Mergers, Acquisitions and Divestitures
‘Standard’ Provisions for Purchase and Sales Contracts
For the Sales of Businesses
by Anthony C. Goodall
Recently a study was conducted by 63 team members working in 11 teams to evaluate certain, critical contract standards and norms for various provisions of contracts for the sale and purchase of businesses. This study was led by two attorneys, namely Wilson Chu of Haynes & Boone, LLP and Larry Glasgow of Gardere Wynne Sewell, LLP.
This team studied the acquisition agreements from a sample of 143 business sales transactions. The original test size was larger but the field was reduced by excluding non-arms length transactions like bankrupt company acquisitions, reverse mergers and other similar transactions that would tend to skew the results.
This study was taken from publicly available information on the SEC’s Edgar system from transactions completed in 2006. Accordingly, the sample field included companies that were of larger size than regular main street mom & pop companies. These were transactions ranging between $25M to $500M in total purchase price.
Here are some of the results of the study performed:
1. Form of Consideration. 65% were all cash transactions. 5% were all stock transactions and 30% were a combination of the two.
2. Sign/Close or Sign First/Then Close. I find that usually these transactions follow a sign/close pattern. In other words, the purchase agreement is signed on the same day the closing takes place. The exceptions are when there are government or financial relationships that require time to review the deal prior to closing. This survey discovered only 12% of the transactions were conducted on a sign/close basis – 88% were closed after the purchase agreement was signed.
3. Earnouts. An “earnout” provision exists whenever part of the purchase price is deferred and determined based upon the future performance of the enterprise after closing. Surprisingly, only 19% of the sample cases included an earnout provision. In my practice I attempt to limit, as far as possible, the post-closing tie-ins between the buyer and seller – to give them the cleanest break possible. In my view, the earnout is one of the most invasive post-closing tie-ins there is. To be effective, the seller must have some level of control over that part of the enterprise’s business that has the greatest impact on the resulting adjustment to the earnout portion of the purchase price. Otherwise, disputes can arise surrounding the fault for the failure to achieve better earnout results. In the last several years I have noticed, however, that the sellers who have agreed to an earnout provision in the purchase agreement were generally pleased with the final results.
There is no one-size-fits-all formula for an earnout provision. An earnout formula can be based on growth in gross revenues, increase in number of outlets, increase in cash flow, arrangements of debt financing and so on. The best earnout provisions include objective, easily determined benchmarks and leave little to subjectivity.
4. Compliance with Law Representation. In an overwhelming majority of time (99%), the purchase agreement includes a provision wherein the seller represents that the enterprise is in full compliance with all laws, rules and regulations. This representation can be risky. In this ever-increasingly complicated society overburdened by regulations, it becomes more and more difficult to know that a business is fully compliant with all laws, rules and regulations that govern it. As an example of this provision:
The Company is in compliance in all respects with all laws and regulations with respect to, and is not subject to any currently existing order, writ, injunction or decree relating to the operations of the Company or the Transferred Assets;
In only 10% of those representations was the representation qualified with the knowledge of the seller. As an example: “To the best of Seller’s knowledge, the Company is in compliance. . .” But in 55% of the cases, the representation was qualified by a materiality standard. As an example: “The Company is in compliance in all material respects with all laws. . .”
5. 10b-5/Full Disclosure. In many purchase agreements, toward the end of the seller’s representations and warranties, there is a catch-all representation that requires the seller to some level of general tell-all obligation. Among the sample tested, 38% of the contracts had no such representation. 10% of the contracts included a representation that required full disclosure of any matter that ‘may materially adversely affect the assets, business, prospects, financial condition or results of operations of Seller not otherwise disclosed in this Agreement.’ The majority of the sample contracts (52%) included a representation along the lines of Rule 10b-5 of the Securities Act, stating that none of the representations by Seller ‘contains any untrue statement or omits to state a material fact necessary to make any of them in light of the circumstances in which it was made, not misleading.’
6. Legal Opinions. Legal opinions are more often required only for larger transactions. It is difficult to say where the break point is, but buyers for transactions that have substantial complexities or whose purchase prices exceed $5,000,000 or $10,000,000 will usually require legal opinions. The test sample universally included transactions larger than this and 70% of those transactions included a requirement for legal opinions.
7. Survival of Claims and Time Limits on Asserting Claims. In the vast majority of the transactions (95% of the time), there was a time limit imposed on the survival of any claims to be asserted against the other party. The standard range was between 12 and 18 months. 5% of the contracts included a time limit longer than 2 years. Varied were the carveouts to the limitation. In other words, for many forms of representations, there was no time limit for making a claim. These include:
c. Due Authority
d. Ownership of Equities Sold
e. Employee Benefits
8. Baskets/Deductible. In the overwhelming majority of the cases (97%), some kind of minimum was established below which the party was not permitted to assert a claim.
9. Caps on Total Claims. 81% of the transactions placed a cap on the total claims that could be asserted against the seller ranging from less than 10% up to 25% of the transaction value. In only 9% of the cases was the cap equal to the purchase price. Again, in many cases there were carveouts imposed where, notwithstanding the cap, no cap applied for certain items. These carveouts tended to be the same as those shown in #7 above.
Hopefully these nine points will provide a guideline standard for reasonableness of negotiations for these various contract provisions. In many cases, if a party is taking a hardline position on points that tend not to be standard, it may be helpful to know what applies in the majority of cases. If nothing else, knowing these standards can assist in the give-take process of contract negotiations. For example, for a small transaction a legal opinion could be removed from the contract on behalf of the seller in exchange for a longer period for asserting claims. Rarely will one party be successful in achieving the norm for every provision mentioned above, but by knowing what the standards are, attorneys can understand the dynamics of the negotiation process for each of them.