The Purchase and Sale Agreement
Whether one is doing a stock transaction or an asset transaction, the purchase and sale agreement follows the same general structure. Although agreements can divide the sections differently, the following are usually found in all of them:
- 1.The terms of the deal
- What is being sold
- What isn’t being sold
- 2.Seller’s representations and warranties
- 3.Buyer’s representations and warranties
- 4.Seller’s covenants
- 5.Buyer’s covenants
- 6.Seller’s conditions to closing
- 7.Buyer’s conditions to closing
- 8.Performance by seller after closing
- 9.Performance by buyer after closing
- 10.Seller’s indemnities
- 11.Buyer’s indemnities
- 12.Termination and waiver
Of course, in transactions in which the agreement is not signed until closing, there is no need for sections on covenants, conditions and termination.
A good purchase and sale agreement should be signed before closing. Then it can do much more than set out the terms of the deal. A good agreement sets out every step that must be taken to get the deal closed. It should set out the buyer’s wish list: “I will buy this business if the following conditions are met.” It is a checklist for what must be done before closing, a negotiating tool, and a protective device for the parties. Reaching an agreement causes the parties to consider and negotiate all of the issues between them and leaves little to be decided later. An agreement allocates risks and describes the legal protections for each party.
A. The Terms of the Deal
Most contracts begin with the terms of the deal. Here, the parties are identified, the price set, and the payment terms are given. This part of the agreement states exactly what is being purchased and what is not being purchased. For instance, the contract will state whether assets or stock is being purchased. In an asset transaction, the assets will be specified, such as equipment, inventory, accounts receivable, leases, and intangibles such as trademarks, trade names, and goodwill. Usually the contracts will specify that except as set out in it, no other assets or liabilities are being purchased or assumed.
It may seem obvious, or trivial, but the date of the agreement deserves some thought because it can impact the substantive agreement in sometimes unintended ways. The date of the agreement:
- (1) may affect pricing;
- (2) is the date as of which most of the representations and the disclosure schedule will speak; or
- (3) may be critical to meet a tax, financial reporting, or other deadline, such as the end of a fiscal year. The payment terms are specified such as the money down, the amount paid at closing, the amount paid into escrow, and the amount being paid pursuant to a promissory note.
The price may be a lump sum or may be described on an asset-by-asset basis. Buyers and sellers in “applicable asset acquisitions” are required to allocate the purchase price among the various business assets using the residual method of allocation, which is provided under IRC Section 1060. An “applicable asset acquisition” is any transfer of assets that constitutes a trade or business in which the buyer’s basis is determined by the purchase price of the assets. Not only does this provision apply to most purchases and sale of business assets, it also applies to stock sales where the purchaser makes an election to write up the basis of corporate assets under IRC Section 338.
No law or regulation requires the parties to agree on the purchase price allocations. In order to minimize the possibility of disputes with the Internal Revenue Service, however, a purchase price allocation should be agreed to and set forth in the agreement of sale. Consideration should be given to obtaining current appraisals or developing other documentation to substantiate the agreed purchase price allocation.
The last part of the deal section is setting the time and place of closing, and the conditions for changing the date of closing, such as by mutual agreement or only if the buyer pays so much per day.
B. Representations and Warranties
The second section of the purchase agreement deals with representations and warranties. While the representations from the seller to the buyer are usually of chief importance, buyers are often also asked to give representations and warranties. When a post-closing business relationship between buyer and seller is contemplated, such as when financing is involved, the buyer’s warranties will be more extensive.
The seller’s representations and warranties are important for three reasons. First, they force the seller to assist the buyer in doing its due diligence. Second, breaches of the representations and warranties may allow the buyer not to close. Third, breaches may trigger indemnity or other remedies.
If a corporation is involved, a crucial issue is who is going to give the representations and warranties. Often the major stockholders of the selling and buying corporations as well as their respective corporations are required to give the representations and warranties. This is done to make the individuals involved take the representations and warranties seriously because of their potential personal liability and also to prevent those individuals from later hiding behind the shell of an empty corporation.
A second issue is whether the representations and warranties will be given jointly and severally or whether the shareholders will be able to divide up the representations and warranties according to their interest in the business.
Often the attorneys for the parties will argue over what the standard for the representations and warranties will be. Should the representations and warranties be absolute or will they be based on knowledge? For instance, seller’s counsel will often say that the seller can only represent what he or she knows and not what he or she does not know.
Assuming the buyer is willing to accept some representations and warranties based onlyon knowledge, the issue then becomes whose knowledge and to what extent. For instance, this leads to quibbling over the following types of language:
- “To the best of knowledge;”
- “To the best of current knowledge;” and
- “To the best of knowledge after due diligence.”
In corporate transactions, both buyers and sellers will represent and warrant their due organization, authority to enter into the agreement, and that there are no restrictions by contract or litigation which prevent them from entering into the contract.
C. Covenants of Seller
The covenants section deals with matters between the time of the signing of the purchase agreement and closing. It may involve provisions that allow the buyer and its representatives, such as accountants and environmental consultants, to inspect the books and records, and the premises. The covenants should deal with the interim operation of the business, such as running the business only in the ordinary course while maintaining the assets, the insurance, and the corporate existence of seller, and not taking on new obligations or liabilities without disclosing them.
Two important matters that may be dealt with in this section are announcing the transaction to employees and the public, and making arrangements with lenders or others holding contractual obligations, such as vendors, customers and lessors.
For sellers, announcing the transaction to the public before closing can cause significant problems. Once the deal is announced to the public, the seller may feel compelled to complete the deal because otherwise the business may be perceived as damaged goods. Therefore, the seller may be in a poor bargaining position once the pending sale is announced. Also, the employees may decide there is little future in being employed there. As a practical matter, the employees themselves usually know about the transaction before closing because they see all of the new people involved during the due diligence period.
Buyers, of course, will want to make sure that all key employees will remain with the business.
Obviously, secured creditors must be dealt with either by paying them off or negotiating new terms before closing. As part of their due diligence, buyers will want to know that they are going to retain their customers and be able to do business with their vendors.
D. Conditions to Buyer’s Obligations to Close
Among the typical conditions to buyer’s closing are that the representations and warranties be correct as of the date of closing. Usually buyers will require certificates from the corporation and perhaps its officers and shareholders stating that the representations and warranties are current up to closing. Similarly, all covenants must be satisfied by closing unless waived, with the buyers in larger deals receiving certificates on this issue. Other conditions to closing may be the release of all or certain liens, and receiving opinion letters from counsel. Other possible conditions are that key personnel will agree to employment with the buyer and that the buyer has received a satisfactory lease for seller’s premises. There may be a requirement that there are no adverse proceedings that could prevent closing or substantially change the basis of the bargain, as well as no adverse changes in the business itself.
There is no longer a requirement in Massachusetts to comply with the Bulk Transfers Act because that Act was repealed by the Massachusetts legislature.
E. Conditions to Seller’s Obligation to Close
Obviously, the major condition to closing for sellers is that they receive their payment at closing. When the seller is not receiving full payment at closing, the seller will also be interested in having all representations and warranties of the buyer updated through closing and will want assurances that there have been no material changes in the buyer’s operation and finances since the signing of the purchase agreement.
F. Termination and Waiver
The termination and waiver section deals with the remedy for breaches of covenants, conditions, representations and warranties, and material adverse changes in the parties. The contract often provides that the non-breaching party does not have to close unless it decides to waive the breach. As a practical matter, when the breaches do not go to the heart of the entire transaction, the usual remedy for the breaches is to renegotiate the purchase price and then close. This section may allocate the expenses if the deal does not close, and set a mechanism for determining what is done with the down-payment. This section may also bind the buyer to not disclosing any confidential information relating to the seller if a separate confidentiality agreement has not previously been negotiated.
G. Performance by Buyer After Closing
When the buyer is not purchasing the seller’s accounts receivable, this section may describe what assistance the buyer will give the seller in collecting accounts receivable.
This section may also include a provision by which the buyer indemnifies the seller in regard to post-closing liabilities if the indemnity is not dealt with in a separate section.
H. Performance of Seller and Shareholders After Closing
The major item in this section may be a non-competition agreement from the seller and its shareholders. Non-competition agreements or covenants are important. They legally restrain a seller or its key people from competing with the purchaser until the purchaser has received the benefit of his or her bargain.
This section may also deal with the seller indemnifying the buyer, the seller delivering to the buyer any receivables of the buyer, and the seller changing or otherwise making available its corporate name if that name has been sold to the buyer. This section may also delineate any assistance the seller will be providing the buyer.
There are several key issues involving indemnity, particularly from the seller and shareholder to the buyer. The first is whether all of the parties are jointly and severally liable or whether they can be liable only to a certain amount. For instance, sellers are rightfully leery of giving an indemnity that would call for them to pay more money than they received from the transaction (before or after taxes). Other sellers are concerned about being potentially liable beyond their percentage of ownership in the business. This issue is sometimes dealt with in a separate agreement among the shareholders of the seller.
The second issue is how broad the indemnity will be. If the representations and warranties are only based on knowledge, will the indemnity go beyond knowledge to an absolute guarantee? A seller can carefully negotiate representations and warranties in an effort to limit its liability and then assume broad liability by agreeing to a broad indemnity which exceeds the scope of the representations and warranties.
Buyers often argue that they are entitled to broad indemnity provisions because they bought the business based on its ability to generate a certain amount of cash flow and that any undisclosed or unknown liabilities will impair that stream of cash flow. Furthermore, they add that if the business had not been purchased, the seller would still have the liabilities.
Sellers often counter that they are not an insurer of their buyer’s success. They may note that if they remained in control of the business, they could mitigate the situation. Some sellers refuse to fully indemnify the buyer so that the buyer has an incentive to mitigate its costs.
Buyers and sellers often negotiate special provisions, such as the indemnity being only to a certain dollar amount, the indemnity only starting above a certain dollar amount, and the indemnity being only for claims raised during a certain time period. Particularly in larger deals, the seller may ask the buyer to pay a percentage of each loss, and/or give the seller control over any litigation or the efforts to cure the problem. Buyers, however, will want restrictions on the seller’s ability to control the litigation or the remedy process. In addition to indemnification rights, buyers often protect themselves through either escrow provisions or set-off provisions. An escrow involves handing an asset to a third-party who holds the asset pursuant to instructions.
A certain amount of money is delivered to the escrow agent. This money may be held until the purchase price is fully determined, such as when the parties agree on the dollar amount of inventory after closing. It also may be held for a certain time period to protect the buyer. If the buyer does not give the escrow agent and the seller notice of any breaches of representations and warranties, then the money is disbursed to the seller. The money may be partly disbursed after a few months and then the balance disbursed a few months later. If the buyer gives notice of a breach, then the seller may authorize the escrow agent to release the money to the buyer or creditor, or may dispute the claim. If there is a dispute, then the parties must resolve the dispute while the escrow agent continues to hold the money. This is a protection for both the buyer and the seller. If the buyer is correct, it will be able to get back some of its money to deal with the problem. If the buyer is wrong, the seller will get the balance of the purchase price without having to enforce a judgment.
A right of set-off can be used in a transaction in which the buyer will be making installment payments to a seller pursuant to a promissory note. The buyer gives the seller notice of any (material) defaults and then the seller has a reasonable time to cure or fix them. If the seller does not do so, the buyer has the right to cure the default and then set off the dollar amount of the cure against the next payment(s) due on the promissory note. The right of set-off is a very powerful protection for buyers who have not delivered the money to the seller. Buyers have access to the money instead of having to sue the seller. Rights of set-off also should make sellers be very careful about the representations, warranties and indemnities that they give.
The miscellaneous section must be read carefully in case anything is hidden in it. Normally, one would find which state’s law applies, where notice should be given, how to amend the agreement, who will bear attorney’s fees, whether any agents or brokers are involved in the transaction, an arbitration and/or mediation clause, and then typical boilerplate language about counterparts and the binding nature of the agreement.