Third Party Consents
What are Third Party Consents? Many times, businesses (or governmental entities) other than the Buyer and Seller will need to provide consent to some aspect of the transaction. This section lays out the consents that are required, which side is responsible for obtaining them, and addresses what happens if they’re not obtained.
The Middle Ground: In written legal agreements there is often language that either allows or prohibits unilateral assignment of the contract or a change of control with regard to a contracting party (such as the sale of a controlling interest of their business). A contract typically contains one or the other, and each has different legal consequences, but for ease of discussion we’ll refer to them collectively as “assignment” unless an explicit distinction is made between the two. In agreements that explicitly allow assignment or are silent on the issue, the Buyer will assume the place of the Seller. In agreements that explicitly prohibit it, the Buyer still needs to take the place of the Seller. In such cases, the Third Party Consents provision states that the Seller must use its reasonable best efforts to obtain the third party’s consent to an assignment. If the third party refuses to grant an assignment, the Seller is required to remain a party to the contract and act on behalf of the Buyer, to the extent the law and the contract at issue allow such an arrangement. Finally, the provision explicitly states that the Buyer retains its right to abandon the transaction if a third-party consent is not obtained, unless the Buyer waives that right in writing or moves forward with the Closing despite the absence of such consent.
Purpose: The Third Party Consents provision determines, where applicable, how third parties will be handled in transitioning contractual relationships. Some industries function almost entirely on the basis of formal contracts that prohibit assignments, while other industries involve few, if any, written agreements. When the target company operates in the former category, this provision is an important element of the Agreement because of its impact on the value of the deal to the Buyer. If the target company is in an industry involving few written agreements, and leased real estate is not an issue, a formal conversation on the issue of third-party consents is likely unnecessary.
Buyer Preference: For the Buyer, the two most important aspects of this clause are the ability to abandon the transaction if third-party consents are not obtained and the standard of effort the Seller must put forth to obtain them. In certain companies and industries, one contract may contribute a significant amount of value to the Business, and if the Buyer cannot benefit from that contract the Business is not worth the contemplated Purchase Price. In that situation, the Buyer must be able to walk away with impunity. By setting an effort standard for obtaining third-party consents, the Buyer has some assurance that the time and money spent on due diligence is not being wasted and that the Seller will attempt to procure the consents even after the Purchase Price has been paid (if the parties have mutually agreed to allow consents to be obtained after Closing). The Buyer wants to set a high effort standard, but one that is within the Seller’s ability to meet. Furthermore, if obtaining third-party consents is critical to the success of the Business moving forward the Buyer may require the Seller to represent that all such consents have been obtained (with any exceptions listed in the Disclosure Schedules).
Seller Preference: The Seller has numerous options for altering this provision to reduce its level of risk. First, it wants to negotiate an effort standard it is confident of being able to meet, which may be something less than “reasonable best efforts.” In lieu of a general standard, it might prefer to set out specific actions it must take to comply with this clause. Other options for controlling the risk presented by this provision include setting an end date for obtaining consents and setting a cap on expenses incurred as a result of trying to comply with this section.
Differences in a Stock Sale Transaction Structure: In a stock sale, no assignment of contracts is necessary since the Business is the party bound by the contract both before and after the acquisition. However, change of control provisions are specifically intended to prevent the Buyer taking the Seller’s place in a contract without the third party’s consent. Therefore, this provision is still necessary in a stock purchase to address the transfer of the Seller’s contracts that contain change of control language.
Withholding Tax
What is Withholding Tax? Sometimes a transaction requires the Buyer to withhold a portion of the Purchase Price for tax purposes (e.g. if the Seller is a foreign person or entity). This provision clarifies whether withholding is necessary and, if so, whether the withheld amount is included in the stated Purchase Price.
The Middle Ground: This section allows the Buyer to withhold from the Purchase Price all Taxes that the Buyer is required by law to withhold or, alternatively, waives the withholding requirement based on a statement by the Seller that no withholding is required.
Purpose: If the Buyer is required to pay withholding tax it will naturally want to reduce the price actually paid to the Seller by the taxes due. The parties include this provision to avoid disputes over whether the agreed upon Purchase Price includes withholding tax or must be “grossed up” to cover such tax. In other words, this provision is included purely for the sake of clarity, and the parties will likely spend no time actually discussing it with one another.
Buyer Preference: The Buyer will want this provision included to avoid a potential dispute, but it need not include any special terms over and above the standard language.
Seller Preference: None.
Differences in a Stock Sale Transaction Structure: None.
Purchase Price Allocation
What is the Purchase Price Allocation? The Buyer and Seller are both taxed on the sale of the Business. As part of the taxation process, they must match (or allocate) the Purchase Price and the value of Assumed Liabilities to different asset classes. Both parties must report the same allocation, so they typically agree on it shortly after Closing in accordance with this provision.
The Middle Ground: This section indicates where the Allocation Schedule can be found, which party is responsible for preparing it, when it must be completed, and a dispute resolution procedure in case the parties cannot agree on the allocation scheme. It also states that the tax returns of both parties must be filed in accordance with the Allocation Schedule.
Purpose: How the Purchase Price is allocated directly affects the taxes paid by both parties, and allocations that benefit the Seller typically work against the Buyer (and vice versa). While this dynamic can cause some tension and lead to a lengthy negotiation, the issue is unlikely to derail the entire transaction. That is, in part, because the parties do not have the ability to allocate the Purchase Price as they see fit; their allocation must be within the bounds of the law, which essentially means it must reflect the reality of the situation. Each party has some latitude to negotiate, but neither party will get a “perfect scenario,” and disagreements can usually be resolved by making the allocation that most closely mirrors the actual value of the assets.
Buyer Preference: One of the major benefits of an asset sale is the Buyer’s ability to receive a “stepped-up” tax basis in depreciable and amortizable assets. A higher tax basis on those assets means greater depreciation and/or amortization, which translates to a lower tax bill. Thus, allocating the bulk of the Purchase Price to those assets effectively lowers the price paid for the Business.
Seller Preference: The Seller wants the same benefit from the allocation as the Buyer hopes to achieve – a lower tax bill. In order for the Seller to accomplish that, it will want to allocate as much of the Purchase Price as possible to capital assets (such as land) so that it is taxed at the capital gains rate rather than the ordinary income rate.
Differences in a Stock Sale Transaction Structure: This section is not necessary in a stock sale structure (unless the parties opt to make a 338(h)(10) election) because the Purchase Price will be treated as capital gains to the Seller and the Buyer will assume the Seller’s tax basis in the assets, which limits the benefits it receives from depreciation and amortization.
Purchase Price Adjustment
What is the Purchase Price Adjustment? Businesses do not shut down operations during the transaction, so there is often a need to adjust the payments after the Closing to reflect the actual state of the Business on the Closing Date. This provision provides a way to make the necessary adjustments.
The Middle Ground: If the parties agree to adjust the Purchase Price based on one or more particular business metrics, the Purchase Price Adjustment section outlines the specifics on how that criteria will be used to adjust the price, and a time period for when the calculations must be made (typically by the Buyer). This section also details how long the Seller has to object to the calculations and, if an objection is made, the procedure for settling the dispute. For example, a popular basis for adjusting the Purchase Price is to calculate the final Working Capital figure (specified Current Assets less specified Current Liabilities), and a popular dispute resolution procedure is to first rely on good faith negotiation and, should that fail, to select a third-party accountant to resolve the discrepancy between the parties. To limit the disputes under this section and encourage resolution through negotiation, the Agreement may allocate payment responsibilities for the accountant’s fee to the party whose Working Capital figure is furthest from the accountant’s final determination. Another good way to avoid post-Closing Purchase Price Adjustment disputes is to clearly define how Accounts Receivable will be counted when calculating Working Capital at Closing. If money is billed before Closing but received after, whose money is it? What is the Buyer’s obligation to pursue the collection of funds that will ultimately flow to the Seller? Such terms are highly fact-specific, meaning there’s no clear middle ground, but it’s important to take those considerations into account in order to maximize the chance of avoiding post-Closing disputes.
Purpose: A Purchase Price Adjustment provision functions to ensure that value paid for the Business matches its current value. The magnitude of this provision’s impact depends on the specifics negotiated by the parties, such as which measurement is used to determine the adjustment. Unless there is a massive change in the value of the metric being used to determine the adjustment between the signing and Closing dates, the shift in Purchase Price will not be significant compared to the overall value being transferred. Despite the relative size, Purchase Price adjustments are often heavily negotiated because neither side wants to end up with less value than they give away.
Buyer Preference: The Buyer wants to be the party preparing the evaluation of the metric(s) in question. If the Buyer prepares the evaluation, it will support a scheme whereby the accountant’s fee is paid proportionally based on how close each side is to the accountant’s final determination. That scheme reduces the likelihood for disputes because taking an unreasonable position may lead to higher costs for the party taking that position, and since the Buyer is preparing the evaluation (in its ideal scenario), the Seller is more likely to accept it unless they are firmly convinced that their valuation will be closer to the accountant’s final determination. The Buyer will typically hold a portion of the Purchase Price in an escrow account until the adjustment is made; it will usually want that account to be separate from an escrow account used for potential indemnification claims to make sure that indemnification payments will be made if a claim arises. As for treatment of Accounts Receivable, the Buyer will likely want to assume those accounts to maintain the Business’s normal cash flow cycle, but in doing so it may request a representation from the Seller about the creditworthiness of the customers or even a guarantee requiring the Seller to pay for any Accounts Receivable that ultimately isn’t paid.
Seller Preference: The Seller wants to prepare the evaluation on which the Purchase Price adjustment is based. When the Seller is in control it will favor a fee arrangement that discourages the Buyer from challenging its conclusion. Timing of the evaluation may also be an important consideration because the Seller will want the adjustment to be based on the company’s performance while still under its control. The Seller is typically against both an escrow arrangement and applying interest to the adjustment. That is because the Seller generally wants to be paid the entire Purchase Price as soon as possible (i.e. no escrow) and adjustments typically favor the Buyer (i.e. no interest), perhaps because the Seller is more likely to be overconfident about the Business’s future performance. The Seller wants to be compensated for the full value of Accounts Receivable that are transferred to the Buyer rather than retaining the risk of nonpayment and relying on the Buyer to collect on the accounts. In other words, the Seller wants to treat these accounts just like any other current asset being factored into Working Capital.
Differences in a Stock Sale Transaction Structure: None.
Purchase Price
What is the Purchase Price? This section explains that the Buyer will pay a specified amount in exchange for the Purchased Assets and Assumed Liabilities.
The Middle Ground: The Purchase Price provision provides payment specifics, including when payment is due, to whom, and any conditions to payment (such as an adjustment to the purchase price). Depending on the situation, this section may include details about a promissory note, escrow arrangement, set-off rights, and/or earnout payments.
Purpose: This provision gives in-depth information on deal value and can include various risk management tools. The use of a promissory note, earnout payments, set-offs, or escrow shifts the risk between parties and can ultimately change the value of the deal for both sides. Structural payment tools like these are often used to align the Seller’s interests with those of the Business and the Buyer, especially in situations where the Seller will remain actively involved in the company post-close. By using such tools, the Buyer mitigates some risk and the Seller almost always ends up with more money than if the entire Purchase Price was paid in cash at Closing.
Buyer Preference: The Buyer typically looks to utilize a combination of the structural tools discussed above to reduce its initial risk on the transaction. A promissory note allows the Buyer to pay less cash up front and spread the Purchase Price over a set time period. Escrow and set-offs reduce the Buyer’s risk by preventing the Seller from taking possession of disputed payments. Earnouts and Purchase Price adjustments may increase the overall Purchase Price, but only if the Business meets certain milestones at predetermined points in time. By deferring a portion of the Purchase Price to the future and tying it to the performance of the Business, earnouts and adjustments can also help the parties close a valuation gap if one exists, which in turn helps close the transaction without the Buyer assuming greater risk.
Not all structural tools are useful in every transaction. The Buyer determines where its greatest areas of concern lie and chooses the appropriate tools to manage those areas of risk.
Seller Preference: There is no “best strategy” or combination of strategies that works for every Seller; the desirability of each option depends on the Seller’s post-Closing plans and desired level of liquidity. Some sellers may want upwards of 90% cash at Closing with no strings attached. However, the Seller can put a higher price tag on the Business if it allows the Buyer to manage its risk using one or more of the aforementioned strategies. A Seller who is confident about the future performance of the Business may actively seek an earnout structure so that it can benefit from that future success right along with the Buyer.
Differences in a Stock Sale Transaction Structure: Due to tax, liability, and operational consequences, the total Purchase Price of a stock sale is likely to differ from the amount for an asset acquisition of the same company. However, all of the structural tools discussed in this section are available for use in both stock and asset sales.
Assumed and Excluded Liabilities
What is the Assumed and Excluded Liabilities section? The Assumed and Excluded Liabilities provisions, taken together, detail which of the Seller’s liabilities will be transferred to the Buyer and which ones will stay with the Seller.
The Middle Ground: Typically, the Assumed Liabilities include current accounts payable and the liabilities associated with Assigned Contracts. Tax liabilities of the Seller are typically excluded. Assumption of other liabilities will vary based on the particular deal, and if there are a number of them they can be listed in detail in the Disclosure Schedules.
Purpose: These provisions spell out which operational risks will reside with each party following the transaction. In achieving that goal, these provisions also force the parties to think through the potential risks of the transaction and how those risks should be allocated within the Agreement.
Buyer Preference: When Assumed Liabilities are broadly defined and Excluded Liabilities are strictly defined, the Buyer is more likely to inherit unknown or unexpected liabilities. While liabilities of any kind increase risk, liabilities that are not anticipated can be exponentially more dangerous. Therefore, the Buyer wants language indicating that it will assume the listed liabilities and no others, and to define the Assumed Liabilities as specifically as possible. It also wants the Excluded Liabilities to be framed as a non-exhaustive list, which means that the list includes any liabilities not explicitly assumed.
In regard to particular liability categories, the Buyer wants to exclude any liabilities arising before the Closing Date as well as any liabilities not arising in the ordinary course of business, including liabilities for which the Seller is at fault. Furthermore, a broad tax liability exclusion is in the Buyer’s best interest to protect it from successor tax liability. Additionally, liability for fees relating to the transaction (i.e. intermediary fees) that are payable by the Seller are typically excluded.
Seller Preference: In general, the Seller wants the Assumed Liabilities section to be a non-exhaustive list that includes any liabilities not specifically excluded in the Excluded Liabilities clause. It also wants to explicitly transfer all accounts payable that are not paid by the Closing Date, all liabilities associated with Assigned Contracts, and any other liabilities that accrue after Closing (e.g. employee compensation and benefits, taxes, etc.).
Differences in a Stock Sale Transaction Structure: In a stock sale, the liabilities of the target company automatically transfer to the Buyer. Therefore, the Agreement does not include the Assumed and Excluded Liabilities sections, and the bulk of the risk allocation is achieved through the Seller Representations and Warranties and Indemnification provisions.
Excluded Assets
What is the Excluded Assets section? The Excluded Assets section consists of a detailed list of the Seller’s assets that will not be transferred as part of the acquisition.
The Middle Ground: The assets to be included here are specific to the deal, and the list will be created in conjunction with the list of Purchased Assets. Basically, any assets of the Business that are not listed as Purchased Assets are considered Excluded Assets.
Purpose: In the event of any sort of confusion regarding the list of Purchased Assets, this list provides clarity about what is and is not being transferred as part of the acquisition (reducing the risk of uncertainty). It is especially useful when the Purchased Assets section lacks detail, or when there are assets with similar names or descriptions but not all of them are being included in the purchase.
Buyer Preference: In terms of the content of this list, the Buyer wants to include assets that hold no value for the Buyer (e.g. unnecessary organizational seals, books, and records), especially if those assets come with significant contingent liabilities (e.g. benefit plans). In drafting terms, the Buyer’s main objective is to achieve the right degree of specificity, ensuring it does not exclude an asset it intends to purchase or include an asset it intends to leave behind.
Seller Preference: The Seller’s motivations in drafting this section largely depend on whether it is selling its entire business or whether it is only selling one division or line of business. If only selling a portion of its business, the Seller will want this section to read broadly so that it retains the assets necessary to continue its own operations. If the Seller will not continue to operate after the sale, a short and detailed list of Excluded Assets is usually not a cause for concern.
Differences in a Stock Sale Transaction Structure: This section will not be included in a stock sale because the Buyer will be purchasing the entire company and will not get to pick and choose which assets to include in the transaction.
Purchased Assets
What is the Purchased Assets section? The Purchased Assets section creates the duty for the Seller to transfer certain assets to the Buyer and lists those assets in detail.
The Middle Ground: Depending on the particular business, the Purchased Assets will likely include accounts receivable, inventory, certain contracts, intellectual property, real and personal property, permits, certain rights held by the Seller, the Seller’s accounting-related books and records, and the goodwill of the Business.
Purpose: This term is supremely important because it identifies which assets will be transferred and sets the foundation for numerous other terms found in the Agreement. For example, the value of the assets listed here forms the basis for the Purchase Price, and other terms, including the Seller’s “Consents” disclosure, rely on this section to determine their scope.
Buyer Preference: Different buyers may have different motivations for making an asset purchase, so it is essential for the list of assets in this section to be tailored to the needs of the particular Buyer. Typically, the Buyer wants broad definitions of various Purchased Assets to ensure that it receives, at a minimum, all the assets it intends to purchase. For example, if the Buyer wants to purchase all the intellectual property held by the Seller, it would be better to list “all intellectual property assets” rather than “all intellectual property registrations” because registered intellectual property is just one subcategory of intellectual property assets. Depending on the specifics of the deal, an aggressive Buyer may even try to include assets not yet owned by the Seller. All Buyers will want to include language stating that all assets are being transferred free and clear of any Encumbrances (except for Permitted Encumbrances).
Seller Preference: The Seller wants to define the Purchased Assets as narrowly as possible to avoid having to transfer assets it does not intend to sell. A Seller’s best practice is to list every individual asset with particularity, but some categories of assets include too many items to list each one. In that case, the Seller’s best bet is to define the asset category as specifically as possible. Asset definitions should exclude any assets the Seller does not have the authority to transfer, as well as assets the Seller needs to retain to operate its remaining lines of business (if it is only selling a division or line of business).
Differences in a Stock Sale Transaction Structure: If the deal is structured as a stock sale rather than an asset acquisition, there is no need to list out the assets being purchased. Instead, a short paragraph creates the Buyer’s duty to pay the Seller and the Seller’s duty to transfer a specified number of shares to the Buyer.