We are almost at the end of our 7-part series on selling an emerging growth company, and we have reached the stage of drafting and negotiating the definitive agreement. When we talk about the “definitive agreement” in the context of a sale of an emerging growth company, this usually refers to an asset purchase or stock purchase agreement as part of an acquisition, but when there is a true merger of the acquirer and target, the definitive agreement will be the merger agreement. The actual drafting and negotiating done by your attorney and your acquirer’s attorneys may not be all that exciting, but, for you, the owner of the target (which I’ll refer to in this post as the seller), this means you are hopefully well on your way to a successful closing.
But before a definitive agreement can be finalized, there are numerous, often challenging issues to be worked out between the acquirer and seller regarding
1) the economics of the transactions;
2) representations and warranties made by the seller; and
3) what rights the acquirer will have if it is determined the representations and warranties were untrue in any way.
The Economics: How Much Will You Get and in What Form?
The definitive agreement will describe the final economic terms of the transaction, which were likely described in summary form, but not in the required detail, in the letter of intent. You can expect the definitive agreement to spell out in detail:
- The exact description of what is being bought (i.e. the company’s stock or its assets, etc.);
- Any liabilities to be assumed by the acquirer;
- The total consideration to be paid by the acquirer;
- The form of the consideration (cash, a promissory note, acquirer stock, a combination thereof, etc.);
- How any earn-outs will work;
- Any conditions to closing; and
- What documents will be exchanged at the closing.
Representations and Warranties
The definitive agreement will usually contain an extensive set of statements, made by the seller, about various aspects of the seller’s business and assets, including issues such as customers, vendors, contracts, intellectual property, legal compliance, and many other areas.
The representations and warranties complement the due diligence process by forcing the seller to make binding statements about the materials it supplied in due diligence. The representations and warranties in the definitive agreement will be the basis for whether the acquirer is later justified in walking away from the deal or suing the seller after the deal has closed. Your goal will be to include as few representations and warranties as possible, and to limit their scope as much as possible, while the acquirer will be motivated to make them as far reaching as possible.
For example, there may be a representation that the seller owns all intellectual property related to its business and that the seller is not infringing on anyone else’s intellectual property. Your lawyer should try to soften that language by limiting that representation to only cover intellectual property that is material to the business and infringement that you have actual knowledge of.
An important part of this aspect of the agreement is the Disclosure Schedule which will set out various lists of supporting documentation for and exceptions to your representations and warranties, which essentially shift the risk of the matters disclosed in the disclosure schedule back the acquirer.
Breaches of Representations and Warranties and Indemnification
The indemnification provisions deal with the issue of what rights does an acquirer have when it discovers a breach of the representations and warranties (e.g. a previously undisclosed threatened IP lawsuit). Much of this depends on when the risk is discovered.
If the definitive agreement is structured such that the closing is scheduled to occur after the signing of the definitive agreement, then a breach of the representations and warranties discovered before closing often allows the acquirer to walk away from the deal without closing. In that case, the acquirer may walk away or at least use the threat to do so to lower the purchase price. In most private company deals, the closing occurs at the same time the definitive agreement is signed, so this is usually not an option.
If the breach is discovered post-closing and the acquirer is harmed or damaged in specific ways after the closing, then the seller is liable to compensate the acquirer for that damage or harm. Your lawyer should try to minimize your risks here by pushing for limits on the indemnification provisions. Some common things to ask for are:
- Time limits as to when the acquirer can bring a claim;
- Total limits to the seller’s liability;
- A deductible, whereby the acquirer’s damages must exceed a certain amount before any liability occurs;
- Ensuring that if any loss is covered by insurance, the acquirer must file an insurance claim before suing the seller; and
- Prohibiting the acquirer from suing over anything that was disclosed in due diligence or that the acquirer actually knew about.
It is of course natural for emerging growth company owners to be focused on the purchase price in a definitive agreement, but, as you can see, making sure you are paying attention to how the various terms of the definitive agreement work together can make a huge difference in whether you will actually get to keep that purchase price.