Condition and Sufficiency of Assets
What is the Condition and Sufficiency of Assets? In this section, the Seller provides information regarding the usefulness of the Purchased Assets. 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 Condition and Sufficiency of Assets representation asserts that each asset being transferred is in good operating condition and, other than the need for ordinary maintenance and non-material repairs, is suitable for use in the same way as it was being used in the Business prior to the transaction. It also states that the Purchased Assets are sufficient to conduct the Business in the same manner as it was conducted prior to the transaction.
Purpose: This representation gives the Buyer comfort that it is purchasing everything necessary to conduct the Business as previously conducted, and if that’s not the case the risk of loss will fall on the Seller. As the party with vastly superior knowledge on the issue, the Seller is in the best position to take on that risk, and allocating the risk this way also ensures that the Buyer receives the full value of the bargained-for assets.
Buyer Preference: Although the “Sufficiency of Assets” portion of the representation states that the Purchased Assets are sufficient to operate the business as previously conducted, as a safeguard the Buyer may want to add a representation that none of the Excluded Assets are material to operation of the Business.
Seller Preference: The Seller would prefer to limit this representation to the statement that the Purchased Assets are sufficient to operate the Business. Instead of attesting to the condition of the Purchased Assets, the Seller can allow the Buyer to inspect the property and assets. The Seller also wants to omit the representation regarding the Excluded Assets because it addresses the same concern as the Sufficiency of Assets representation.
Differences in a Stock Sale Transaction Structure: In a stock sale where the business being purchased is an independent entity as opposed to being part of a larger group, the Sufficiency of Assets representation is not necessary. However, if the stock purchase relates to a company that is part of a parent/subsidiary structure that shares the use of certain assets, the Sufficiency of Assets representation should be included in the Agreement.
Title to Purchased Assets
What is the Title to Purchased Assets? In this section, the Seller provides information regarding its ownership of the Purchased Assets. 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 represents that it has good and valid title to, or a valid leasehold interest in, all of the Purchased Assets (i.e. it is the legal owner or lessee of all the Purchased Assets). It also represents that the Purchased Assets are free and clear of any Encumbrances other than Permitted Encumbrances. The remainder of the clause is devoted to defining Permitted Encumbrances (usually in list form). Permitted Encumbrances are generally limited to Encumbrances that are not material to the Business or the Purchased Assets, either individually or when taken together.
Purpose: In an asset sale, the Buyer is purchasing every single asset for a reason, so it’s important that the Seller is able to transfer every single asset according to the transaction terms. Its failure to do so could meaningfully alter the value of the deal for the Buyer. This clause and the Indemnification section of the Agreement place the risk of that failure squarely on the Seller’s shoulders so that the Buyer is compensated for any such loss in value.
Buyer Preference: The Buyer wants this section to apply to all the Purchased Assets to avoid receiving assets with Encumbrances other than the Permitted Encumbrances. Furthermore, it wants to limit the list of Permitted Encumbrances to those Encumbrances that do not impede the use or reduce the value of the Purchased Assets. The Seller may insist on excluding Intellectual Property Assets from this representation because they are addressed in a separate section of the Agreement, and if that is the case the Buyer wants to make sure there is a similar representation included in the Intellectual Property section.
Seller Preference: The Seller wants to limit this representation to tangible personal property (which excludes Intellectual Property). If Intellectual Property is included in this representation, the Seller wants to make sure that the representation does not exceed the scope of what is required by the Intellectual Property section of the Seller Representations and Warranties. Also, instead of qualifying the Permitted Encumbrances using a general materiality standard, the Seller may want to argue for the narrower Material Adverse Effect standard. The Seller also wants an expansive definition of Permitted Encumbrances, including a catchall clause for any Encumbrances that would not have a Material Adverse Effect on the Business.
Differences in a Stock Sale Transaction Structure: There is a minor drafting difference when using a stock sale structure, which is that use of the phrase “purchased assets” is not accurate since the entire company, not just the assets, is being purchased.
Material Contracts
What are Material Contracts? In this section, the Seller provides information regarding the Business’s contracts. 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 Material Contracts provision defines the term “Material Contracts” and requires the Seller to list all the Material Contracts affecting its Business in the Disclosure Schedules. It also includes a Seller representation that those contracts are valid, binding, and in full force and effect and that the Seller is not in breach or default under them. The representation also states that there are no material disputes, pending or threatened, related to the Material Contracts.
Purpose: This representation plays a major role in allocating the risk that stems from the Business’s Material Contracts. For many companies the Material Contracts will make up the bulk of its business, so the representation that those contracts are valid, have not been breached, and are not the subject of any material disputes is a valuable one. In addition to the representation, having access to the contracts themselves gives the Buyer extensive insight into the Seller’s operations and standards – information that is tremendously important during the transition phase.
Buyer Preference: The Buyer wants to carefully consider what constitutes a Material Contract in the target’s industry and Business and include those attributes in the definition of Material Contracts. In addition to the list of attributes, the Buyer wants to include a catchall category that uses a materiality standard to encourage disclosure in borderline situations. Because non-Assigned Contracts may affect the value of Assigned Contracts, it is best for the Buyer if Material Contracts are not limited to Assigned Contracts. A Buyer may also want a representation that no party is in breach or default of any Material Contract.
Seller Preference: The Seller wants to limit this disclosure to Assigned Contracts since those are the contracts with which the Buyer will be involved. It also wants to limit its representation regarding breach or default under the Material Contracts to its own breach or default rather than speaking for all contract parties. As a compromise, it may allow the representation to be included for all parties if a knowledge qualifier is added.
Differences in a Stock Sale Transaction Structure: None.
Undisclosed Liabilities
Significance: Moderately Material
Section: Representations and Warranties of Seller
Negotiation Time: Minimal to Moderate
Transaction Costs: Insignificant
Major Impact: Risk Management
What are Undisclosed Liabilities? One major purpose of the Agreement is to detail how certain liabilities of the Business will be treated after the Closing. This term focuses on a particular set of liabilities, those that are unknown to the Buyer at the time of the sale, and requires the Seller to either disclose them in the Disclosure Schedules or remain on the hook for them post-Closing.
The Middle Ground: Since the Balance Sheet Date on which it was delivered prior to Closing, the Seller represents that all liabilities of the Business are reflected or reserved against in the Balance Sheet, except for immaterial liabilities incurred in the ordinary course of business, consistent with past practice.
Purpose: This representation is targeted at unknown liabilities that transfer to the Buyer (along with the Business) as a matter of law. Major liabilities can usually be predicted and planned for, so it is unlikely the Buyer will be held responsible for a significant, unplanned-for liability incurred by the Seller. Even so, this representation provides some level of comfort to the Buyer by shifting the risk of unknown pre-Closing liabilities back to the Seller.
Buyer Preference: The Seller may try to limit this representation or exclude it altogether, but the Buyer will want to include it as is on the grounds that any liabilities incurred by the Seller should be borne by the Seller. If the Seller does try to limit the applicability of the representation, it will likely argue for (1) a knowledge qualifier, (2) a materiality or Material Adverse Effect qualifier, (3) a GAAP qualifier, or (4) excluding certain specified liabilities. For the Buyer, argument (1) is a non-starter because the entire reason the Buyer wants this provision is to avoid shouldering liability for unknown liabilities, plus the Buyer does not want to be forced to prove the Seller’s knowledge about a particular topic. Similarly, the Buyer wants to exclude the GAAP qualifier because including it would mean the representation does not apply to unknown contingent liabilities and those liabilities are exactly why the Buyer is seeking the protection offered by this representation. Including materiality qualifiers of some sort or excluding specified liabilities may be more agreeable to the Buyer, but the Seller’s risk from small inaccuracies can be addressed just as well by applying a Basket to the Buyer’s indemnification rights, and taking that approach doesn’t create much additional risk for the Buyer.
Seller Preference: The Seller likely wants this representation excluded in its entirety, or, alternatively, to implement one or more of the limitations listed above. The Seller’s best hope is to exclude certain categories of liabilities, especially if they are addressed elsewhere in the Seller Representations and Warranties (i.e. environmental liabilities). Otherwise, the Seller may have to give in on a different point of negotiation in order to lower its risk from unknown pre-Closing liabilities.
Differences in a Stock Sale Transaction Structure: This representation is a necessity for the Buyer in a stock sale since, under that transaction structure, all of the Business’s liabilities are transferred to the Buyer by operation of law. The content of the representation may not change, but the Buyer’s level of risk if the clause is excluded increases exponentially when the transaction structure changes from asset to stock sale.
Financial Statements
What is the Financial Statements section? In this section, the Seller provides information regarding the financial statements 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 it has provided the Buyer with Financial Statements (i.e. Balance Sheet, Income Statement, etc.) for a specified number of years and for the most recently ended fiscal quarter (the latter being referred to as the “Interim Financial Statements”). The Seller also typically represents how the Financial Statements were prepared (e.g. based on GAAP), that they are based on the books and records of the Business, and they fairly reflect the Business’s financial performance.
Purpose: The purpose of the Financial Statements representation is to confirm that the Financial Statements delivered to the Buyer are, in fact, representative of the Business. This representation could rightly be described as either a deal driver or a moderately material term, the difference being a result of whether the inaccuracy in the Financial Statements is intentional or unintentional. Unintentional inaccuracies that constitute a breach of this representation are certainly undesirable, but they generally have no more than a moderate impact on the value of the deal (otherwise, they would’ve been flagged internally by the Seller). Intentional inaccuracies tend to be larger, thereby influencing deal value to a greater degree. The more troubling result of intentional inaccuracies is that they decimate trust between the parties, and at that point most buyers will walk away from the deal. Thankfully, unintentional inaccuracies are the much more common variety.
Buyer Preference: In the event that the Seller’s Financial Statements are not prepared in accordance with GAAP, the Buyer wants to see an explanation of the Business’s accounting policies and procedures, and will likely conduct a more rigorous due diligence review of the Business’s financial information. A more aggressive Buyer will resist a materiality qualifier as part of the representation that the Financial Statements fairly depict the financial condition of the business, and may seek to include language indicating that the statements are “true, complete, and correct.” A cautious Buyer may also request the Seller’s tax returns in order to confirm the accuracy of the internally-prepared company financials.
Seller Preference: The Seller will want to include a materiality qualifier and/or a “GAAP qualifier” that simply states that the Financial Statements present the financials of the company in accordance with GAAP. Most sellers will settle for one qualifier or the other, but some may seek to include both if they want to rely on GAAP assumptions and are worried about minor inaccuracies or omissions.
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.
Organization, Qualification, and Authority of Seller
What is the Organization, Qualification, and Authority of Seller section? In this section, the Seller provides information regarding its legal ability to conduct the Business and enter into the Agreement. 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: In this collection of clauses, the Seller represents that: (1) it is a validly organized business, (2) it is qualified to do business in the states where it operates and where the Purchased Assets are held, (3) it has the power and authority to enter into the Agreement and abide by its terms, and (4) it has taken or will take the necessary corporate action to perform its obligations under the Agreement.
Purpose: Taken together, these clauses have a significant impact on the Buyer’s level of risk and the Seller’s legal ability to live up to its end of the bargain. The Agreement is typically made between the Buyer’s company and the Seller’s company, and the assets being transferred are assets owned by the Seller’s company. Therefore, whether the Seller can fulfill its obligations under the Agreement hinges on its status as a validly organized entity that has the authority to transfer the assets. When the Seller makes representations to that effect, the risk of those representations being false shifts to the Seller. Furthermore, by representing that it is qualified to do business in the jurisdictions where it operates, the Seller is shielding the Buyer from potential liability and penalties for any unlicensed operations (in jurisdictions where a license is required).
Buyer Preference: The Buyer generally wants these representations to be drafted broadly, without any qualifiers relating to Material Adverse Effect and without limiting the jurisdictions to which the representations apply. However, the Buyer will be asked to make essentially the same representation as part of its representations and warranties, so it should be willing to include the same language used here.
Seller Preference: The Seller will want to limit its qualification representation to jurisdictions where failure to be licensed or qualified will have a Material Adverse Effect. It may also want to limit the qualification representation to a list of jurisdictions provided in the Disclosure Schedules, rather than in all jurisdictions where it operates or where the Purchased Assets are held. To limit the risk posed by third parties, a Seller can seek to include an exception in its authority representation that allows it to get out of the Agreement if equity principles or creditors’ rights laws deem the Agreement to be unenforceable (e.g. because it violates fraudulent conveyance laws).
Differences in a Stock Sale Transaction Structure: None.
Closing Deliverables
What are Closing Deliverables? Both parties to the transaction are required to provide certain documents and property to the other side at the Closing. This portion of the Agreement sets out everything that must be delivered, and who is responsible for delivery of each item.
The Middle Ground: The exact deliverables depend on the specifics of the transaction, but typically they include a Closing certificate, necessary consents, deeds for real property, intellectual property assignment agreements, and the money due at Closing.
Purpose: The failure of either side to provide the deliverables listed in this section could completely destroy the deal. One of the Conditions to Closing is that both parties have satisfied their requirements under the Closing Deliverables provision, meaning if one party does not comply with these obligations the other party can walk away from the deal without repercussion. Therefore, this section motivates both sides to promptly address their obligations by setting a deadline for delivery and imposing a severe punishment for a failure to follow through. Even with the option to walk away, most buyers and sellers are willing to move forward with the Closing in the absence of a closing deliverable so long as the deliverable is not a central piece of the transaction (e.g. cash due at Closing). Rather than throw out months of hard work on both sides, generally the parties will agree on how to deal with the missing deliverable and amend the Agreement accordingly.
Buyer Preference: If registered intellectual property is being transferred, the Buyer will prefer to have short-form assignment and assumption agreements in addition to the longer forms so they can use the short-forms for public filings with the US Patent and Trademark Office (generally, neither side wants all the details included in the long forms to become public record). If a deed for real property is part of the transfer, the Buyer will want to seek a deed that, in light of the facts, provides maximum protection against third parties coming in after the sale and claiming the land as their own. A general warranty deed is the ideal choice, but obtaining one may not be feasible in certain situations. Finally, the Buyer wants to obtain a power of attorney from the Seller for all matters related to operation of the Business and any Purchased Assets.
Seller Preference: For transfers of real property, the Seller prefers to provide a deed with little or no warranties, meaning a quitclaim deed is the ideal choice. Whether a deed backed by further warranties is appropriate depends on the Seller’s familiarity with the real estate in question.
Differences in a Stock Sale Transaction Structure: This section is not included in a stock sale, as the only items to be tendered at the time of Closing are the cash due at Closing and the shares being transferred.
Closing
What is the Closing section? Both sides have to agree when and where the Closing will happen; this section is where they put those details in writing.
The Middle Ground: This clause states the procedural details relating to the Closing, including the date, time, and place where the Closing will occur. It also states when the Closing will take effect for legal purposes (often at 11:59 pm on the Closing Date).
Purpose: This section is purely informational and is included mostly for the sake of convenience. Once the parties agree on a Closing Date they are not likely to give a second thought to this section until that date approaches.
Buyer and Seller Preference: Both parties will want the Closing Date to fall on a weekday so wire transfers can be executed and any last-minute approvals or other closing-related items can be obtained.
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.
Withholding Tax
What is Withholding Tax? Sometimes a transaction requires the Buyer to withhold a portion of the Purchase Price for tax purposes (e.g. if the Seller is a foreign person or entity). This provision clarifies whether withholding is necessary and, if so, whether the withheld amount is included in the stated Purchase Price.
The Middle Ground: This section allows the Buyer to withhold from the Purchase Price all Taxes that the Buyer is required by law to withhold or, alternatively, waives the withholding requirement based on a statement by the Seller that no withholding is required.
Purpose: If the Buyer is required to pay withholding tax it will naturally want to reduce the price actually paid to the Seller by the taxes due. The parties include this provision to avoid disputes over whether the agreed upon Purchase Price includes withholding tax or must be “grossed up” to cover such tax. In other words, this provision is included purely for the sake of clarity, and the parties will likely spend no time actually discussing it with one another.
Buyer Preference: The Buyer will want this provision included to avoid a potential dispute, but it need not include any special terms over and above the standard language.
Seller Preference: None.
Differences in a Stock Sale Transaction Structure: None.
Purchase Price Allocation
What is the Purchase Price Allocation? The Buyer and Seller are both taxed on the sale of the Business. As part of the taxation process, they must match (or allocate) the Purchase Price and the value of Assumed Liabilities to different asset classes. Both parties must report the same allocation, so they typically agree on it shortly after Closing in accordance with this provision.
The Middle Ground: This section indicates where the Allocation Schedule can be found, which party is responsible for preparing it, when it must be completed, and a dispute resolution procedure in case the parties cannot agree on the allocation scheme. It also states that the tax returns of both parties must be filed in accordance with the Allocation Schedule.
Purpose: How the Purchase Price is allocated directly affects the taxes paid by both parties, and allocations that benefit the Seller typically work against the Buyer (and vice versa). While this dynamic can cause some tension and lead to a lengthy negotiation, the issue is unlikely to derail the entire transaction. That is, in part, because the parties do not have the ability to allocate the Purchase Price as they see fit; their allocation must be within the bounds of the law, which essentially means it must reflect the reality of the situation. Each party has some latitude to negotiate, but neither party will get a “perfect scenario,” and disagreements can usually be resolved by making the allocation that most closely mirrors the actual value of the assets.
Buyer Preference: One of the major benefits of an asset sale is the Buyer’s ability to receive a “stepped-up” tax basis in depreciable and amortizable assets. A higher tax basis on those assets means greater depreciation and/or amortization, which translates to a lower tax bill. Thus, allocating the bulk of the Purchase Price to those assets effectively lowers the price paid for the Business.
Seller Preference: The Seller wants the same benefit from the allocation as the Buyer hopes to achieve – a lower tax bill. In order for the Seller to accomplish that, it will want to allocate as much of the Purchase Price as possible to capital assets (such as land) so that it is taxed at the capital gains rate rather than the ordinary income rate.
Differences in a Stock Sale Transaction Structure: This section is not necessary in a stock sale structure (unless the parties opt to make a 338(h)(10) election) because the Purchase Price will be treated as capital gains to the Seller and the Buyer will assume the Seller’s tax basis in the assets, which limits the benefits it receives from depreciation and amortization.
Purchase Price Adjustment
What is the Purchase Price Adjustment? Businesses do not shut down operations during the transaction, so there is often a need to adjust the payments after the Closing to reflect the actual state of the Business on the Closing Date. This provision provides a way to make the necessary adjustments.
The Middle Ground: If the parties agree to adjust the Purchase Price based on one or more particular business metrics, the Purchase Price Adjustment section outlines the specifics on how that criteria will be used to adjust the price, and a time period for when the calculations must be made (typically by the Buyer). This section also details how long the Seller has to object to the calculations and, if an objection is made, the procedure for settling the dispute. For example, a popular basis for adjusting the Purchase Price is to calculate the final Working Capital figure (specified Current Assets less specified Current Liabilities), and a popular dispute resolution procedure is to first rely on good faith negotiation and, should that fail, to select a third-party accountant to resolve the discrepancy between the parties. To limit the disputes under this section and encourage resolution through negotiation, the Agreement may allocate payment responsibilities for the accountant’s fee to the party whose Working Capital figure is furthest from the accountant’s final determination. Another good way to avoid post-Closing Purchase Price Adjustment disputes is to clearly define how Accounts Receivable will be counted when calculating Working Capital at Closing. If money is billed before Closing but received after, whose money is it? What is the Buyer’s obligation to pursue the collection of funds that will ultimately flow to the Seller? Such terms are highly fact-specific, meaning there’s no clear middle ground, but it’s important to take those considerations into account in order to maximize the chance of avoiding post-Closing disputes.
Purpose: A Purchase Price Adjustment provision functions to ensure that value paid for the Business matches its current value. The magnitude of this provision’s impact depends on the specifics negotiated by the parties, such as which measurement is used to determine the adjustment. Unless there is a massive change in the value of the metric being used to determine the adjustment between the signing and Closing dates, the shift in Purchase Price will not be significant compared to the overall value being transferred. Despite the relative size, Purchase Price adjustments are often heavily negotiated because neither side wants to end up with less value than they give away.
Buyer Preference: The Buyer wants to be the party preparing the evaluation of the metric(s) in question. If the Buyer prepares the evaluation, it will support a scheme whereby the accountant’s fee is paid proportionally based on how close each side is to the accountant’s final determination. That scheme reduces the likelihood for disputes because taking an unreasonable position may lead to higher costs for the party taking that position, and since the Buyer is preparing the evaluation (in its ideal scenario), the Seller is more likely to accept it unless they are firmly convinced that their valuation will be closer to the accountant’s final determination. The Buyer will typically hold a portion of the Purchase Price in an escrow account until the adjustment is made; it will usually want that account to be separate from an escrow account used for potential indemnification claims to make sure that indemnification payments will be made if a claim arises. As for treatment of Accounts Receivable, the Buyer will likely want to assume those accounts to maintain the Business’s normal cash flow cycle, but in doing so it may request a representation from the Seller about the creditworthiness of the customers or even a guarantee requiring the Seller to pay for any Accounts Receivable that ultimately isn’t paid.
Seller Preference: The Seller wants to prepare the evaluation on which the Purchase Price adjustment is based. When the Seller is in control it will favor a fee arrangement that discourages the Buyer from challenging its conclusion. Timing of the evaluation may also be an important consideration because the Seller will want the adjustment to be based on the company’s performance while still under its control. The Seller is typically against both an escrow arrangement and applying interest to the adjustment. That is because the Seller generally wants to be paid the entire Purchase Price as soon as possible (i.e. no escrow) and adjustments typically favor the Buyer (i.e. no interest), perhaps because the Seller is more likely to be overconfident about the Business’s future performance. The Seller wants to be compensated for the full value of Accounts Receivable that are transferred to the Buyer rather than retaining the risk of nonpayment and relying on the Buyer to collect on the accounts. In other words, the Seller wants to treat these accounts just like any other current asset being factored into Working Capital.
Differences in a Stock Sale Transaction Structure: None.
Purchase Price
What is the Purchase Price? This section explains that the Buyer will pay a specified amount in exchange for the Purchased Assets and Assumed Liabilities.
The Middle Ground: The Purchase Price provision provides payment specifics, including when payment is due, to whom, and any conditions to payment (such as an adjustment to the purchase price). Depending on the situation, this section may include details about a promissory note, escrow arrangement, set-off rights, and/or earnout payments.
Purpose: This provision gives in-depth information on deal value and can include various risk management tools. The use of a promissory note, earnout payments, set-offs, or escrow shifts the risk between parties and can ultimately change the value of the deal for both sides. Structural payment tools like these are often used to align the Seller’s interests with those of the Business and the Buyer, especially in situations where the Seller will remain actively involved in the company post-close. By using such tools, the Buyer mitigates some risk and the Seller almost always ends up with more money than if the entire Purchase Price was paid in cash at Closing.
Buyer Preference: The Buyer typically looks to utilize a combination of the structural tools discussed above to reduce its initial risk on the transaction. A promissory note allows the Buyer to pay less cash up front and spread the Purchase Price over a set time period. Escrow and set-offs reduce the Buyer’s risk by preventing the Seller from taking possession of disputed payments. Earnouts and Purchase Price adjustments may increase the overall Purchase Price, but only if the Business meets certain milestones at predetermined points in time. By deferring a portion of the Purchase Price to the future and tying it to the performance of the Business, earnouts and adjustments can also help the parties close a valuation gap if one exists, which in turn helps close the transaction without the Buyer assuming greater risk.
Not all structural tools are useful in every transaction. The Buyer determines where its greatest areas of concern lie and chooses the appropriate tools to manage those areas of risk.
Seller Preference: There is no “best strategy” or combination of strategies that works for every Seller; the desirability of each option depends on the Seller’s post-Closing plans and desired level of liquidity. Some sellers may want upwards of 90% cash at Closing with no strings attached. However, the Seller can put a higher price tag on the Business if it allows the Buyer to manage its risk using one or more of the aforementioned strategies. A Seller who is confident about the future performance of the Business may actively seek an earnout structure so that it can benefit from that future success right along with the Buyer.
Differences in a Stock Sale Transaction Structure: Due to tax, liability, and operational consequences, the total Purchase Price of a stock sale is likely to differ from the amount for an asset acquisition of the same company. However, all of the structural tools discussed in this section are available for use in both stock and asset sales.
Assumed and Excluded Liabilities
What is the Assumed and Excluded Liabilities section? The Assumed and Excluded Liabilities provisions, taken together, detail which of the Seller’s liabilities will be transferred to the Buyer and which ones will stay with the Seller.
The Middle Ground: Typically, the Assumed Liabilities include current accounts payable and the liabilities associated with Assigned Contracts. Tax liabilities of the Seller are typically excluded. Assumption of other liabilities will vary based on the particular deal, and if there are a number of them they can be listed in detail in the Disclosure Schedules.
Purpose: These provisions spell out which operational risks will reside with each party following the transaction. In achieving that goal, these provisions also force the parties to think through the potential risks of the transaction and how those risks should be allocated within the Agreement.
Buyer Preference: When Assumed Liabilities are broadly defined and Excluded Liabilities are strictly defined, the Buyer is more likely to inherit unknown or unexpected liabilities. While liabilities of any kind increase risk, liabilities that are not anticipated can be exponentially more dangerous. Therefore, the Buyer wants language indicating that it will assume the listed liabilities and no others, and to define the Assumed Liabilities as specifically as possible. It also wants the Excluded Liabilities to be framed as a non-exhaustive list, which means that the list includes any liabilities not explicitly assumed.
In regard to particular liability categories, the Buyer wants to exclude any liabilities arising before the Closing Date as well as any liabilities not arising in the ordinary course of business, including liabilities for which the Seller is at fault. Furthermore, a broad tax liability exclusion is in the Buyer’s best interest to protect it from successor tax liability. Additionally, liability for fees relating to the transaction (i.e. intermediary fees) that are payable by the Seller are typically excluded.
Seller Preference: In general, the Seller wants the Assumed Liabilities section to be a non-exhaustive list that includes any liabilities not specifically excluded in the Excluded Liabilities clause. It also wants to explicitly transfer all accounts payable that are not paid by the Closing Date, all liabilities associated with Assigned Contracts, and any other liabilities that accrue after Closing (e.g. employee compensation and benefits, taxes, etc.).
Differences in a Stock Sale Transaction Structure: In a stock sale, the liabilities of the target company automatically transfer to the Buyer. Therefore, the Agreement does not include the Assumed and Excluded Liabilities sections, and the bulk of the risk allocation is achieved through the Seller Representations and Warranties and Indemnification provisions.
Excluded Assets
What is the Excluded Assets section? The Excluded Assets section consists of a detailed list of the Seller’s assets that will not be transferred as part of the acquisition.
The Middle Ground: The assets to be included here are specific to the deal, and the list will be created in conjunction with the list of Purchased Assets. Basically, any assets of the Business that are not listed as Purchased Assets are considered Excluded Assets.
Purpose: In the event of any sort of confusion regarding the list of Purchased Assets, this list provides clarity about what is and is not being transferred as part of the acquisition (reducing the risk of uncertainty). It is especially useful when the Purchased Assets section lacks detail, or when there are assets with similar names or descriptions but not all of them are being included in the purchase.
Buyer Preference: In terms of the content of this list, the Buyer wants to include assets that hold no value for the Buyer (e.g. unnecessary organizational seals, books, and records), especially if those assets come with significant contingent liabilities (e.g. benefit plans). In drafting terms, the Buyer’s main objective is to achieve the right degree of specificity, ensuring it does not exclude an asset it intends to purchase or include an asset it intends to leave behind.
Seller Preference: The Seller’s motivations in drafting this section largely depend on whether it is selling its entire business or whether it is only selling one division or line of business. If only selling a portion of its business, the Seller will want this section to read broadly so that it retains the assets necessary to continue its own operations. If the Seller will not continue to operate after the sale, a short and detailed list of Excluded Assets is usually not a cause for concern.
Differences in a Stock Sale Transaction Structure: This section will not be included in a stock sale because the Buyer will be purchasing the entire company and will not get to pick and choose which assets to include in the transaction.
Purchased Assets
What is the Purchased Assets section? The Purchased Assets section creates the duty for the Seller to transfer certain assets to the Buyer and lists those assets in detail.
The Middle Ground: Depending on the particular business, the Purchased Assets will likely include accounts receivable, inventory, certain contracts, intellectual property, real and personal property, permits, certain rights held by the Seller, the Seller’s accounting-related books and records, and the goodwill of the Business.
Purpose: This term is supremely important because it identifies which assets will be transferred and sets the foundation for numerous other terms found in the Agreement. For example, the value of the assets listed here forms the basis for the Purchase Price, and other terms, including the Seller’s “Consents” disclosure, rely on this section to determine their scope.
Buyer Preference: Different buyers may have different motivations for making an asset purchase, so it is essential for the list of assets in this section to be tailored to the needs of the particular Buyer. Typically, the Buyer wants broad definitions of various Purchased Assets to ensure that it receives, at a minimum, all the assets it intends to purchase. For example, if the Buyer wants to purchase all the intellectual property held by the Seller, it would be better to list “all intellectual property assets” rather than “all intellectual property registrations” because registered intellectual property is just one subcategory of intellectual property assets. Depending on the specifics of the deal, an aggressive Buyer may even try to include assets not yet owned by the Seller. All Buyers will want to include language stating that all assets are being transferred free and clear of any Encumbrances (except for Permitted Encumbrances).
Seller Preference: The Seller wants to define the Purchased Assets as narrowly as possible to avoid having to transfer assets it does not intend to sell. A Seller’s best practice is to list every individual asset with particularity, but some categories of assets include too many items to list each one. In that case, the Seller’s best bet is to define the asset category as specifically as possible. Asset definitions should exclude any assets the Seller does not have the authority to transfer, as well as assets the Seller needs to retain to operate its remaining lines of business (if it is only selling a division or line of business).
Differences in a Stock Sale Transaction Structure: If the deal is structured as a stock sale rather than an asset acquisition, there is no need to list out the assets being purchased. Instead, a short paragraph creates the Buyer’s duty to pay the Seller and the Seller’s duty to transfer a specified number of shares to the Buyer.