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The Purchase Agreement, Part 5: Indemnity Caps

June 2, 2011 By Ney

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.  This post covers Indemnification Caps.

1. Introduction
2. Price and structure of the acquisition / purchase
3. Representations and warranties of the buyer and seller
4. Covenants of the buyer and seller
5. Conditions to closing
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
9. Representations and warranties of the buyer and seller

As I explained in the last post, indemnity is one of the most contentious issues in a purchase agreement.   A buyer doesn’t want to inherent ANY pre-close risk while a seller at some point in the future wants to relax and know someone isn’t going to the knock on the door and ask for all the money back (or even more). A compromise invariably gets worked out, and it involves indemnity caps and baskets.

Indemnity Caps, in Theory

A cap is simply a limit for what a seller is liable for, for pre-close issues.   From a buyer’s perspective, there should be no cap.  The seller was liable for EVERYTHING before the buyer entered the picture and it should remain that way for anything that happened before the close.  That doesn’t sound unreasonable, doesn’t it?  That means that if a company was sold for $3 million and the new buyer had to pay a settlement of $5 million for a product liability issue that occurred pre-close, the seller would have to give back all the purchase price, PLUS $2 million.  There goes the retirement. However, if the seller had not sold the business, they would still have to have paid the $5 million settlement.  So really, nothing has changed. Right?

From a seller’s perspective, there absolutely should be a cap.  They are almost invariably selling to a larger entity that may be more likely to attract lawsuits (the deeper pockets lawsuit rule of thumb).  It is also possible the new owners mismanage the company enough that customers, employees, etc. decide to sue for something that happened to have occurred pre-close.  Using the example above, the $5 million settlement may have been much less if the lawsuit involved the original seller only, who at at the time didn’t have much in the way of liquid assets, and it is entirely possible the lawsuit wouldn’t have even happened at all under the seller’s ownership.

Both perspectives are valid, so it is up to the attorneys, intermediaries, buyer and seller to work out a compromise.

Indemnity Caps, in Practice

Caps are common in some form in about 80% of deals (according to a study published by the American Bar Association).  Sometimes liability is capped at the purchase price, and often it is capped at less than purchase price.  A typical range for a cap is 20% to 50% of the purchase price.

It is also common to “carve out” certain types of reps and warranties that have no caps.  Fraud, taxes, ownership and authority to do the sale are common cap carve outs.  In other words, the buyer is saying, “Hey, I kind of see your point on the other stuff, but I want you COMPLETELY on the hook for fraud, paying your taxes, whether you actually own the company you are selling me, etc.”  It is hard to argue with that logic, thus the cap carve outs.

I’ve had ownership issues pop up during a transaction (“Oh, I forgot that I promised my sales guy 5% of the company.  I never got around to actually doing that, so how do I give him shares right now, just before close?”).  Fortunately, I’ve never run across a situation where a transaction closed, and someone popped up later claiming that they actually own all or part of the company.

Filed Under: Legal / Due Diligence

The Purchase Agreement, Part 4: Indemnification

May 26, 2011 By Ney

Earlier in the purchase agreement, and an earlier blog post, I described how a business owner makes representations and warranties to the buyer.  The indemnity section describes what happens when the buyer later finds out some of those reps and warranties were not true.

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.  This post covers Indemnification.

1. Introduction
2. Price and structure of the acquisition / purchase
3. Representations and warranties of the buyer and seller
4. Covenants of the buyer and seller
5. Conditions to closing
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
9. Representations and warranties of the buyer and seller

Indemnification, in its most simple definition, describes how to compensate someone for any loss that they may suffer during the performance of a contract.  The indemnitors indemnify the indemnitees for all losses, expenses, damages and liabilities arising out of breach of a representation, warranty, covenant by the other party in the purchase agreement.

The indemnity section is one of the mostly hotly contested sections in a purchase agreement, for good reason.  This is where a buyer wants not only clearly drafted language defining the damages, they also typically want an escrow account (also called a hold back) set up so they know they will actually get paid for the damages.

Escrow

Business owners should realize that in most cases there will be around 10% of the purchase price held back in an escrow account to be used for damages or the appearance of any previously unknown liabilities (or any number of things, such as final reconciliation of the books at closing, inventory at close, etc.).   In a study done by the American Bar Association of middle market transactions, they found approximately 80% of transactions used an escrow account.  The other 20% probably were probably using seller notes or another structure which allowed the buyer access to seller funds.  In other words, if you are selling your company and you get an all-cash-at-close offer, don’t expect to walk away with all cash at close.

The same study shows that 71% of the escrow/holdback accounts are between 6 and 15% of the purchase price.  16% are below 6%, while 10% are above 15%.   The average was right about 10%.

How long to expect your money to be held back?  12 to 18 months is the norm.

It is also important to realize that the buyer’s claim against the seller is rarely limited to the amount held in escrow.  The escrow merely provides easy access to a set amount, and the buyer will likely have to sue for the rest.

How much is the seller ultimately on the hook for?  In next blog post I’ll cover caps and baskets in order to describe the indemnity limits.

 

Filed Under: Legal / Due Diligence

Purchase Agreement Part 3: Covenants and Conditions to Closing

May 23, 2011 By Ney

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.  This post covers Covenants and Conditions to Closing.

1. Introduction

2. Price and structure of the acquisition / purchase

3. Representations and warranties of the buyer and seller

4. Covenants of the buyer and seller

5. Conditions to closing

6. Indemnification

7. Termination clauses and remedies

8. Miscellaneous

9. Representations and warranties of the buyer and seller

Covenants within the purchase agreement are promises, or agreements between the buyer and seller. Conditions to Closing typically provide an escape hatch for a buyer to legally walk away from the deal at the last minute if certain conditions are not meet.

Covenants, usually a seller’s obligation to a buyer, may be a promise to conduct the business in an ordinary course between the time of signing and closing, or it may be an agreement to cooperate with the buyer on an outstanding tax issue in future after the close. Here are some other common covenants:

– The seller agrees to pay their taxes

– The seller agrees to settle outstanding liens

– The seller agrees to cooperate on future employee issues

It can be important to pay attention to the conditions of closing in the purchase agreement. It may be boilerplate text about the buyer being able to walk away should he find out any of the seller representations are false, but the covenants may also contain financing contingencies or other conditions that would be critical to know about.

For example, a financing contingency means that the seller could expend significant time and expense in working through due diligence and signing an agreement, yet the buyer could fail to get financing. In that case, with a financing contingency in place, there would be no consequence for the buyer. You can’t always get rid of financing contingencies, but you can work to minimize the risk, and you should at least be very aware of the contingency and an idea of what the odds are for financing success.

I always identify financing contingencies at the letter-of-intent stage, and ideally you should force the buyer to have financing commitments in place before the definitive agreement stage, but of course it is possible for a lender to back out at the last minute.

Financing contingencies are very common for smaller deals as they often relying on an SBA loan. For larger deals it is on a case by case basis.

For us, I’ve had two financing contingencies in the last year. In one, the private equity fund that our seller had signed with put in a condition on financing. When I asked about where they expected to raise the debt from, they said it was actually from their own fund, they just called it debt instead of equity. No problem. The other deal was also a private equity fund, and they failed in the due diligence phase to produce financing. Unfortunately that killed the deal with that buyer.

 

Filed Under: Legal / Due Diligence

Purchase Agreement Part 2: Reps and Warranties

May 9, 2011 By Ney

Representations and Warranties are a critical part of a business purchase agreement. This is a summary of these statements of fact that are inserted into the agreement, as well as “qualifiers” that can strengthen or water down the agreement.

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.

  1. Introduction
  2. Price and structure of the acquisition / purchase
  3. Representations and warranties of the buyer and seller
  4. Covenants of the buyer and seller
  5. Conditions to closing
  6. Indemnification
  7. Termination clauses and remedies
  8. Miscellaneous
  9. Representations and warranties of the buyer and seller

Reps and Warranties are statements of fact that a seller makes to a buyer (and vice versa) about all aspects of the company, and pledges that they are true. Even the most diligent of a buyer’s due diligence will not uncover and mitigate all of the risk that a buyer takes when buying a company.  Thus, through the Reps and Warranties, the buyer is asking the seller to disclose in writing (and memorialize in the formal agreement) every aspect of the company from taxes, contract, ownership, finances, legal issues, intellectual property, etc.

Disclosing everything in the reps and warranties is critical, as an omission of a liability or significant fact can give an unhappy buyer a cause of legal action for breach of contract.  It is well worth the effort to go through the list carefully and spend some quality time thinking about each item.  In fact, a good deal attorney will force the seller to sit through a final walkthrough of all the reps and warranties, trying to uncover every little thing that could be out there and get them into the agreement.

Lawyerese becomes critical in reps and warranties, and a good deal attorney is important to have.  For example, the buyer’s attorney will typically draft the reps and warranties, and one warranty may state that “all contracts have been performed in all respects and conforms with all federal, state and local laws, regulations, etc.” The seller’s counsel may add a “knowledge qualifier” so that it now states “To the best of the Seller’s Knowledge, all contracts have been performed in all respects and conforms with all federal, state and local laws, regulations, etc.” They may also add a “materiality qualifier” so that it becomes: “To the best of the Seller’s Knowledge, all contracts have been performed in all material respects and conforms with all federal, state and local laws, regulations, etc.”

By adding these qualifiers, a buyer would have a much tougher time coming after the seller later.  For example, they would have to prove not only that a contract wasn’t performed, but that the seller had knowledge of that fact.  Proving that the seller had prior knowledge is extremely difficult to accomplish, so by adding that clause it completely changes the legal exposure of both the buyer and the seller.

Deal attorneys can (and will) spend a great deal of time negotiating the reps and warranties, and the qualifiers on the reps and warranties.

An example is that we were getting ready to close and the final documents had been prepared.  Our sellside attorney did the final reps and warranties check with the seller and I was a little bored while listening in on the conference call.  One of the most basic representations is ownership.  Does the seller (or group of shareholders) actually own the company he is selling?  The attorney was asking questions around this area and asked the seller about the ownership of the patents he was selling with the business.

All of the sudden the call got a lot more interesting when the seller exclaimed: “Oh my gosh, I forgot that I don’t actually own the patents!”.  A scientist that worked for the company was the inventor and the owner of the patents.  The scientist still worked for the company and would continue, so the seller knew he could work something out, but he just forgot to do it.   Whoops. Kind of a big thing to work out at the last minute, but he was able to work out in a matter of days a time-limited royalty arrangement for purchase of the patents.

During that process he also realized that the scientist was working with some of his own equipment in the laboratory, and we were about to sell that equipment out from under him.  I’m sure the buyer would have worked something out in this case because it wasn’t a lot of equipment, but much better to specifically exclude that equipment in the purchase agreement than to work it out later.

Filed Under: Legal / Due Diligence Tagged With: Reps and Warranties

The Definitive Purchase Agreement to Acquire a Business: Part I

May 5, 2011 By Ney

Whether it’s a small company purchase put together by a business broker or a large firm acquired with the help of a team of attorneys, a purchase agreement is used to transfer ownership.  Here are the basic components of these agreements.

1.        Introduction

2.       Price and structure of the acquisition / purchase

3.       Representations and warranties of the buyer and seller

4.       Covenants of the buyer and seller

5.       Conditions to closing

6.       Indemnification

7.       Termination clauses and remedies

8.       Miscellaneous

Let’s start with the first few in this blog post:

1.       Most legal contracts, including most business purchase agreements, start with an introduction to layout some definitions, or “recitals”, and to describe the intentions of the parties.

2.       The next section lays out the most significant details of the business transfer.  It not only defines the purchase price, but also the structure of the acquisition.  For example, it defines whether the transaction is a stock sale, asset sale or merger, and also describes many of the mechanics of the deal that will enable that structure.  This section will detail the cash payment, escrow requirements, timing of payments, and any earnout provisions.

If it is an asset sale, this section contains a description of the assets purchased (referencing exhibits or schedules) and liabilities assumed.  If there is to be an adjustment of price depending on the final closing of the books (adjustments for inventory, bad debt, working capital, work in process, etc.) then this is also described in this section.

The price section can be refreshingly short in the case of an all cash deal, to quite lengthy in the case where there are notes, contingent notes, working capital adjustments, earnouts, etc.

This is the section where you find out that the deal you sketched out on a napkin actually took two pages (and a lot of money) for the attorney to describe legally.  It is always best to attempt to keep everything as simple as possible, because even the deals that start out fairly simple tend to grow in complexity.

Filed Under: Legal / Due Diligence Tagged With: Purchase Agreement

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