will usually be condensed and presented on disclosure schedules that are linked to specific representations in the Agreement. Generally the seller will seek to absolve itself of responsibility for items that it has scheduled and disclosed to the buyer. The buyer on the other hand desires to avoid responsibility for anything that occurred prior to the closing and may require specific language in the Agreement that disclaims such liability. If a disclosed item is significant, the parties will need to specifically negotiate who is responsible after the closing for the disclosure item.
Buyer and seller negotiations over representations and warranties often revolve around use of the term "knowledge" to qualify a representation. The seller will seek to confine representations to the actual knowledge of the owner, while the Buyer desires that the knowledge of all employees of the company should be imputed to the company. Often, an agreement will merely use the term "knowledge" without defining it. This can create disputes after the closing date which the parties could avoid with a better definition. For example, "knowledge" might be defined as " the "knowledge of seller’s owner, chief executive officer, and chief financial officer after due inquiry." The number of individuals included in the knowledge definition will ultimately reflect the compromise between the buyer’s desire to include the knowledge of all employees of seller and the seller’s desire to limit knowledge to one person or a select number of key executives or employees.
Representations in the Agreement may also be qualified by the term "material," or "material adverse affect." These qualifications often appear in the representations associated with the seller’s financial statements. Many agreements do not define "material" or "material adverse affect." Even an authoritive definition of materiality in a financial statement context is murky:
"...the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement."11
The parties may resort to specifying a certain dollar threshold as being "material." Based upon the size of the transaction, the parties should consider the degree to which they need to define the terms "material" or "material adverse affect."
Conditions to Closing/ Closing Deliveries
The closing conditions are specific conditions imposed upon the seller and buyer as a condition to closing the transaction. These usually include "date down" representations from the seller that there has not been any material change in the business of the seller, or the condition of the purchased assets from the date of the Agreement or a prior date to the closing date. The closing conditions may also restrict the seller’s ability to make decisions about its operations. For example, the closing conditions may prohibit the seller from paying bonuses to its employees or increasing compensation. As a practical matter, the buyer and the seller are often negotiating the Agreement to the closing date. If so, the conditions to closing are less relevant, because the buyer and seller technically do not have a binding Agreement.
Following the closing conditions, the Agreement will specify closing deliveries (what each party is required to produce at the closing). Some attorneys prefer to place the closing deliveries at the front of the Agreement. It is more common for the deliveries to follow the conditions to closing. The closing deliverables generally list the manner of delivering the purchase price and the various documents executed on the closing date, including the bill of sale, assignment and assumption agreement, directors and shareholders resolutions and any leases or other agreements specific to the transaction and needed to consummate the closing of the transaction.
Post Closing Covenants and Indemnification.
The post closing covenants section of the Agreement contains the various promises of the parties that survive the closing date. The most prominent covenant is often the covenant not to compete, which details the scope and duration of non-competition and related restrictions on the activities of seller and its owner after the closing date.
The indemnification section, although technically a post closing covenant, is usually in a separate section of the Agreement after the post closing covenants. The indemnification provisions describe how the seller and buyer will indemnify each other for the items in the Agreement that trigger any indemnification obligation. Generally, the Agreement will require each party to indemnify the other for liability arising out of claims that occur before or after the closing date, as applicable. Each party will also indemnify the other for a breach of their respective representations and warranties.
The parties often negotiate the indemnification provision’s duration, any basket or deductible on indemnifiable claims, and the ceiling or cap on damages recoverable from the indemnifying party.
In order to avoid the ten year statute of limitations on a written contract, the seller, and seller’s owner who is often required to personally indemnify the buyer, will seek to limit the indemnification period to a relatively short term of twelve months or less. The buyer, knowing the seller will not agree to a ten year indemnification provision, typically seeks an indemnification period such as three years. Generally, the indemnification for environmental matters and fraud will not contain any limitation period and indemnification for tax matters typically will not expire until the relevant statute of limitations underlying the tax matter has expired.
The indemnification deductible is premised upon the desire of the parties to avoid disputes over minor items. For example, if the purchase price is $10 million, the parties may agree that the first $50,000 of items that would otherwise be indemnifiable by the seller cannot be recovered by the buyer. The deductible may take the form of a true deductible so that the buyer recovers the first dollar for any claim or claims in excess of the deductible (e.g. only $1 is indemnified for $50,001 in damages in the above example), or a reset or disappearing deductible which requires the seller to indemnify the buyer from the first dollar if claims exceed the deductible. Like the varying limitations periods on certain representations, the parties may agree that a deductible does not apply to particular claims such as tax or fraud claims.
Whether there is a cap or ceiling on the amount indemnified and the dollar amount of such cap is the final major prong the parties typically negotiate involving indemnification. The seller and its owner seek to limit indemnification obligations as much as possible, while the buyer seeks to avoid any cap or ceiling. Often, the negotiated result is a cap on indemnification limited to the purchase price for the purchased assets. In certain circumstances, the seller may be able to reduce the indemnification ceiling based upon the nature of the industry and the knowledge that the buyer possesses about the seller.
The indemnification procedure to be followed by the parties is also an important part of the Agreement. This section should describe the way in which the indemnitee must notify the indemnitor about an indemnifiable claim, the ability of the indemnitor to use its own counsel, and the consequences of the indemnitor’s failure to fulfill its indemnification obligations under the Agreement.
Miscellaneous and Signatures.
The final section of the Agreement usually contains miscellaneous but often overlooked terms. The miscellaneous section typically specifies governing law, the venue for disputes and the method of resolving disputes. This section may also specify that the prevailing party is entitled to its legal fees and costs if it prevails in any dispute. Arbitration clauses are growing in popularity as a means of resolving disputes. If the parties agree that arbitration will resolve disputes, they should specify in detail the protocol for conducting the arbitration and its legal effect. 1 Finally, the attorneys should make sure that after they have devoted substantial effort to the Agreement, they have verified the "little things." Clients will not appreciate all of the hard work and effort devoted to the Agreement if they see their name misspelled.
This article has reviewed the major components of a business purchase agreement. Attorneys that craft an effective purchase agreement will truly add value for their clients and assure that the "simple deal" is structured as their client intended.
1. See §1(h) (1) of the Internal Revenue Code of 1986 (the "Code"). Technically, there are four maximum capital gains rates of 5%, 15%, 25% and 28% applying to different types of capital gain, some of which apply only with respect to specific taxable years.
2. If the purchase price is relatively small, and the assets or business operations purchased are less complex, it may not justify the time and expense associated with a lengthy acquisition agreement.
3. Working capital is typically expressed as net working capital, or the excess of accounts receivable and inventory over accounts payable. The parties will usually customize the definition of working capital to fit the transaction.
4. Limited liability companies and Subchapter "S’ corporations are generally not taxpayers for federal income tax purposes, while a Subchapter "C" corporation is a taxpayer liable for tax in accordance with §11(b) of the Code. .
5. §1245 of the Code.
6. See Martin Ice Cream Co. v. Comr., 110 T.C. 189 (1998).
7. See §197 of the Code which requires all acquired intangibles, which include covenants not to compete, to be amortized on a straight line basis over a 15 year period.
8. Upon the sale of assets constituting a "trade or business" the parties must allocate the purchase price among the assets using the "residual method." The residual method requires the purchase price to be allocated among seven asset classes according to their respective fair market value. See §1060. The allocation is reported by the parties on IRS form 8594.
9. Adams, "A Lesson in Drafting Contracts," 15 ABA Business Lawyer No.2 Nov/Dec. 2005.
10. Adams, at 33, 35.
11. Financial Statements Accounting Standards Board Statement of Financial Accounting Concepts (1985).
12. The American Arbitration Association website at www.adr.org contains a substantial amount of information about the arbitration process.
Ken Clingen is a founding member of Clingen Callow & McLean; he represents privately owned businesses and their owners as outside general counsel with specific emphasis on federal income