CHAPTER 20

Negotiating the Purchase Agreement

As due diligence progresses along with your confidence that this deal will close, you and your attorney need to start drafting an asset purchase agreement, which is the definitive legal acquisition contract. Because this is a meaningful investment of professional fees and time, you should usually wait to begin drafting the contract until after the most important confirmatory due-diligence work is satisfactorily completed.

Your attorney always creates the initial draft of the purchase agreement, and then the seller’s attorney returns a marked-up copy containing their comments. That begins a negotiation between you and the seller as the two of you decide on the precise contours of the business deal. For you, the confirmatory due diligence you have conducted links seamlessly to the preparation of the purchase agreement. The schedules that are appended to the purchase agreement—third-party contracts, financial statements, employee payroll, pending litigation, physical assets, and others—represent documents that you have previously received and reviewed. You have already identified the form of the acquisition and the net working capital target. But for the seller, the preparation of the required schedules takes a lot of time and is a new and often tedious task. And if the schedules include items that you have not reviewed, you’ll need to do due diligence on them. It generally it takes about a month to complete a purchase agreement.

This chapter outlines the most critical items you will need to determine as you draft the purchase agreement. Let’s examine them one by one.

Your Acquisition Entity

You need to legally create a company to be the acquirer of the business you are buying. You can use the search fund company that you created as you were starting to look for an acquisition, or you can create a new acquisition entity. Because the decision is largely determined by legal considerations, your attorney will advise you on which company structure is best, given your situation. This acquisition company will also be the borrower if you are using bank debt or seller debt in the acquisition, and it will issue securities to investors if you are raising equity capital. The creation of a company will establish limited liability, meaning that your personal assets are safe from creditors looking to be paid by your company other than any personal guarantees you explicitly granted to, for example, the senior lender. It also creates only a single level of income tax on its earnings. In the United States, there are three entity forms that accomplish both of these goals: limited liability companies (LLCs), limited partnerships (LPs), and S-corporations. Today, the most commonly used entity form is the LLC because of the ease with which it can be formed and its flexibility in accommodating different deal structures for investor equity.

The Structure of Your Purchase

You decided whether the purchase transaction would be an acquisition of assets or stock when you created your LOI. Now you’ll capture that decision in the purchase agreement.

You’ll also want to take other steps that affect how (and how much!) you will be taxed. In the United States, if you are acquiring the stock of an LLC, LP, or S-corporation or are directly buying the assets from any of these types of entities, you should structure the purchase agreement so that you “step up” the tax basis to the price you are paying. Doing so will create valuable tax deductions under your future ownership. While the actual appraisal and valuation happens after closing, you will want to negotiate the outline of the appraisal in advance, when you are drafting the purchase agreement. As a practical matter, this means that every year for the next 15 years, the income tax liability is reduced by a deduction of at least 1/15th of the purchase price from the company’s taxable income, and this deduction is passed through to you and your investors’ personal tax returns.

Once you have closed on the company, you will hire an independent appraiser to allocate the purchase price to the business’s tangible assets and any remaining value to goodwill. This appraisal and valuation will form the basis for future depreciation and amortization tax deductions, which can be quite significant. Buyers generally prefer that as much value as possible be allocated to tangible assets because their value depreciates more rapidly than does that of goodwill.

Although sellers frequently leave the postsale appraisal entirely to the buyer, the allocation of price can affect them because different tax rates apply to different types of assets. It is in the seller’s interest to allocate the sale price to assets that carry a lower tax rate. This is why it is a good idea to negotiate the terms of the appraisal in advance.

While most smaller firms in the United States are organized as pass-through entities, if the seller organized their company as a C-corporation, you will probably not be able to effect a step-up, because the tax consequences to the seller are so unattractive that your purchase would no longer work for them. If the prospect is a C-corporation, you and your accountant, and perhaps your lawyer, will have hopefully caught this entity form as part of your due diligence, before you reach agreement on the major terms of the acquisition, including purchase price.

Representations and Warranties

Your lawyer will ask the seller to make a number of representations and warranties in the purchase agreement. These have two principal purposes: First, they provide disclosure for you. If the seller is representing that there is no litigation involving the company “other than as presented on Schedule A,” then Schedule A provides you with valuable information about the company you are acquiring. Second, these representations and warranties give you the opportunity to make claims against the seller. If the seller represented that his or her company faced no litigation and you later discover undisclosed litigation, you have the opportunity to make a claim against the seller.

Buyers and sellers regularly negotiate these representations and warranties. The negotiations often occur around a so-called knowledge standard. Sellers prefer their representations to read more narrowly: “To the best of seller’s knowledge, the company has all necessary permits.” On the other hand, buyers want a broader representation: “Seller represents that the company has all necessary permits.”

Escrows and Setoffs

A portion of the transaction proceeds are typically held back from the seller and placed in an escrow account. In smaller firm acquisitions, the size of the cash escrow is typically small (or sometimes zero), and instead the seller provides the buyer a right to set off claims against the value of the seller note or against future earn-out payments.

If you later have claims, this account will be your primary source of proceeds so that you don’t have to be concerned about the ongoing creditworthiness of the seller. In addition, a holdback escrow encourages faster resolution of claims because the seller does not receive back money from the escrow until the claims are resolved. This creates a more buyer-friendly dynamic than if the sellers receive all their cash and therefore have an incentive to delay resolving claims and paying back money.

Escrows and setoffs are usually negotiated around four issues: size, survival period, basket size, and total dollar cap.

• Size: The amount of the seller’s cash proceeds that will be held back in an escrow account to settle the claims, or the amount of the seller note subject to setoff for this purpose, or both.
• Survival period: The end date of the period during which claims can be made. After the survival period, any undisputed portion of the escrow is released to the seller and no new claims can be made. The survival period is usually at least long enough for the financial statements to be completed for the year in which the acquisition occurred.
• Basket: The minimum claim amount that is necessary for you to be entitled to funds from the escrow account. The basket’s purpose is to eliminate disputes over very small claim amounts. As a buyer, however, you want it to be as small as possible so that you can have flexibility on the kinds of claims that come out of the escrow. On a $5.0 million acquisition, the basket might be $25,000 or $50,000. When the total claims exceed that threshold, then the escrow account pays from the first dollar of claims.
• Cap: Represented as a percentage of the purchase price, the maximum amount that the buyer can claim back from the seller. Usually, the cap amount is equal to the escrow account or setoff amount. Sometimes, however, the seller is willing to agree to a larger indemnification cap than the size of the escrow account, particularly for certain classes of claims. Sellers almost always get some cap on their indemnification: They want to know that there is a limit to the amount of their proceeds that are subject to claims from the buyer.

While each deal is unique, typical indemnification terms are as follows:

Seller Note

Your LOI specified the important characteristics of the seller note, and you further honed your terms of seller debt as you determined your financing, which included the amount, the interest rate, and the amortization schedule. These terms are formalized as either part of the asset purchase agreement or in a separate document drawn up by your attorney. The separate document is then negotiated much like the rest of the purchase agreement.

Net Working Capital

Your LOI also specified the amount of working capital to be delivered at closing. The purchase agreement cements this arrangement and, because working capital is subject to constant changes, specifies how variances from the target will be handled. Usually the purchase price is adjusted according to an estimate of net working capital made as of the closing day, and a final net working capital settlement is done sometime after the closing, when buyer has had an opportunity to do an inventory count and to carefully review receivables and payables. Then the seller has a chance to review the buyer’s final computation of net working capital, and if there is an additional deficiency, those funds are released to the buyer from the seller’s escrow account. If there is a surplus, the seller receives that amount.

Key Personnel Issues

A few specific employees are critical to the company’s success. These might be the departing owner or several executives and salespeople who are staying on. At the time of your purchase, you want to make sure everyone agrees on their future roles. While employment and noncompete agreements are separate from the purchase agreement, their execution is usually a condition required in the purchase agreement and they are executed simultaneously.

Noncompete agreements

Departing owners often have strong relationships with customers, suppliers, and employees. They also have an intimate knowledge of how the company operates (for example, the prices charged to each customer or the dates that contracts renew)—information that would be valuable to any competitor. You’ll want the seller to sign a noncompete agreement that has a term of three to five years from the closing date and that gives you several elements of protection:

• Noncompetition: The seller agrees not to compete with the company for a certain period, “competing” being carefully defined to fit your specific business situation. It might be a promise not to contact existing customers, not to manufacture or sell specific products, or not to operate any similar business within a certain geographic area. Non-compete agreements prohibit any kind of participation in competing businesses: as an investor, a manager, a board member, or a consultant.
• Confidentiality: The seller promises to keep confidential all of the company’s proprietary information.
• Nonsolicitation: The seller agrees not to recruit or hire any of the company’s employees.

Seller transition

Most buyers want the seller to remain with the business during a transitional period; you should negotiate the transition agreement at the same time as the purchase agreement. Typically, this arrangement includes a short period, one to three months, during which the seller continues to work full time at the company and is paid as a salaried employee. After that, there is a longer period, usually one year, when the seller makes himself or herself available on a consulting basis and receives hourly compensation.

Employment agreements

If the company you are buying has key employees who would be difficult to replace or harmful if they went to a competitor, you should discuss with them their roles going forward and potentially put in place employment agreements. You’ll get the contractual protection of non-competition, confidentiality, and nonsolicitation agreements as provisions of the employment agreements, and your employees get greater clarity on their terms of employment and perhaps an enhancement to compensation such as a performance-related bonus, stock options, or a contractually guaranteed severance period.

When Randy Shayler was acquiring Zeswitz Music, he understood the value of the excellent relationships its sales force had established with school band directors. Accordingly, he signed its top salespeople to noncompete agreements as part of a set of improvements he made to the sales force commission system.

The Closing

The weeks leading up to the closing are a busy period for everyone involved in the acquisition and especially for you. As you approach the closing day, you are finalizing a set of interrelated documents discussed in this chapter:

• The purchase agreement
• Noncompetition, nonsolicitation, and confidentiality agreement with the seller
• Employment agreements with key employees
• Loan agreement with your lender
• Seller note agreement with the seller
• Stock purchase agreement between your entity and its investors (and probably an employment agreement between your entity and yourself)

Your job is to communicate constantly with the different people involved with these various documents, solving problems that emerge and moving them toward completion. It is typical for an unanticipated issue or two to arise as closing approaches, and these can surely add stress to the process. Our advice is to keep moving forward and solve each problem as it emerges. Just as you imagine the huge costs of abandoning your acquisition this late in the process, the seller also has psychologically committed to the sale and would be loath to start over. Both sides have strong incentives to work together to close the acquisition.