Indemnification Procedures
What are Indemnification Procedures? While previous indemnification-related sections focus on the circumstances under which a claim can be made, this section details the procedural rights and requirements of both sides once a claim is made. Essentially, it provides the rules that must be followed once the indemnification process has been initiated.
The Middle Ground: The Indemnifying Party’s rights typically include (but are not limited to) receiving prompt notice of the claim and its details, the right to assume and control the defense of the claim (except in a few limited circumstances), and the right to the Indemnified Party’s cooperation in investigating claims. The Indemnified Party’s rights usually include controlling legal proceedings when the Indemnified Party is the Buyer and the claim is brought by a customer or supplier of the Business or when an equitable remedy is sought, as well as participating in the defense of claims when such defense is controlled by the Indemnifying Party.
Purpose: Indemnification is an essential tool used to enforce the terms of the Agreement, and this section lays out the steps that must be taken and the rights of each party involved when an indemnification claim is made. It has a moderate impact on risk for both parties (more so for the Seller, who is typically the Indemnifying Party), yet its main purpose is to give effect to more substantive indemnification provisions. It is important for the parties to strike the right balance between implementing enough procedures and rules to allow the Indemnifying Party to mitigate its risk as much as possible, while not employing so many hurdles that they interfere with the Indemnified Party’s ability to actually receive indemnification.
Buyer Preference: The Buyer generally favors terms that benefit the Indemnified Party such as including a specific but generous notice period, allowing the Indemnified Party to control all claims against it once the Cap is met (if a Cap is included), and giving the Indemnified Party the option whether to control defense of all claims. The Indemnified Party may also want a say over who the Indemnifying Party enlists as counsel to defend against a claim and/or the ability to control the defense when the Indemnified Party has defenses available to it that are not available to the Indemnified Party.
Seller Preference: The Seller’s preferences will usually be those of the Indemnifying Party. Those preferences typically include the desire for a flexible notice standard (e.g. “reasonably prompt notice”) and the ability to control the defense of all third-party claims and settlements. The Seller may also want to insert an arbitration provision so that disputes over direct claims can be resolved quickly and less expensively than would be the case with litigation.
Differences in a Stock Sale Transaction Structure: If the Stock Purchase Agreement contains a tax-specific indemnification provision tax issues will need to be carved out of this section so there is no question they are governed solely by the tax indemnification provisions.
Certain Limitations
What is the Certain Limitations section? If no limits are set on the right to indemnification it is a tool that can be abused by the parties, especially in situations where there is not a working relationship between the Buyer and Seller after the Closing. Here, the parties implement boundaries around indemnification to avoid the problems caused by abuse of indemnification rights.
The Middle Ground: This provision limits the indemnification claims that can be brought by setting “Caps” and “Baskets” around the right to indemnification. A Basket sets a minimum amount of damages that must be incurred before an indemnification claim can be brought, and it is typically limited to claims based on breaches of the representations and warranties in the Agreement. Typically, the Basket sets a minimum threshold for making a claim and once that threshold is reached the injured party is eligible to receive 100% of the damages it suffered. A Cap may also be included, and it serves as an upper limit on the amount that will be paid in the event of a claim or the aggregate amount that will be paid out for all indemnification claims of a party.
Purpose: The purpose of a Basket is to prevent one party from trying to recapture some of the value given up in the deal by making numerous “nickel and dime” claims against the other side. In other words, it prevents the parties from abusing their indemnification rights. By doing so, the provision protects the parties’ expectations regarding their risk exposure and the value received from the transaction. Caps are also used as a tool to manage overall risk exposure, and they are especially important in situations where there is a reasonable potential for one of the parties to make a large indemnification claim. In addition to their risk management function, Caps and Baskets also increase the chances that the transaction will be completed by encouraging the parties to provide expansive indemnification rights since they know those rights are not subject to abuse and will not create unlimited liability.
Buyer Preference: The Buyer is the party most likely to bring an indemnification claim, which has a number of implications for how it wants to structure this provision. At the most basic level, it wants the Basket to be small (to allow for the payment of moderate claims) and the Cap to either be large or nonexistent. It may also want to tailor the Cap to its specific concerns; if the potential Losses based on one representation are much greater than for the other representations, the Buyer may be better off negotiating for a significantly higher Cap (or no Cap at all) in that area and a smaller Cap in the other areas than for a moderate Cap applicable to every representation. It certainly wants no Cap regarding any liabilities kept by the Seller, as it has no control over those liabilities. It also wants to carve out certain fundamental representations from the Basket and Cap, such as the Organization and Authority representations.
The Buyer wants to resist additional limitations on indemnification payouts, such as a Duty to Mitigate or a requirement to subtract from such payouts any tax or insurance amounts. However, when a Basket is included in the Agreement the Buyer is more likely to seek a “materiality scrape,” which is a provision that removes any materiality qualifiers from the representations and warranties for indemnification purposes. When a materiality scrape is used, the materiality qualifiers used in the representations and warranties still apply to limit what the Seller must disclose in the Agreement, but they do not apply for purposes of determining whether an indemnification claim can be brought and what the damages for the claim will be. The reasoning underlying the use of a materiality scrape in this context is that the Basket already screens out any non-material claims, so including an additional materiality requirement will likely complicate the indemnification process and lead to needless disputes.
Seller Preference: Since the Seller is going to be paying out an indemnification claim in most cases, it will typically seek a high Basket and a low Cap. In addition to this basic position, the Seller will also prefer a “deductible” Basket rather than a “dollar one” or “tipping” Basket. The distinguishing factor about deductible Baskets is that the Basket amount is more than just a threshold, it is also the amount deducted from the total damages to determine the required payment. To put it another way, with a deductible Basket the side making the claim is only entitled to the amount of damages exceeding the Basket amount. In lieu of a deductible Basket, the parties could settle on a hybrid approach, in which the amount deducted from the payout is less than the threshold amount but more than zero. Another beneficial option for the Seller is to include one or more “mini-baskets” that require damages from a particular representation to reach a certain amount before they are counted toward the overall Basket.
Over and above changing how the Basket functions, the Seller could also try to have the Basket apply to all representations, warranties, covenants, and obligations contained in the Agreement, not just the selected representations and warranties. Similarly, the Seller can try to negotiate for the Cap to extend to all indemnification claims. If unsuccessful on that front, the Seller can argue that some Cap (e.g. the Purchase Price amount) should be placed on payments for breach of fundamental representations and warranties, as well as the remaining covenants and obligations in the Agreement, even if that Cap is higher than the Cap applied to the non-fundamental representations and warranties.
Furthermore, the Seller can avoid a “double recovery” situation by including language reducing any indemnification payments by the amount of any insurance money paid to the Buyer for the claim, and it can make the language more effective by requiring the Buyer to use its reasonable best efforts to pursue any viable insurance claim. Another way to avoid double recovery is to reduce the amount of any indemnification claims that result in a tax benefit to the Buyer by the amount of the tax benefit. For instance, if the Seller breaches a representation and the Loss from that breach causes the Business to sustain a net operating loss (NOL) for the year, the amount of the indemnification claim would be reduced by the tax value of the NOL. One final way to limit double recovery applies in situations where the Agreement allows for a Purchase Price Adjustment, and the goal is to ensure that any such adjustment is subtracted from the Losses payable based on an indemnification claim. The Seller could also seek to impose on the Buyer a “Duty to Mitigate,” meaning the indemnified party would be required to try to reduce its damages from a breach by taking some sort of corrective action.
Finally, if the Agreement contains an escrow provision, the Seller can negotiate for its money held in escrow to be paid out to satisfy a claim for indemnification before it is required to pay money out of its own pocket to do so.
Differences in a Stock Sale Transaction Structure: None.
Conditions to Obligations of Buyer
What are the Conditions to Obligations of Buyer? This provision contains a comprehensive list of requirements that must be completed by the Seller or waived by the Buyer in order for the Buyer to be obligated to complete the purchase. If the Seller fails to fulfill any condition included in the list, the Buyer can walk away from the deal without penalty.
The Middle Ground: Typically, the list states that:
(1) the Seller’s representations and warranties are true in all material respects at the time of the signing of the Agreement and the Closing;
(2) the Seller has complied with the Agreement and any other Transaction Documents in all material respects;
(3) no legal action has been taken that would prevent the transaction;
(4) all third-party approvals, consents, and waivers listed in the Disclosure Schedules relating to the Seller’s representations and warranties have been obtained;
(5) nothing has occurred that would constitute or cause a Material Adverse Effect;
(6) all Closing Deliverables and Transaction Documents have been signed by the Seller (as applicable) and delivered to the Buyer;
(7) the Buyer has received all Permits necessary to conduct the Business as conducted by the Seller;
(8) the Seller has provided the Buyer with title insurance and a Land Title Survey (or other appropriate deliverables) for each piece of Owned Real Property;
(9) written evidence has been provided to the Buyer that all Encumbrances, other than Permitted Encumbrances, have been released;
(10) the Buyer has received a signed copy of the Seller Closing Certificate;
(11) the Buyer has received a signed copy of the Seller’s Secretary’s Certificate;
(12) the Buyer has received a FIRPTA Certificate relating to the Business; and
(13) the Seller has delivered any other documents or instruments reasonably requested by the Buyer that are reasonably necessary to consummate the transaction.
Purpose: This provision provides numerous “outs” for the Buyer that create a relatively painless path out of the deal if the Seller does not meet its obligations, including some obligations that are relatively minor. The fact that the Buyer can walk away without penalty if a condition is not met means the risk of the Seller’s failure to deliver is shifted entirely to the Seller, who is obviously in a much better position to control that risk.
Buyer Preference: In addition to the conditions listed above, any number of requirements can be added to this section through negotiation among the parties. Common additional conditions sought by the Buyer include: (a) a “due diligence out” that allows the Buyer to walk away if it cannot complete due diligence to its satisfaction; (b) a “financing out” that conditions the Buyer’s obligation to close on it being able to obtain financing to fund the deal; and (c) financial or operating targets, such as sales or working capital, that, if not met, provide the Buyer with a way out of the deal. If the Seller operates in a highly-regulated industry, the Buyer may also require a legal opinion from the Seller’s legal counsel regarding the Business’s compliance with applicable laws. In addition to these general additional conditions, the Buyer also has certain preferences regarding the listed conditions, such as:
(1) The Buyer will likely include a materiality qualifier but will not want that qualifier to apply to any representation or warranty that already contains a materiality qualifier (i.e. the Buyer does not want a “double materiality” standard). Some exceptions for which the Buyer will want no materiality qualifier whatsoever include the representation regarding the organization and authority of the Seller, any monetary obligations, and financial statements. The Buyer will typically want this condition to Closing to be satisfied both at the time of signing the Agreement and at the Closing so that it can walk away if it receives materially inaccurate information at either time.
(2) Here, the Buyer once again wants to avoid a double materiality standard.
(3) The Buyer does not want any materiality qualifiers whatsoever in this “litigation out.” The Buyer will want to include any actions brought against it in addition to those brought against the Seller.
(4) The Buyer wants all third-party consents to be obtained as a condition to Closing, not just specifically-identified material consents.
(5) The Buyer may want to eliminate the Material Adverse Event condition altogether and replace it with specific event-based conditions, such as operational or financial benchmarks. Or, it may want to keep the Material Adverse Event condition and merely supplement it with specific benchmarks. In either case, the Buyer should be aware when selecting such benchmarks that financials usually lag behind operations and it is easier to manipulate the financial measurements than to inaccurately represent that an operational benchmark was met.
(8) To determine which conditions relating to real property need to be included here, the Buyer should consult a real estate attorney. If the transaction involves Leased Real Property, the Buyer will seek estoppel certificates from the landlord of the property.
(9) If the Buyer knows which documents are necessary to release Encumbrances associated with the Seller’s property, it will want to specify the documents and include a general statement like the one seen above to cover any documents needed but not listed. If the only way the Seller can have the Encumbrances released is to pay the creditor using the Closing payment, the Buyer will want to have the release documents placed in escrow until the creditor is paid.
Seller Preference: In general, the Seller wants to avoid allowing any conditions in this section that are not within its control, such as a due diligence out and a financing out. More specifically, the Seller will generally have the following preferences regarding the listed conditions:
(1) The Seller wants to go beyond a general materiality standard and require that, in order for the Buyer to walk away, a false representation or warranty must have a Material Adverse Effect on the Business. The Seller also wants this condition to apply only at the Closing so that it can cure any inaccuracies that exist when the Agreement is signed.
(3) The Seller wants to limit this condition to legal actions that are reasonably likely to succeed on the merits as a way of excluding frivolous claims that do not have any practical chance of preventing the transaction. Regarding any legal actions taken by a Governmental Authority, the Seller will want only those that prevent a material transaction contemplated by the Agreement to qualify as a litigation out for the Buyer.
(4) The Seller wants to limit this condition to specifically-identified material third-party consents, especially if there are a significant number of third-party consents to be obtained.
(5) Because it is difficult to prove that an event had a Material Adverse Effect on the Business, and because the burden is on the Buyer to prove a Material Adverse Effect, the Seller wants that standard to be applied here, rather than using specific financial or operational benchmarks. If the Buyer insists on specific benchmarks, the Seller will likely favor financial metrics over operational ones.
(8) The party customarily held responsible for paying survey and title insurance costs varies by jurisdiction, but regardless of convention the Seller will want the parties to split any costs related to these items (unless, of course, local custom says the Buyer pays).
Differences in a Stock Sale Transaction Structure: In a stock sale, the Buyer wants any representations and warranties relating to the shares of the Seller to be true and correct in all respects or, in other words, not subject to any sort of materiality qualifier. If the Buyer in a stock purchase is going to replace the directors and/or officers of the Business, receipt of their resignations should be included as a condition to the Buyer’s obligation to close. The Buyer in a stock purchase will also need a certificate of good standing for the Business from the appropriate Governmental Authority in the company’s state of organization.
Environmental Matters
What are Environmental Matters? In this section, the Seller provides information regarding environmental issues relating to the Business. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: Here, the Seller makes comprehensive representations regarding its compliance with Environmental Laws. Those representations include:
(1) The Business is and always has been in compliance with applicable environmental laws and the Seller has not received notice of an Environmental Violation or Claim, or a request for information pursuant to Environmental Law that remains unresolved;
(2) The Seller has obtained all Environmental Permits necessary to conduct the Business or use the Purchased Assets as currently conducted or used and all such Environmental Permits are in full force and effect. Nothing has occurred, to the Seller’s knowledge, that would interfere with the validity of the Environmental Permits after the Closing Date, and the Seller has undertaken all measures necessary to transfer the Environmental Permits on the Closing Date;
(3) None of the Purchased Assets or any real property used or formerly used (whether owned or leased) by the Business have been listed on, or proposed for listing on, the National Priorities List under CERCLA or any similar state list;
(4) There has been no Release of Hazardous Materials in violation of Environmental Law with respect to the Business or the Purchased Assets, including on any real property currently or formerly used by the Business. Furthermore, the Seller has not received any notice that it violated an Environmental Law or the terms of an Environmental permit, or that could reasonably be expected to result in an Environmental Claim against the Seller, the Business, or the Purchased Assets;
(5) The Disclosure Schedules contain a complete and accurate list of all active or abandoned storage tanks owned or operated by Seller in connection with the Business or the Purchased Assets;
(6) The Disclosure Schedules contain a complete and accurate list of all off-site facilities or locations for the treatment, storage, or disposal of Hazardous Materials used by the Seller, and any predecessor to the extent the Seller may retain liability, in connection with the Business or Purchased Assets. No such facilities or locations have been placed on or proposed for placement on the National Priorities List under CERCLA, or any similar state list, and the Seller has not received any Environmental Notice of potential liability with respect to any such facilities or locations;
(7) The Seller has not retained or assumed any liabilities or obligations from third parties with respect to Environmental Laws (whether by contract or operation of law);
(8) The Seller has provided Buyer with (i) all material documents in Seller’s possession or control relating to compliance with Environmental Laws, Claims, or Notices in connection with the Business or Purchased Assets, or any real property used by the Business at any time, and (ii) all material documents relating to actual or potential capital expenditures made to ensure current or future compliance with Environmental Laws; and
(9) The Seller is not aware of and does not reasonably anticipate, as of the Closing Date, any condition or event relating to Hazardous Materials that may, after the Closing Date, prevent, impede, or materially increase the costs associated with performance of the Business or use of the Purchased Assets as currently conducted or used.
Purpose: The importance of this section depends largely on the Business and the industry in which it operates, as well as the location of the properties utilized by the Business. If the Business uses Hazardous Materials as part of its normal operations, this section is essential for the Buyer. Likewise, if the Business’s real property is adjacent to another business that uses Hazardous Materials, these representations lessen the risk that the Buyer will have to pay for the environmental violations of others. However, if the Business itself does not use any materials that are subject to environmental regulation and there is no similar threat posed by neighboring landowners, the scope of representations contained here may not be necessary. In the event that the Seller only used Hazardous Materials at a specific point in time or at one specific location, the parties can agree to limit the Seller’s representations to address those situations without including the entire set of representations listed above.
Buyer Preference: Due to the potential magnitude of penalties related to environmental violations, the Buyer wants to include the most comprehensive set of environmental representations that will be acceptable to the Seller and may also want to exclude environmental matters from any limits on its indemnification rights. If there are identifiable environmental issues and the Seller wants to limit the representations to those situations, the Buyer has a number of options. It may insist on the Seller correcting those issues prior to the sale or require a portion of the Purchase Price to be placed in escrow until the problems are remedied. A more conservative Buyer might seek to exclude the property from the transaction or lower the Purchase Price based on projected remediation costs. Another option would be to purchase environmental insurance. Still, the Buyer will want representations that apply to the entire Business and all properties utilized by the Seller. The Buyer prefers specific, material exceptions to the representations listed in the Disclosure Schedules, but nothing more, since it wants the representations to be as widely applicable as possible. Lastly, if the Business operates in an industry that interacts with climate change regulation (e.g. the energy, utility, and manufacturing industries), the Buyer may want to include a representation that speaks to the validity and transferability of “Environmental Attributes” (e.g. emissions allowances or renewable energy credits).
Seller Preference: If real property is not involved in the purchase and/or the Business does not utilize Hazardous Materials, the Seller may want this section to be excluded in its entirety. If that is not the case and these representations are included, the Seller can try to limit the environmental representations to this section by including a statement to that effect. As for the representations themselves, the Seller will want them to be qualified using a materiality or Material Adverse Effect standard, and/or with knowledge qualifiers. It may also want to limit them to cover specific properties or time frames if it can identify specific situations that are more likely to result in environmental-related costs for the Buyer. If the Seller agrees to deal with the Buyer’s environmental concerns prior to the sale, it can include those terms in a separate agreement and limit the representations to exclude the subject matter of the separate agreement. Because the Seller is most likely to provide an incomplete or misleading representation when instances or exceptions are listed with specificity in the Disclosure Schedules, it will want to make broad disclosures to avoid unintentionally breaching a representation.
Differences in a Stock Sale Transaction Structure: Since the Buyer inherits all the liabilities of the Business in a stock sale, the environmental representations are likely to be more comprehensive under that structure than in an asset sale.
Compliance with Laws; Permits
What is the Compliance with Laws; Permits section? In this section, the Seller provides information regarding the Business’s compliance with legal requirements. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The Seller represents that it is currently in compliance with all laws applicable to the Business and that it has previously complied with all such laws for a specified period (e.g. the previous three years). The Seller also represents that it has all permits necessary to conduct the Business, all fees related to those permits are paid, the permits are in full force and effect, and nothing has occurred that would result in their limitation or revocation.
Purpose: The Seller’s current and past compliance with laws applicable to the Business is obviously a significant issue; the Buyer will not want to purchase a business operating outside the confines of the law or be stuck with liabilities created by the Seller. However, whether the parties will spend a substantial amount of time during due diligence and negotiations to cover legal compliance depends largely on the industry in which the Business operates. In a highly regulated industry, the Buyer will find it worth the time to inquire about specific laws and negotiate over the extent of the Seller’s compliance representations. On the other hand, if any potential penalties are minuscule and/or the chances of enforcement are remote, the parties may insert this clause into the Agreement and leave it at that.
Buyer Preference: The Buyer wants a clause that does not limit the Seller’s representation regarding past compliance. Regardless of when the bad act occurred, the Buyer does not want to be liable for someone else’s misconduct. The Buyer also wants to avoid materiality qualifiers for both sets of representations included here.
Seller Preference: The Seller wants to limit this representation to current compliance only, especially if past violations have already been cured. It can also limit its risk by inserting some sort of materiality qualifier (e.g. requiring a violation or lack of a permit to have a Material Adverse Effect on the Business before indemnification applies). Finally, the Seller may seek to exclude entire areas of law from these representations because they are dealt with elsewhere in the Agreement (e.g. environmental laws and permits).
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.