Finding Middle Ground: How Purchase Agreements Work
To understand why certain provisions in the Agreement are important, it’s necessary to understand how they interact with one another and how they are enforced.
The Purchase and Sale, Closing, Conditions to Closing, Termination, and Miscellaneous sections are all enforceable through typical contract law principles, meaning that if one of those sections is violated the injured party can bring a lawsuit claiming breach of contract.
On the other hand, the Representations and Warranties (of both parties), Covenants, and Indemnification sections are all tied together by the fact that the Representations and Warranties and Covenants are enforced through the Indemnification section. Because the representations, warranties, and covenants are some of the most important risk management tools utilized in transactions, the indemnification terms become equally important to preserve the effectiveness of those tools. In short, you can get the best representations, warranties, and covenants in the world, but if the indemnification terms don’t provide for meaningful enforcement of them they will be rendered toothless and ineffective.
Defined Terms
Although this document skips over the “Definitions” section of the Agreement, the defined terms are essential to understanding the Agreement itself. Perhaps the most difficult aspect of deciphering some contracts is understanding the implications that follow from the use of defined terms in the body of the contract. To help you get accustomed to the use of defined terms, throughout this resource we have capitalized terms that are defined in the Agreement when they are used as defined. If used in a more general sense, the terms are not capitalized (for a good example of contrasting uses, examine the uses of “business” and “Business”).
Finding Middle Ground: Our Assumptions
Our main goal in creating this guide is to provide a resource that is as helpful as possible without being distractingly complicated. When dealing with legal language, that is a tall task. While the following assumptions will apply to most lower middle market deals, every transaction is unique and will require terms to be tailored to the particular circumstances. The assumptions we’ve made in drafting this guide include:
Single corporate Buyer, single corporate Seller (“corporate” includes C Corps and S Corps, unless one or the other is specified)
An arm’s length transaction (the Buyer and Seller are not friends or family)
The signing and closing are not simultaneous
The transaction warrants a long-form agreement
Individual shareholders do not need to be party to the agreement
A purchase price adjustment based on working capital will be made after the Closing
Finding Middle Ground: Disclaimer
The contents of this guide do not constitute legal or investment advice, and should not be relied upon for such purposes. The suggestions provided herein are meant to provide a general idea of the deal terms that can be expected in the acquisition of a business operating in the lower middle market (under $100 million in enterprise value), and are not tailored to the particularities of any specific acquisition.
A business acquisition is a highly customizable transaction that should reflect the needs and interests of the parties involved, and should only be undertaken with the help of competent professionals (attorneys, accountants, tax advisors, etc.) with acquisition experience.
How To Use "Finding Middle Ground"
This guide will be most helpful when read side-by-side with a purchase agreement to help make sense of the Agreement’s terms. Each section can be read by itself, without reference to the other sections, and in any order.
Each guide begins with:
A rating of that section’s Significance to the deal
An estimate of that section’s Time to Negotiate
An estimate of that section’s impact on Transaction Cost
An indication of whether that section affects Deal Value, Risk Assessment, and Ability to Close
We provide each of these in an easy to read format as shown below:
In this example, we learn the following about the Real Property section of a Purchase Agreement:
The Significance of Real Property on a deal is Situation Specific
The impact Real Property has on the Time to Negotiate ranges from Minimal to Moderate
The impact of Real Property on Transaction Costs can either be Minimal or Substantial (as its Situation Specific nature would suggest)
Real Property impacts both Deal Value and Risk Assessment
How We Measure “Significance”
Each term is categorized according to its impact on (1) deal value, (2) risk allocation and management (together, “risk management”), and (3) the likelihood that the parties will complete the proposed transaction. Each term has been classified into one of the following four categories:
Deal-Drivers
These terms have the most significant effect on one or more of the three factors listed above. They should be the main focus when conducting research and negotiating an agreement. Because they are supremely important to both sides, the middle-ground options are more likely to be a starting point than the final terms. Typically, the contents of these terms will be specialized to cater to the needs of the participating parties. That is not to say that the middle ground terms are not fair and useful, but the more important the term is, the less likely it is that the standard position will satisfy each side’s goals. Once in place, if these terms are not adhered to the deal will likely fall apart and, in many cases, may result in legal liability.
Situation-Specific
These terms are labeled “Situation Specific Terms” because their importance depends on the context of the particular deal. They may be worthy of significant focus, or they may address a remote contingency that is not worth formal negotiation. When they are important to a deal, they will usually take center stage in the negotiations. When they are largely irrelevant, they can safely be relegated to the background through the use of a middle-ground term or by letting each side’s lawyers sort it out. Likewise, there may be substantial transaction costs relating to these terms, or those costs may be almost nonexistent. If important to the specific situation, these terms may act as deal-driving terms. If irrelevant, leaving them unaddressed may simply be ignored.
Moderately Material
These terms have a moderate influence on one or more of our classification factors. They also may serve the role of enhancing the effectiveness of more important terms. They are worth consideration and negotiation, but using a standard, middle-ground term instead of a highly-negotiated term is not likely to cause significant harm for either party. A violation of these terms, or the failure to include one or more of them in the Agreement, will typically expose one or both sides to modest risk or a relatively small loss in deal value, but they are not likely to disrupt the entire transaction.
Insignificant
These terms tend to be related to operational procedures or conduct, and are not likely to cause significant disagreement between the parties. Their effect is typically to make fulfillment of other terms more likely or to allocate smaller levels of risk. Because the dollar-value impact of these terms is less than that of the other terms, they can safely fly under your radar. But, a word of caution. No term in an acquisition agreement is included without reason. Every standard term addresses a potential issue, no matter how remote. Under the radar terms aren’t worthy of great attention from the Buyer and Seller, but they should be reviewed by the lawyers on both sides to ensure no unnecessary or unwanted terms make it into the Agreement.
Welcome To Finding Middle Ground: Demystifying Deal Structure
Permanent Equity’s Guide to Purchase Agreements
With the majority of successful private companies owned by Boomers and most without succession plans in place, there’s a wave of transactions starting to build. It’s the opportunity for owners to cash in on decades of work and for the firms created to endure beyond. The stakes could hardly be higher.
Encountering an unfamiliar process with so much on the line often leads sellers to engage in excessive negotiation, research, and second-guessing. That, in turn, results in higher transaction costs, fewer completed deals, and longer time horizons.
Our goal in creating this resource is to start a conversation about “the middle ground” and hopefully find it quicker. Instead of starting at extremes and going through the costly, tedious, and perilous process of negotiating to the middle, what if we started in "the middle" and made arguments, based on particular deal facts, for moving outside of it?
But, what is “the middle?”
We spent 18 months collecting and organizing our decade of experience, read what others had written on the topic, and phoned a few knowledgeable friends. As lawyers and deal professionals, we need your help to add nuance, refine the terms, and track trends.
Our analysis is grounded in the terms of an Asset Purchase Agreement (the “Agreement”), the most common deal structure in lower middle market acquisitions. For each term, we will discuss (1) the standard, middle ground contents; (2) the term’s level of importance; (3) the preferred tweaks from both the buyer’s and seller’s perspective; and, when appropriate, (4) how and why the terms in a stock sale would be materially different from those in an asset acquisition. We will also highlight the negotiation time and transaction costs typically associated with each term, as well as the section of the Agreement where each term can be found.
We hope you find it useful. If you’d prefer to read through in PDF form, you may download it here.
The Permanent Equity Team