The purchase agreement details the final terms of an acquisition, so understanding its features is critical to a successful M&A transaction.
There is no standard layout or format for a purchase agreement. I have identified the primary clauses and sections that most contain, but they may appear in a different order, combined or separated, in yours.
Generally, the purchase agreement can be broken down into the following major sections:
Purchase agreements take the form of an asset sale, stock sale, or merger. How the transaction is structured for legal purposes will impact the type of purchase agreement that’s used.
Sections of the purchase agreement:
This section is an alphabetical list of definitions of the key terms used throughout the document. Anytime a defined term is used in the purchase agreement it is usually capitalized, such as Assets, Assumed Liabilities, Balance Sheet, Basket, Best Efforts, Bill of Sale, Bulk Sale Laws, Business, and so on.
The next section commonly describes the transaction at a high level, such as whether it will be structured as an asset sale, stock sale, or merger and what assets and liabilities are included in the purchase price. If it’s structured as an asset sale, it’s important to list the assets and liabilities included in the purchase price. Excluded assets should also be listed, including furniture. If the transaction is structured as a stock sale, the type and number of shares should be listed. A detailed list of assets is usually included in the appendix. Mergers are often used if there is a large, diverse set of shareholders, so this is a less common transaction type in the lower middle market.
Representations and warranties are statements and guarantees made by the parties related to the transaction, and comprise a significant portion of the purchase agreement. Called “reps and warranties” for short, they are heavily negotiated and used by many buyers to force the seller to disclose all material facts about the business and flush out potential problems. If the seller doesn’t disclose material facts, chances are the buyer will discover them after the closing and will then be entitled to pursue the seller for damages.
Covenants are agreements to take certain actions (an affirmative covenant) or not to take them (a negative or restrictive covenant). Covenants can govern the actions of both parties before the closing (pre-closing covenants) or after (post-closing covenants) regarding ordinary operations, access to the business, exclusivity, funding the sale, etc.
If the purchase agreement is signed before closing occurs, it will also contain conditions, or contingencies, that must be satisfied before the closing can take place. These conditions may include the buyer obtaining financing, obtaining a license, transferring a lease, or obtaining franchisor approval.
Termination provisions outline how, why, and when parties can terminate the deal. This section is only necessary if the purchase agreement is signed prior to the closing. It includes conditions for canceling the agreement and penalties for defaulting, such as a break-up fee for the terminating party, or obligating one party to reimburse the other’s expenses.
This section includes general provisions you would expect to see in most legal agreements, including attorney fees, a note on the governing law, mediation, severability, etc.
While not essential to the deal, certain additional agreements help bring everything together in a structured way, and help you plan and and consummate the transaction. These include the Bill of Sale, Employment and Consulting Agreements, Corporate Resolution, Deed of Sale, List of Titled Property, Training Log, etc.
One of the last steps of the M&A process is preparing the purchase agreement. A far more detailed version of the letter of intent, the purchase agreement replaces any prior agreement and includes all of the agreed terms and several newly negotiated ones.
The purchase agreement also governs the transaction once it closes, setting forth the final terms for executing the deal.
The sheer size of the first draft overwhelms most sellers. But there’s no reason to be intimidated. With this guide in hand and your M&A attorney negotiating on your behalf, you’ll have a thorough understanding of what to expect and which clauses to pay special attention to.
The purchase agreement can be broken down into the following ten sections:
There’s no single, standard layout or format for a purchase agreement. I’ve identified the main clauses and sections that most contain, but they may appear in a different order, combined or separated, in yours.
A major consideration in every deal is whether it’ll be structured as an asset sale, stock sale, or merger. How the transaction is structured for legal purposes impacts the type of purchase agreement that’s used. Regardless of the form, the contract contains several clauses that remain the same across all scenarios, while the legal structure changes certain other clauses.
In an asset sale, the buyer purchases the individual assets of the business directly from the seller. An Asset Purchase Agreement (APA) transfers ownership of those assets, while the seller retains ownership of the entity. The buyer merges the assets into their existing company or forms a new one to acquire the assets. The buyer only inherits liabilities they explicitly agree to in the purchase agreement.
Most buyers prefer an asset deal due to the lower risk. The majority of transactions in the lower middle market are structured as asset sales since there is less possibility of the buyer inheriting unknown liabilities.
Most deals in the lower middle market are structured as asset sales due to the lower possibility of the buyer inheriting unknown liabilities.
In a stock sale, the buyer purchases the shares of the entity (corporation or LLC) that owns the assets of the business. By purchasing the shares, the buyer assumes ownership of the entity’s assets and liabilities. As a result, a Stock Purchase Agreement (SPA) must be more comprehensive than an Asset Purchase Agreement and the buyer bears more risk.
Shares in an LLC are technically called membership interests. For the sake of simplicity, most parties refer to the transaction as a stock sale.
Many larger transactions are structured as stock deals, while the majority of smaller deals are structured as asset sales.
In a merger, two separate entities are consolidated into one legal entity. Mergers are created at the state level by filing a Certificate of Merger with the secretary of state. There are several different types of mergers, such as a reverse triangular merger and a forward triangular merger.
Mergers are rare in the lower middle market. They’re most common when a company is acquiring a target with a diverse base of shareholders. A stock sale would require the buyer to purchase individual shares from each stockholder, which can be a cumbersome process. This is why, if there are a lot of shareholders, the deal is usually structured as a merger since it doesn’t require the consent of each shareholder.
Most purchase agreements start with a section known as the Preamble. This section provides the reader with an overview of the context of the agreement. It usually names the agreement, introduces the parties, and sets forth the effective date of the contract.
Here is a sample preamble:
This Purchase Agreement (this “Agreement”) is made and entered into as of January 1, 20xx, by and between:
Seller, a company duly incorporated and existing under the laws of Delaware; and
Purchaser, a partnership formed in Delaware.
The Seller and the Purchaser are herein referred to each as a “Party” and collectively as the “Parties.”
Immediately after the preamble, the purchase agreement often contains a series of statements beginning with the word “Whereas,” which are known as the Recitals. While recitals are generally not meant to be binding, they lay out the parties’ intentions and provide context to anyone attempting to interpret the purchase agreement.
Here are some sample recitals:
“Whereas, as of the date of this Agreement, the Seller owns 1,000 common shares of Acme Holdings, Inc., a corporation existing under the laws of Delaware, whose registered office is 12345 Main Street, Acme, Delaware, 123456, with par value being $1.00 per share (the “Common Shares”); and
Whereas, the Seller wishes to sell to the Purchaser, and the Purchaser wishes to purchase from the Seller, an aggregate of 1,000 Common Shares of the Company upon the terms and subject to the conditions set forth herein.
Now, therefore, in consideration of the premises and the mutual agreements and covenants hereinafter set forth, and intending to be legally bound, the Parties hereby agree as follows…“
This section will define the key terms used throughout the document. Any well-written purchase agreement contains an alphabetical list of keyword definitions, which are usually capitalized throughout the contract.
Definitions are critical to preventing misinterpretations. For example, does Adjusted EBITDA include market adjustments to the seller’s salaries? What payables are included in Net Working Capital?
Some terms, such as Assets, Material Adverse Effect, or Seller’s Knowledge are used throughout the purchase agreement and can spark extensive interpretations and negotiations.
Here is a sample list of terms that may be defined in a purchase agreement:
This section commonly describes the transaction at a high level, such as whether it’ll be structured as an asset sale, stock sale, or merger, and what assets and liabilities are included in the purchase price.
If the sale is structured as an asset sale, a detailed list of assets is usually appended to the purchase agreement. It’s important to list all assets and liabilities included in the purchase price, and the excluded assets. If the sale doesn’t include your custom desk, chair, artwork, or other personal effects, then be sure to list those as excluded.
The purchase price should generally include all assets required to generate the business’s cash flow except for real property.
In an asset sale, the buyer usually only assumes short-term liabilities, such as accounts payable.
| Assets commonly included in the sale of a business: | Assets commonly excluded in the sale of a business: |
| Tangible personal property | Cash and cash equivalents |
| Inventory | Seller’s personal vehicle, cell phone, laptop, etc. |
| Accounts receivable | Corporate minute books |
| Contracts | Insurance rights |
| Data and records | Personnel records |
| Intangible assets (patents, copyrights, trademarks) | Claims for refunds of taxes |
| Insurance benefits |
If the transaction is structured as a stock sale, the type and number of shares should be clearly listed. This is simple if there’s only one class of stock and a limited number of shareholders. Otherwise, this section can become complex as the classes of shares and the number of shareholders increase.
In a merger, two or more companies combine into one with a single identity, typically that of the larger or largest of the companies. The new company may use the name of one of the former companies, though it’s still a new company with a new set of books and records.
This section defines the amount of the purchase price and how it’ll be paid, also called the consideration. This is usually the first significant clause in the purchase agreement.
Some of the terms used in this section may have appeared in the letter of intent, while others may be new. For example, a buyer may propose an earnout if they discover new areas of concern during due diligence.
The purchase price should include all assets required to generate the cash flow the business produces, except for real property.
This section is relatively simple as its purpose is to define the purchase price, although the price is usually subject to adjustments. Here’s a sample clause defining the purchase price:
“The Purchase Price will be $10,000,000; plus or minus the Adjustment Amount, and the assumption of the Assumed Liabilities.“
The Adjustments to the Purchase Price clause covers any adjustments made to the purchase price, such as prorations for changes in net working capital. The purchase agreement usually includes a net working capital target, or a minimum that must be delivered at the closing. If the amount delivered at closing differs, then the purchase price will be adjusted accordingly.
The Consideration clause describes how and when the purchase price will be paid and provides a timeline for payment.
The clause may list a variety of different forms, such as:
The Purchase Price and Consideration section may also include clauses such as:
Representations and warranties are statements and guarantees made by the parties about the transaction. Called “reps and warranties” or “R&Ws” for short, they comprise a significant portion of the purchase agreement, are heavily negotiated, and are used by many buyers to flush out potential problems.
Buyers use reps and warranties to force the seller to disclose all material facts about the business. If the seller doesn’t disclose material facts, chances are the buyer will discover them after the closing and will then be entitled to pursue the seller for damages.
The purchase agreement contains significantly more representations concerning the seller because the buyer has much more to lose. The seller is primarily concerned with receiving payment, meaning that the buyer’s representations are mainly about access to capital and authority to purchase the business.
On the other hand, the buyer is concerned about dozens of aspects of the business and its operations, so the seller’s reps and warranties relate to the assets, liabilities, and contracts of the business being sold.
Reps and warranties relate to past events and shouldn’t be used to mitigate general business risks the buyer assumes by owning a business.
Examples of representations you might make as a seller include:
The scope of the reps and warranties differs from transaction to transaction. For example, a stock sale may contain a different scope of reps and warranties than an asset sale. Likewise, a buyer who is intimately familiar with an industry and is, therefore, more confident in their ability to conduct due diligence, may demand a lesser scope than a buyer who’s not. As a result, no two negotiations are alike.
If a representation or warranty is breached after the closing, the purchase price will be adjusted. This is usually deducted from a portion of the purchase price held by a third-party escrow firm. The Indemnification section of the purchase agreement addresses what will happen if a representation or warranty is breached, and is hotly negotiated in most cases.
As seller, your exposure is limited through the following:
Reps and warranties work like an insurance policy. There are exclusions or events that the policy does not cover, and there are deductibles, in the form of a basket, and a maximum payout cap.
The Indemnification clause requires the parties to indemnify (i.e., guarantee or insure) one another for breaches of representations, warranties, covenants, and other types of claims that may arise, such as those related to tax, the environment, or employee issues. The Indemnification clause – sometimes called a Hold Harmless clause – functions similarly to an insurance policy and requires the breaching party to reimburse the other for all expenses resulting from a breach.
In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations. This prevents the seller from running off to the Maldives with all the dough and leaving the buyer empty-handed.
Indemnification rights are much more specific than the general legal rights included in most contracts. The indemnification provisions include specific rules governing the level of involvement the parties may have in defending suits or other claims, and other options rarely afforded to the parties under the general legal rights.
Examples of potential disputes include:
Indemnification is normally subject to limitations, such as the maximum indemnification (a cap) and a minimum threshold that must be triggered (a basket). The latter is similar to an insurance deductible.
Indemnification can also be limited by knowledge qualifiers such as “to the best of seller’s knowledge” or “to seller’s knowledge,” materiality qualifiers, and survival periods. For example, the reps and warranties normally expire after 18 to 24 months. These collectively serve to limit the seller’s exposure level and further allocate risk between the parties beyond the specific language provided in each individual representation.
In summary, reps and warranties work like an insurance policy. There are exclusions or events that the policy does not cover, and there are deductibles in the form of a basket, and a maximum payout cap.
Covenants are agreements to take a certain action (a positive or affirmative covenant) or not to take it (a negative or restrictive covenant). Covenants govern which actions the parties can or must take either before the closing (pre-closing covenants) or after the closing (post-closing covenants). They provide a guide for how the parties are expected to act during and after the transaction.
For example, a common pre-closing covenant requires the seller to continue operating the business in the normal course of events. A common post-closing covenant may require the buyer to offer the staff employment on similar or better terms than those they have with the seller.
Covenants also serve as closing conditions. Violating a covenant implies that a condition to closing has been violated, and the party not in breach will be able to claim indemnification from the other or terminate the agreement.
If the purchase agreement is signed before the closing, it will require significantly more covenants, specifically pre-closing covenants.
Positive and restrictive pre-closing covenants include:
Positive and restrictive post-closing covenants include:
| Common M&A Purchase Agreement Conditions | |
| Reps and Warranties | The reps and warranties are accurate as of the signing, as well as of the closing date. This is referred to as a “bring down” of the reps and warranties, which confirms that all are true and accurate at the time of closing. |
| Material Adverse Effect | The business has not experienced a Material Adverse Effect. |
| Approvals | The buyer has obtained any necessary regulatory approvals or licenses necessary to operate the business. |
| Consents | The buyer has obtained any necessary third-party consents. |
| Lease | The buyer has obtained an acceptable transfer of the building lease. |
| Financing | The buyer has obtained financing on terms acceptable to the buyer. |
| Legal | No legal proceedings affect the target or any of the parties’ ability to close. |
| Due Diligence | The buyer’s due diligence has been satisfactorily completed. |
| Deliverables | All ancillary agreements and closing deliverables have been made. |
Conditions are events that must be met or take place before closing can occur, such as the buyer obtaining financing, getting a license, transferring a lease, or receiving franchisor approval. The purchase agreement will contain conditions, or contingencies, that must be satisfied if it’s signed before closing occurs.
This section of the purchase agreement is only necessary if it is signed prior to closing. If so, and a closing condition has not been satisfied, then in most cases, the buyer can terminate the agreement without effect.
Termination provisions outline how, why, and when parties can terminate the deal. They include conditions for canceling the agreement and penalties for defaulting, such as a break-up fee for the terminating party, or obligating one party to reimburse the other’s expenses. Termination rights can be invoked when any conditions to the sale can’t be fulfilled.
This section explains the effect of termination, usually specifying that some provisions of the purchase agreement will survive termination, such as confidentiality and miscellaneous clauses.
This section is only necessary if the purchase agreement is signed prior to the closing.
Termination fees range from 2% to 3% of the purchase price. They’re intended to penalize the seller or buyer for a last-minute change of heart, to reduce liability and cover the other party’s costs, and to discourage sellers from entertaining other buyers.
As the seller, you generally shouldn’t expect to receive a termination fee if the buyer walks away before the closing date, unless the purchase agreement is signed well before and there’s a significant delay between signing and closing.
A drop-dead date is also commonly included in this section. This date specifies that the agreement will be terminated if the closing does not occur by then. Usually far in the future, the drop-dead date prevents parties from indefinitely committing to the transaction, even if it drags out well beyond the intended timeframe.
This section includes most of the general provisions you’d expect to see in any legal agreement, including attorney fees, a note on the governing law, mediation, severability, etc.
While not of essence to the deal, certain additional agreements bring everything together in a structured way, and help you to plan and finalize the deal.
Now you’re aware of everything you can expect to find in a purchase agreement – its stocks, costs, claims, and covenants – and you’re ready to take it all the way to closing day.
Of course, the letter of intent is the seed that grows the purchase agreement. How well you planned it, sowed it, and nurtured it, informs every pitfall and hurdle you’re dealing with now.
But the past is the past. There’s still time to negotiate a better purchase agreement, to make sure indemnification is carefully tailored, and to armor yourself with reasonable reps and warranties.
You’ve invested your blood, sweat, and tears into an enterprise that has provided for you, your family and your employees. The moment has finally come for you to start a new chapter in your life. Explore your options now.
