Termination and Effect of Termination
What is the Termination and Effect of Termination section? These two clauses describe when either party (or both) can terminate the Agreement without breaching it and the effect termination would have on their respective covenants and obligations contained in the Agreement.
The Middle Ground: The Termination section allows for termination of the Agreement based on: (1) mutual consent of the parties; (2) only one party being in breach of the Agreement, if the other party sends written notice of the breach and it is not cured within ten days; (3) if one party will not be able to fulfill their Conditions to Closing, and such failure is not the fault of the other party; or (4) the existence or issuance of a Law or Governmental Order prohibiting the transaction. The Effect of Termination section makes clear that, once termination occurs, the Agreement is void and no party is liable to the other except that the Termination and Miscellaneous Articles survive termination, as does the Confidentiality provision, and the parties remain on the hook for any willful violation of any provision of the Agreement.
Purpose: In conjunction with other clauses throughout the Agreement, the Termination provision provides both parties with the opportunity to walk away from the deal without penalty under certain circumstances. By making it easier to walk away, the provision encourages the parties to be on their best behavior. The result is that the transaction is actually more likely to be completed.
Without the Effect of Termination clause, the prospect of abandoning the transaction prior to the Closing would be a difficult decision given concerns regarding confidentiality and the information provided to the other side during due diligence. Furthermore, if claims for willful breach of the Agreement died along with the Agreement, the mere proposal of mutual termination would be grounds for suspicion of bad behavior, and termination by mutual consent would likely only occur when the relationship between the parties is broken beyond repair.
In other words, the termination provisions set the bar for walking away from the transaction at just the right height; the bar is not so high that the parties are forced into completing a bad deal, and not so low that committing significant time and money to the due diligence process simply isn’t worth the risk of the other party walking away on a whim.
Buyer Preference: If there are any specific facts or circumstances that are not encompassed by the middle ground term and would make the Buyer want to terminate the Agreement, the Buyer can include them as grounds for termination. Also, if the Buyer must obtain financing for the transaction and there is no “financing out” in the Agreement, the Buyer may want to include a provision allowing it to pay a reasonable “reverse break-up fee” to walk away from the transaction. If a reverse break-up fee is included, the Buyer may seek to include a traditional break-up fee to be paid by the Seller if it is the one who walks away from the deal. The Buyer may also want to expand the claims that would survive termination to include any breaches of the Agreement whatsoever and any fraud or intentional misrepresentations.
Seller Preference: Because the Seller’s representations and warranties are so much more expansive than those of the Buyer, the Seller does not want to extend the Effect of Termination provision to cover any breach of the Agreement. However, it does want to be able to recover for any willful breaches by the Buyer, so the Seller will typically be content with the grounds for termination provided by the middle ground term. Additionally, while the Buyer prefers a financing out and, in its absence, a nominal reverse break-up fee, the Seller prefers no financing out and a significant reverse break-up fee to compensate it for the time and expense associated with the due diligence process. However, if the Seller insists on a reverse break-up fee it can expect the Buyer to demand a similar fee to be applied if the Seller refuses to close the transaction.
Differences in a Stock Sale Transaction Structure: None.
Exclusive Remedies
What are Exclusive Remedies? Buyers and sellers usually spend significant time agreeing on an indemnification scheme, so they tend to want most claims for breaches of the Agreement to be governed by indemnification. This section identifies the claims that must be pursued through indemnification and those that are exempt from that limitation.
The Middle Ground: Subject to the equitable remedies provided for in the Agreement, this provision limits the parties’ available remedies in the event one of them breaches the Agreement, except for situations involving fraud, criminal activity, or intentional misconduct. More specifically, if a breach occurs that is not due to one of the three listed exceptions and for which an equitable remedy is not available, the non-breaching party’s only option is to make an indemnification claim (if the parties have chosen to make all covenants and other terms subject to indemnification in addition to the representations and warranties).
Purpose: This restriction is intended to limit the parties’ risk by making indemnification the sole avenue for resolving most claims related to the Agreement. In fact, this term is necessary if indemnification is intended to be the Agreement’s main enforcement mechanism, because without it the parties could simply bypass the indemnification process by filing a lawsuit.
Buyer Preference: Being a fairly standard provision, most buyers accept it as part of the Agreement and, consequently, spend a considerable amount of time negotiating their indemnification rights. However, more aggressive buyers may argue for an alternate provision that allows for indemnification in addition to the usual legal and equitable remedies.
Seller Preference: The Seller wants the exceptions included in this provision to be as narrow as possible since it is typically the party against whom a complaint is being made. In particular, the definition of fraud varies from state to state and may not be as limiting as the Seller intends it to be. To prevent an unwelcome surprise, the Seller (and/or its attorney) must be aware of the legal bounds of fraud, criminal activity, and intentional misconduct in the state whose law governs the Agreement.
Differences in a Stock Sale Transaction Structure: None.
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.
Indemnification by Buyer
What is Indemnification by Buyer? Indemnification is used to enforce representations, warranties and covenants made in the Agreement. Here, the parties list out which breaches by the Buyer are subject to the Seller’s right to indemnification.
The Middle Ground: Much like the previous provision, this one requires the Buyer to indemnify the Seller, its Affiliates, and its Representatives for any Losses caused by an inaccuracy or breach of the Buyer’s representations, warranties, covenants, and other Buyer obligations that the parties agree will be covered by indemnification. The provision is meant to mirror the “Indemnification by Seller” section, with the only difference being the list of items for which indemnification is available.
Purpose: While the Buyer is usually the party most concerned with managing the risk that accompanies the transaction, there are significant areas of risk that the Seller has to deal with as well. Often, that risk is allocated to the Buyer through other pieces of the Agreement because the Buyer is in the best position to control it. This clause gives effect to the risk allocation agreed upon by the parties by providing the Seller with a relatively quick and simple method of recouping damages caused by a Buyer’s breach or misrepresentation.
Buyer Preference: Ideally, the Buyer wants this list to be as short as possible. In practice, the categories listed above will likely all be included because they all represent issues associated with potential liabilities, and they are the areas within the Buyer’s control. Furthermore, if there are any additional issues listed in the Seller’s indemnification section for which the Buyer has a reciprocal responsibility, the Buyer can expect for those issues to be included here since this provision is meant to mirror the Indemnification by Seller provision.
Seller Preference: The Seller wants the Buyer’s responsibilities to extend to any situation where the Seller could lose money due to the actions of the Buyer. For example, if the Seller leases a piece of land from a third party and the landowner requires the Buyer to sublease that land from the Seller rather than take it by assignment (perhaps because the landowner knows the Seller but not the Buyer), the Seller could end up being responsible for unpaid rent if the Buyer fails to live up to its obligations. Typically, the Buyer’s duty to pay rent will be established elsewhere in the Agreement, so it need not be listed separately here, but the Seller would want it listed here if not previously addressed.
Differences in a Stock Sale Transaction Structure: None.
Indemnification by Seller
What is Indemnification by Seller? Indemnification is used to enforce representations, warranties and covenants made in the Agreement. Here, the parties list out which breaches by the Seller are subject to the Buyer’s right to indemnification.
The Middle Ground: This provision requires the Seller to reimburse the Buyer, its Affiliates, and their Representatives for any Losses arising out of: (1) the inaccuracy or breach of any representation or warranty contained in the Agreement or other Transaction Documents, if the representation or warranty was inaccurate or breached when made or at the Closing; (2) non-fulfillment of any covenant, agreement, or obligation undertaken by the Seller pursuant to the transaction; (3) any of the Excluded Assets or Excluded Liabilities; and (4) any Third Party Claim resulting from the Seller’s (or its Affiliates) operation or handling of the Business or Assets prior to the Closing Date.
Purpose: The indemnification aspect of the Agreement is the most efficient tool available for motivating the parties to stand by their agreed-upon obligations. As such, it is the main way for the parties to enforce the risk allocation scheme created throughout the Agreement.
Buyer Preference: If the Buyer is particularly worried about exposure from certain liabilities, it can specifically include those liabilities in this section so there is no debate whether they fall under the Seller’s indemnification obligation. Examples of the liabilities the Buyer may want to specify include retained employee liabilities, product liability claims, environmental issues concerning any assets or property transferred as part of the deal, and noncompliance with any applicable bulk sales laws. The Buyer also wants to carefully evaluate the definitions of “Affiliates” and “Representatives” to ensure the terms cover all those who may have an indemnification claim against the Seller in the future.
Seller Preference: The Seller wants to limit the matters eligible for indemnification as much as possible. Particularly, the Seller will be looking out for issues it cannot control to avoid being held responsible for problems caused by third parties.
Differences in a Stock Sale Transaction Structure: In a stock sale, there are no Excluded Assets or Excluded Liabilities, so it is even more essential for the Buyer to specifically list the liabilities for which the Seller has indemnification obligations. An often-used alternative to including a specific list in this section is to address those concerns in the representations and warranties since they are incorporated here by reference.
Conditions to Obligations of Seller
What are the Conditions to Obligations of Seller? This provision contains a comprehensive list of requirements that must be completed by the Buyer or waived by the Seller in order for the Seller to be obligated to complete the purchase. If the Buyer fails to fulfill any condition included in the list, the Seller can walk away from the deal without penalty.
The Middle Ground: The main difference between this provision and the Conditions to Obligations of Buyer is that there aren’t as many conditions to the Seller’s obligations since its paramount concern in most instances is whether the Buyer can pay the Closing payment. With that said, the typical list of requirements in this provision includes conditions to be completed at (or before) Closing such as:
The Buyer’s representations and warranties are true and correct in all (material) respects at the time of signing the Agreement and at the Closing;
The Buyer has complied with all terms of the Agreement and the Transaction Documents in all material respects;
No Governmental Authority has issued an order or injunction restraining the transaction;
The Buyer has obtained all third-party consents listed in its Disclosure Schedules, if applicable to the transaction;
The Buyer has delivered signed copies of the Transaction Documents;
The Buyer has transferred the Closing payment by wire transfer and the amount to be held in escrow to the Escrow Agent, if applicable;
The Seller has received a signed copy of the Buyer Closing Certificate;
The Seller has received a signed copy of the Buyer’s Secretary’s Certificate; and
The Buyer has provided other documents and instruments reasonably requested by the Seller and that are reasonably necessary to consummate the transaction.
Purpose: If the Buyer does not meet any one of the conditions listed in this provision, the transaction could fall apart instantly. This provision places the risk of that happening on the Buyer. It’s important to note here that the risk allocation scheme created by this provision and the previous one is not unfair to either side; both are afforded the opportunity to walk away if the other side does not meet its obligations, and the obligations each must meet are the product of negotiation and, typically, within the control of the party who must meet them.
Buyer Preference: The Buyer wants as few conditions listed here as possible, with those listed being wholly within its control, if possible. Furthermore, the Buyer will want materiality qualifiers included, particularly relating to conditions (1), (2), (3), and (4). However, this is another area where the requirements applicable to the Buyer will largely mirror those of the Seller, so the Buyer will have to decide what level of accuracy it is comfortable promising regarding its own deliverables. One condition for which it makes sense to have some divergence between Buyer is Seller is the “litigation out” listed in condition (3). With that condition, the Buyer is rightfully worried about any litigation whatsoever affecting the Seller’s Business since the Buyer will undoubtedly be impacted by that litigation. Depending on the Seller’s post-transaction plans and the nature of the litigation, it may or may not be concerned with a lawsuit brought against the Buyer. In regard to the third-party consent condition, it may not be necessary for the Buyer to obtain any such consents, but if it is the Buyer will want the condition limited to those consents which are material to the transaction.
Seller Preference: Here, the Seller is looking for equality. In the Seller’s mind, whatever standards are applied in the Conditions to Obligations of Buyer section should also be applied here. For example, the Seller will want the Buyer’s representations and warranties qualified by materiality only to the same extent that its own are subject to those qualifications. More specifically, it will want any representations or warranties already qualified by a general materiality standard or a Material Adverse Effect standard to not be qualified by any such standard in this section. Going even further, it will not want the Buyer’s representations regarding its organization and authority to conduct the transaction to be subject to any materiality qualifier whatsoever.
While the Seller’s overall goal in this section is parity between the conditions applicable to the Buyer and the conditions that it must meet, to retain its negotiating credibility the Seller only wants to insist upon parity when it makes sense in the context of the transaction. By the nature of the deal, not every condition that the Seller must fulfill will need to be fulfilled by the Buyer. So, the Seller’s best approach is to be aware of its interests, have an understanding of the conditions necessary to meet those interests, and fight for the conditions that matter while not wasting resources on those that don’t.
Differences in a Stock Sale Transaction Structure: None.
Tax Clearance Certificates
What are Tax Clearance Certificates? When a company is registered to conduct business in a particular state, the state keeps records of state-level taxes owed by the company. A tax clearance certificate is a document provided by the state indicating that the Business does not have any overdue taxes or, if taxes are owed, indicating the amount that the Business is required to pay.
The Middle Ground: This covenant requires the Seller to notify the taxing authorities (in jurisdictions that impose taxes on the Seller) of the transaction and to request tax clearance certificates from those taxing authorities where available. If the taxing authority indicates that the Seller is liable for unpaid taxes, the Seller must promptly pay those taxes and provide evidence of the payment to the Buyer.
Purpose: The goal of this provision is to prevent the Buyer from becoming liable for the Seller’s delinquent tax obligations. It plays a small role in risk allocation, but its importance is limited by the fact that the Buyer is indemnified for any such tax obligations. Thus, the covenant is most useful for the Buyer in situations where the Caps or Baskets on indemnification would preclude the Buyer from making a claim. With that said, indemnification can be tricky to negotiate and can involve a long claims process, so this covenant also serves to provide some peace of mind that state-level taxes will not cause problems for the Buyer.
Buyer Preference: The Buyer wants to include this covenant, especially if time is not an issue and including it would not place an undue burden on the Seller. The Buyer may even prefer to obtain the certificates itself rather than putting that task on the Seller’s plate. However, most buyers will not object to omitting it, especially if they can exclude tax-related claims from the limitations on indemnification.
Seller Preference: The Seller wants to exclude this covenant on the grounds that it unnecessarily adds more work to an already lengthy and exhaustive process. The Seller can point to the Buyer’s indemnification rights to show that the Buyer’s risk from delinquent taxes is already addressed elsewhere in the Agreement.
Differences in a Stock Sale Transaction Structure: This covenant is not included in stock sales. In the asset acquisition context, the covenant only requires the Seller to make notifications and requests of the relevant taxing authorities if the failure to do so would result in the Seller’s tax liability being transferred to the Buyer. Since that transfer is automatic in a stock sale, the Buyer relies on its indemnification rights to shield it from becoming responsible for the Seller’s unpaid taxes.
Governmental Approvals and Consents
What are Governmental Approvals and Consents? The lack of an important governmental approval or third-party consent can kill a deal despite the Buyer and Seller both wanting to move forward. To avoid that situation, the parties list out the necessary consents and approvals and split up the work in a way that makes sense for both sides. They also use this covenant to set boundaries around how far they must go in order to obtain a consent or approval.
The Middle Ground: This covenant requires both the Buyer and Seller to make all filings necessary to consummate the transaction, and to use their reasonable best efforts to obtain all the requisite consents from governmental authorities and third parties (e.g. customers and suppliers). It then lists out specific actions that the parties must carry out or avoid in order to obtain the necessary consents, such as litigating any order blocking the transaction, again modified by a reasonable best efforts standard. It also requires the parties to share certain information regarding communications with Governmental Authorities. Lastly, it expressly states that the Buyer is not required to sell off any part of its business or change the terms and conditions of the transaction to appease a Governmental Authority seeking to halt the transaction based on antitrust concerns.
Purpose: Once a potential deal reaches the exclusivity stage, it’s unlikely that a third party will prevent it from going through unless that third party is the government or has an important contract with the Seller and won’t consent to a change of control. This covenant seeks to deal with those two threats by allocating the serious risks they present between the parties.
Buyer Preference: The Buyer’s main concern with this clause is the application of the “reasonable best efforts” standard. The Buyer wants the standard included, but in defining what it means the Buyer needs to be aware of what it is willing (and unwilling) to do to close the transaction. For anything that it is unwilling to do, the Buyer will want an express statement to that effect included in the definition of reasonable best efforts. Given that the Seller will be the one that has the pre-existing relationships with important third parties other than the government, the Buyer generally wants the risk of not obtaining a third-party consent to fall on the Seller, with the risk of not obtaining Governmental Approval shared equally.
Seller Preference: The Seller wants to place the risk of not obtaining necessary Governmental Approvals on the Buyer, and it can do so by replacing the reasonable best efforts standard with a more demanding one. The Seller’s main concern is avoiding governmental interference with the deal, so it wants to place the burden relating to any such interference on the Buyer. The Seller can allocate that risk to the Buyer by requiring the Buyer to either divest assets to satisfy regulators or litigate any Governmental Order blocking the transaction. If the Buyer objects, the Seller can suggest putting caps on the amount of assets the Buyer must divest or that the parties list out specifically which assets would be subject to divestiture.
Differences in a Stock Sale Transaction Structure: None.
Equitable Remedies and Reasonableness of Restrictive Covenants
What is he Equitable Remedies and Reasonableness of Restrictive Covenants section? These two terms help enforce the three important restrictive covenants: the Confidentiality, Non-Compete and Non-Solicitation provisions. All of those restrictive covenants call for non-monetary (“equitable”) remedies, and the restrictions must be reasonable for a court to enforce them. By agreeing to this section, the Seller is agreeing that a non-monetary remedy is appropriate for the situation and that the specific restrictions included in the restrictive covenants are reasonable in the context of the transaction.
The Middle Ground: The Equitable Remedies provision states that a violation of any of the restrictive covenants would cause the Buyer irreparable harm for which money would not provide adequate compensation. It is meant to allow the Buyer to obtain an equitable remedy such as an injunction to prevent violations. The Reasonableness provision includes an acknowledgement from the Seller that the Confidentiality, Non-Compete and Non-Solicitation covenants are reasonable. It also states that if a court finds the restrictive covenants unreasonable, the Seller agrees that the court should reform the terms to the point where they are considered reasonable but still achieve the desired effect to the maximum extent allowed by law.
Purpose: These two provisions are aimed at protecting the viability of the restrictive covenants. The Confidentiality, Non-Compete and Non-Solicitation covenants do most of the heavy lifting in terms of protecting deal value, and these two covenants perform a smaller risk management function by ensuring that the more important covenants remain enforceable and effective.
Buyer Preference: Although there will typically be a specific performance clause applicable to the entire Agreement, the Buyer wants to include the Equitable Remedies covenant here so that there is no question that it applies to all restrictive covenants. The Buyer wants to be sure to include language that tracks the standard for granting injunctions and other equitable remedies (i.e. “irreparable harm…for which monetary damages would not be an adequate remedy”). In regard to the Reasonableness covenant, the ability to modify restrictive covenants rather than completely invalidating them is not available in all states. So, the Buyer’s counsel should adjust its approach depending on whether the law governing the agreement allows “blue-pencil” revisions. If not, the Buyer may want to include a choice of law clause or reduce the covenant restrictions so there is no doubt they are enforceable.
Seller Preference: If the Seller agrees that the restrictive are reasonable, it will likely have no objection to these two subsections since the entire purpose of both is to protect the viability of the restrictive covenants.
Differences in a Stock Sale Transaction Structure: None.
Non-Solicitation of Employees and Clients
What is Non-Solicitation of Employees and Clients? In addition to limiting the Seller’s ability to compete, this covenant is another way for the Buyer to protect the value of the Business post-Closing. Because non-compete covenants are limited to a certain geographic area, buyers include this covenant to protect relationships with customers and employees in case the Seller decides to compete in a geographic area that is not covered by the non-compete restriction.
The Middle Ground: This covenant prevents the Seller and its Affiliates from attempting to lure employees away from the Business. It may also prevent the solicitation of clients and prospective clients of the Business, if that restriction is not included in the Non-Competition covenant. In regard to employees of the Business, the restriction is typically aimed at employees who have been offered employment by the Buyer, but does not apply to general solicitations, employees terminated by the Buyer, or employees who terminated their own employment with the Business after a specified time period.
Purpose: The Seller has a massive informational advantage over the Buyer in being able to identify the key employees and clients of the Business. If the Seller were allowed to poach them away from the Business, it could easily decimate the value of the Buyer’s investment. Put another way, the Buyer agrees to a Purchase Price based on expectations for how the Business will perform in the future, and the purpose of this covenant is to protect those expectations.
Buyer Preference: Similar to other restrictive covenants, the Buyer wants this covenant to be as broad as possible while still being enforceable. That means any and all restrictions should be rationally related to protecting the Business. The Buyer may also seek to prevent the general solicitation of employees (and will surely want to do so for clients), and it will want the restrictive language to apply to the Seller’s affiliates and to indirect attempts to solicit employees.
Seller Preference: The Seller wants to include all exceptions contained in the middle ground term, and additionally it might try to reduce the waiting period required to hire any employees who leave the Business of their own volition. It may also want to reduce the effective period for this covenant, if there is a logical reason for it to be shorter than the effective period for the non-compete covenant (generally the Buyer wants the time periods to mirror one another for ease of enforcement). An ambitious Seller may want to avoid this covenant altogether, but most Buyers will refuse to make an acquisition without some protection regarding clients and employees of the Business.
Differences in a Stock Sale Transaction Structure: None.
Non-Competition
What is the Non-Competition section? One of the ways a Buyer protects its investment is by limiting future competition by the Seller, who is more knowledgeable about the Business (and often the industry) than the Buyer. By limiting competition from the Seller, this covenant protects the Business’s relationships with customers, suppliers, employees, and other stakeholders.
The Middle Ground: In most acquisitions, the Seller agrees not to compete with the Business after the Closing. The covenant terms describe who is not allowed to compete (generally, the Seller and its Affiliates); the duration of the restriction, which varies from state to state based on differences in state law (typically anywhere from 1-10 years); the specific acts that are restricted, either defined in detail or by reference to the acquired Business (e.g. any business that directly or indirectly competes with the Business); the geographic scope of the restriction, which is also either defined in detail or based on where the Business operates; and any exceptions to the restriction on competition. The covenant will likely also prevent the Seller from inducing any current or prospective clients to end their relationship with the Business, although this restriction is sometimes included in a separate non-solicitation covenant.
Purpose: This covenant is an essential component of the Agreement because of its impact on the value of the deal to the Buyer. In small to mid-sized businesses, much of a company’s value is derived from the owner’s relationships with customers, suppliers, and others in the community. Significant value also stems from the owner’s know-how and familiarity with the industry. If the owner were to go out and start a competing business following the acquisition, the value of the Business in the hands of the Buyer would likely plummet.
Buyer Preference: The Buyer wants each term in the covenant other than the exceptions to be defined as broadly as possible while still being enforceable. Restrictive covenants such as non-compete agreements are disfavored by the courts. In this context, that means overbroad restrictions that don’t directly protect the acquired Business will likely not be enforced. Whether a restriction goes too far depends on the facts and circumstances surrounding the particular acquisition, as well as the state law that governs the Agreement, so it’s important to tailor the covenant terms to the situation.
Seller Preference: Whether the Seller wants to spend significant time and effort negotiating these terms depends on its post-acquisition plans, but in general it wants the restrictions to be as limited as possible and the exceptions to be plentiful. More specifically, if the Seller plans to invest in other ventures following the acquisition it wants to make sure that this covenant does not prevent it from doing so. Some investments will undoubtedly be restricted (e.g. investing in a direct competitor), but the Seller wants to make sure that any such restrictions are directly related to protecting the value of the Business. If the Seller is only selling a division of its business, it also needs to make sure none of the restrictions affect its ongoing operations.
Differences in a Stock Sale Transaction Structure: None.
Confidentiality and Non-Disparagement
What is the Confidentiality and Non-Disparagement section? All businesses possess information that is beneficial to them because it is not known by the public (e.g. customer lists, trade secrets, etc.). Prior to the Closing, the Seller protects that information by requiring the Buyer to keep non-public information confidential. Post-Closing, the Buyer wants to place a similar confidentiality requirement on the Seller, and this covenant is used to accomplish that goal.
The Middle Ground: This covenant requires the Seller, its Affiliates, and its Representatives to use their reasonable best efforts post-Closing to keep confidential all information about the Business that is not otherwise publicly available. It also requires the Seller to take certain precautions if it is required by law to disclose the information, such as only providing information it is legally required to provide (as advised by legal counsel) and taking steps to limit who is able to access the confidential information that is disclosed. The parties also agree not to make negative or disparaging comments about each other to third parties.
Purpose: This covenant is intended to protect the value of the Business after the transfer of ownership has occurred by protecting the confidential information of the Business. For a serial buyer such as a private equity firm, it also protects future deals by preventing the Seller from providing potential future sellers with information about terms the Buyer is willing to accept and/or the Buyer’s negotiation strategies.
Buyer Preference: The Buyer wants to pay close attention to the definitions of Affiliates and Representatives to ensure that everyone who has access to the information sought to be protected has a duty of confidentiality with regard to that information. If the sale was initially conducted by auction, expansive definitions of Affiliates and Representatives may not adequately protect the Buyer’s risk, so the Buyer can have the Seller assign the confidentiality agreements signed by the other auction participants to protect the Business’s sensitive information. The Buyer also wants to be able to enforce this covenant using an injunction rather than indemnification, because preventing a violation is more valuable than receiving monetary compensation after one has occurred. To achieve that goal, the Buyer should explicitly carve out this covenant from the Exclusive Remedies provision.
Seller Preference: The Seller may want to include language indicating that the Buyer’s confidentiality obligations (often originating in the Letter of Intent) apply to information disclosed pursuant to the Agreement and that the Buyer’s confidentiality obligations survive termination of the Agreement. Essentially, such language provides protection for the Seller if the deal does not go through. The Seller will also pay attention to the scope of the disclosure restrictions so it can avoid being penalized for sharing information that doesn’t have the potential to hurt the Business or the Buyer.
Differences in a Stock Sale Transaction Structure: None.
Employees and Employee Benefits
What is the Employees and Employee Benefits section? Transferring employees and their benefit plans from the Seller’s business entity to the Buyer’s is a process that involves quite a few underlying issues that must be worked out between the parties. This covenant lays out how the parties have answered questions such as which employees will be transferred, what benefits they will receive, and who is responsible for employee-related issues that pop up after the Closing.
The Middle Ground: In this covenant, the Seller promises to terminate its employees on the Closing Date so the Buyer can hire some or all of them on its own terms. Next, the Seller agrees to be responsible for all compensation (including benefits) owed to its employees up to the Closing Date, and to pay out that compensation by the Closing Date. The Seller also agrees to remain responsible for all insurance, disability, and workers’ compensation claims that are based on events that occur on or prior to the Closing Date. For those employees of the Seller that the Buyer does hire, the Buyer typically agrees to offer them substantially similar compensation and benefits as previously offered by the Seller or as offered to Buyer’s similarly situated employees. Finally, the Buyer agrees to give the employees it hires from the Seller “service credit” under the Buyer’s health and retirement benefits plans according to their length of service with the Seller.
Purpose: The most important feature of this covenant is the Buyer’s promise to hire the Seller’s employees because it can be used to maintain employee stability and quell any panic that may arise after the acquisition is announced. It is something the Seller can point to in order to assure its employees that the sale of the company does not automatically translate to a loss of their jobs. In other words, it is a wonderful risk management tool. However, the Buyer retains the discretion not to hire employees as it sees fit and the other promises made by the Buyer relate only to the employees it ends up hiring. Thus, the covenant does not guarantee that no employees will be worse off after the sale, but if the Buyer agrees to include it that is a good signal that its intent is to disrupt normal operations of the Business as little as possible.
Buyer Preference: The Buyer wants to retain as much discretion as possible, especially with regard to who it must hire and the level of compensation it must provide. While stability is typically in the Buyer’s best interest, some buyers may use the transition as an opportunity to cut costs by selectively reducing the number of employees, and it is not unreasonable for the Buyer to want to maintain the discretion to do so. Also, if the Seller is subject to the WARN Act (or any state-level corollaries), the Buyer wants to ensure that the Seller takes responsibility for any resulting liabilities.
Seller Preference: The Seller will typically seek a promise from the Buyer to hire all or most of the Seller’s employees at comparable compensation and benefit levels. The desire for the Buyer to hire as many employees as possible is even stronger when the Seller is subject to the WARN Act or a similar state law, since liability under the Act can be minimized or avoided entirely if enough employees are hired by the Buyer. Another tactic for the Seller to avoid WARN Act liability is to explicitly shift that liability to the Buyer in the Agreement, but that will likely take significant negotiation leverage.
Differences in a Stock Sale Transaction Structure: This covenant is not included in a stock sale because the target company remains intact so there is no need to transfer employees to a new entity.
No Conflicts; Consents (Buyer)
Significance: Deal Driver
Section: Representations and Warranties of Buyer
Negotiation Time: Minimal
Transaction Costs: Insignificant to Intermediate
Major Impact: Risk Management and Transaction Completion
What is the No Conflicts; Consents section? In this section, the Buyer provides information regarding its ability to complete the transaction without third-party interference. It is part of the Representations and Warranties of Buyer section.
The Representations and Warranties of Buyer portion of the Agreement is used to save the Seller time and money. Rather than require the Seller to go through third parties to find certain information, the Buyer provides the information and must reimburse the Seller for any Losses it suffers if the information is false or misleading.
The Middle Ground: Much like the Seller’s reciprocal representation, here the Buyer represents that performance of its obligations under the Agreement does not conflict with its organizational documents or any law or Governmental Order. It states that execution of the Agreement does not require notice to or consent from any party that has a contract with the Buyer, other than the parties listed in the Disclosure Schedules. It also represents that no consents, approvals, permits, or Governmental Orders are required from the government, and no notice or filings are required to be provided to the government, to consummate the transaction (other than those required by the HSR Act, if applicable).
Purpose: The rationale for classifying this representation as a Deal Driver mirrors that of the Seller’s “No Conflicts; Consents” representation. Both indicate there are no legal roadblocks to completing the deal, which, if true, makes it much more likely that the transaction will be finalized. This representation also has a substantial effect on the allocation of risk between the parties because the Buyer is assuming responsibility if the transaction doesn’t go through based on a failure to obtain necessary consents.
Buyer Preference: Depending on the situation, the Buyer may want to include a materiality qualifier regarding the consents, approvals, and notices contemplated by this section. It may even want a Material Adverse Effect standard to limit its required disclosures. However, the Buyer must keep in mind that any qualifiers it insists upon will almost always be mirrored in the Seller’s representation. So, the Buyer wants to weigh its desire to limit its own disclosures against its need for full disclosure from the Seller. Most buyers will opt for full disclosure in this section since anything short of that has the potential to reduce the value of the deal or put the entire acquisition at risk.
Seller Preference: The Seller wants the Buyer to disclose any conflicts, consents, Governmental Orders, etc. that could interfere with the transaction. Although this is a reciprocal representation, the Buyer’s representation may be somewhat more limited than that of the Seller since the Seller is not concerned with the post-Closing operation of the Buyer’s business. The Seller should find a more limited representation acceptable, so long as the concerns it does have regarding conflicts, consents, and Governmental Orders are addressed.
Differences in a Stock Sale Transaction Structure: None.
Inventory
What is Inventory? In this section, the Seller provides information regarding the inventory of 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: The Seller represents that the inventory held by the Business is consistent with the Business’s past practices, in terms of both quality and quantity. The Seller also represents that the inventory does not have any Encumbrances that would prevent its sale.
Purpose: Inventory is another area that drives some companies but is utterly irrelevant for others. If inventory is a necessity it will receive significant attention during the due diligence process. Buyers want to know everything about it: how much there is, how often it comes in and goes out, how is it accounted for, etc. On the other end of the spectrum, inventory is a non-issue on which neither side will spend much time or money.
Buyer Preference: The Buyer wants this representation included if inventory is an essential part of the Business, and it wants to be specific about the representation to ensure that the inventory referred to is sufficient to satisfy customer needs and expectations.
Seller Preference: The Seller likely wants to exclude this representation entirely. Since inventory is an item listed on the balance sheet, the Seller may argue that the issue is adequately covered by the financial statement representations contained elsewhere in the Agreement.
Differences in a Stock Sale Transaction Structure: None.
No Conflicts; Consents (Seller)
What is the No Conflicts; Consents section? In this section, the Seller provides information regarding its ability to complete the transaction without third-party interference. 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 performance of its obligations under the Agreement does not conflict with its organizational documents or any law or Governmental Order. It also represents that no consents are required to transfer the Purchased Assets other than those listed in the Disclosure Schedules and that performance of the Agreement will not result in any Encumbrances, other than Permitted Encumbrances. Finally, it states that no consents, approvals, permits, or Governmental Orders are required from the government, and no notice or filings are required to be provided to the government, to consummate the transaction (other than those required by the Hart-Scott-Rodino Antitrust Improvements Act of 1976, known as the “HSR Act,” if the HSR Act applies to the transaction).
Purpose: These representations indicate there are no legal or governmental roadblocks to completing the deal, which, if true, makes it much more likely that the transaction will be finalized. Furthermore, the Disclosure Schedules that correspond with this section are where the Seller lists out every consent that is required to transfer the Assigned Contracts to the Buyer, and the parties work from that list to try to obtain those consents. Thus, this representation is a significant source of both comfort and information for the Buyer, and it gives the parties an idea of the legwork that will be required to complete the transaction.
Buyer Preference: The Buyer will want the representations regarding Assigned Contracts to cover all such contracts, not just Material Contracts. Furthermore, the Buyer will not want this representation to include any sort of materiality qualifiers. It will also want to know whether performing the Agreement will give any third party the right to terminate or modify existing contracts or permits and, if so, which contracts or permits could be affected.
Seller Preference: The Seller will only want to speak to (and/or disclose) conflicts and consents that have a material impact on the transaction. More specifically, the Seller does not want to be exposed to liability for making a false representation in this section unless the representation relates to its own organizational documents or has a Material Adverse Effect on the transaction or the value of the Purchased Assets. In other words, the Seller will want a basic materiality qualifier at a minimum, but ideally disclosure would only be required if the conflict or consent would have a Material Adverse Effect.
Differences in a Stock Sale Transaction Structure: None.
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.
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.