How Do Closing Conditions and Covenants Work When Buying or Selling a Business?



In this post, we return to key components of purchase agreements, this time focusing on closing conditions and covenants.  Closing conditions set out the contingencies for when the parties must go through with – or “close” – a transaction.   Covenants are obligations that the parties have between signing and closing and post-closing.  To learn more, keep reading.

Closing Conditions

“Simultaneous sign and close” transactions are those where the parties are ready to close when they sign the agreement, and the deal closes the moment the deal documents are signed.  

More typically, though, there will be a pre-closing period between signing and closing where the parties handle items required for closing, like obtaining and/or finalizing financing, third-party consents, and other items.  Closing conditions include the items that must be finalized before the parties are obligated to close.  Some conditions are applicable to both parties, and some may only give one side a right to walk away if not met.  

Sellers usually want narrow and minimal closing conditions to increase the certainty that the sale actually happens, while buyers want broad and expansive closing conditions for flexibility in case changed circumstances make them rethink the transaction.  Broad closing conditions can also be used by buyers to pressure sellers to fix issues prior to closing.

Common closing conditions include the following:

  • Reps and Warranties Bring Down: That the reps and warranties made by the other party at signing remain true at closing.  Buyers will want the reps to be true “in all material respects,” while sellers will want the reps to be true except as would not constitute a “Material Adverse Effect” (see below).

  • Material Adverse Effect: A material adverse effect (MAE) (sometimes called a material adverse change or MAC) has not occurred.  What constitutes an MAE is the subject of negotiations.  The recent COVID-19 pandemic is a good example of an MAE.  If a buyer signed an agreement to purchase a business just before the outbreak, and the business’s prospects and value suffered as a result of COVID-19, an MAE clause could let the buyer walk away from the transaction.

  • Debt and Liens: Any required debt has been paid off and required liens have been released.

  • Key Personnel: Employment agreements, non-compete, and similar agreements, consulting / transition agreements, and equity documents have been signed.

  • Regulatory Approvals: Any approvals required by governmental or other regulatory bodies have been obtained.

  • Third-Party Consents and Approvals: The seller has received all required consents under its agreements with landlords, customers, suppliers, and other third parties.  Sometimes, sellers will successfully negotiate for this to be limited to “material” third-party consents that are listed on a schedule. 

  • Financing: Often, if cash at closing is required, buyers will negotiate for a “financing condition,” requiring the buyer to close only if adequate financing (whether from a commercial lender or another source) is in place.

The acquisition agreement will include covenants or agreements for the parties to take or not take certain actions (“affirmative covenants” and “negative covenants,” respectively) before and after closing.  

  • Pre-Closing Covenants: Usually, the pre-closing covenants are relatively standard and not hotly negotiated.  For example, the seller’s obligations to run the business normally, maintain relationships with customers, suppliers, and others, comply with laws, keep the transaction confidential (if required), facilitate the buyer’s continued diligence, not increase employee compensation, not make capital expenditures, and not incur debt or liens.

  • Post-Closing Covenants: Post-closing covenants are usually subject to more negotiation.  These include covenants regarding the seller’s stockholders’ non-disclosure of the target’s confidential information, non-competition with the target, non-solicitation of employees and customers, and non-disparagement of the target.  The length of the non-competition and non-solicitation covenants are negotiated within the limits of state law.  Periods from 1-5 years are common.  The rationale for these covenants is that the purchaser should get protection in exchange for the purchase price they paid.  It’s important to have these covenants in the acquisition agreement in addition to key managers’ employment agreements because courts are more likely to enforce these restrictions in the context of a business sale (and, in fact, states like California may only enforce certain restrictive covenants in connection with business sales).  Post-closing convents concerning tax obligations and reporting, as well as financial information if there is an earnout, seller financing, or equity component to the purchase price, are relatively non-controversial. 

In our next post, we will continue with a discussion of common ancillary agreements.



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