What Do I Need to Know About the Purchase Price, Payment Terms, and Earnouts for Selling a Business?

The Heart of the Deal

The definitive acquisition agreement – whether a stock purchase agreement, an asset purchase agreement, or a merger agreement – is where the transaction terms from the LOI are implemented in a negotiated, binding manner. In large transactions, it’s customary in most deal processes for the buyer to prepare the first draft of the acquisition agreement. In small-business transactions, usually the seller’s counsel prepares the first draft, though not always. Once the initial draft is prepared, the other side will provide comments, often in the form of an issues list.

Key Provisions

Purchase Price + Payment Mechanics
The price the buyer is paying for the business. The purchase price can be paid in cash at closing, through seller financing in the form of a promissory note, equity in the purchaser, through earnouts and other deferred / contingent payments, or a combination.

An earnout is an additional consideration that becomes payable if the business meets certain financial or other metrics over a defined period post-closing. Sellers often resist earnouts because the seller will no longer be in control of the business after closing. To mitigate that risk when earnouts are used, sellers will typically require the buyer to make certain efforts (for example, by providing funding, personnel, and operational support) to help the business meet the earnout goals.

Purchase Price Adjustments
Often, the purchase price is adjusted to reflect changes in the business between signing and closing. The most frequent type of adjustment is for “net working capital” (current assets minus current liabilities). Other types of adjustments include those for net worth, cash at closing, and accounts receivable. Adjustments can be “downward only” or “two way,” and usually a “buffer” is used around the target amount so that small variations don’t require an adjustment.

Reps and Warranties
Representations and warranties are a focal point of most transactions. A “rep” is a statement in the agreement by one party to the other concerning a fact about the seller or its business (buyers make reps, too, but buyer reps are usually less important in the overall arc of the deal). Reps touch on areas like finances, taxes, compliance with laws, permits, properties, assets, IP, employees, contracts, customers and suppliers, litigation, and other matters. Reps are usually subject to disclosure schedules, which disclose additional information or exceptions to the reps. Reps serve several key functions:

  • Accountability:  Reps hold the seller accountable for the accuracy of the information provided about the business.
  • Diligence Function:  Reps and the accompanying disclosure schedules are often a good way to ferret out pertinent information.
  • Conditionality:  At closing, the buyer reaffirms that the reps made at signing are still true at closing (a “bring down”).  If the business has changed between signing and closing such that the reps are no longer true, the buyer has the right to walk away and not close.  Because of that, the breadth of the reps affects the transaction’s conditionality or certainty of closing.
  •  Indirect Purchase Price Adjustment: The reps can serve as a basis for a functional purchase price adjustment: If the rep is untrue, the buyer can seek indemnification for associated loses, indirectly reducing the purchase price.

Reps are often subject to carve-outs and qualifiers, like “knowledge,” “materiality” and “Material Adverse Effect.”  In many instances these qualifiers are appropriate, but seller’s counsel will often attempt to overuse them, blunting the force of the reps in order to minimize the seller’s exposure and increase closing certainty.  The use of carve-outs and qualifiers is negotiated, and experienced counsel can assist with ascertaining what’s appropriate and what isn’t.

Buyers should use the reps to protect against risks, including specific risks identified during diligence.  Sellers need to ensure that the reps are appropriate and not overbroad, giving rise to indemnification rights that aren’t truly intended or giving the buyer an “option on the deal” though too much conditionality.  An experienced M&A attorney can help.

In our next post, we will continue with a discussion of indemnification.

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