A definitive purchase agreement is the final agreement that is signed during the process of buying or selling a business. It outlines the terms and conditions for buying or selling a company, such as the payment structure, the representations, the termination clause, and other important considerations. Unlike a letter of intent, which is a non-binding, preliminary document, “definitive” means the agreement is the final one to be signed before the closing.
A definitive purchase agreement transfers the ownership of a business. A business is nothing more than a collection of individual assets, owned by an entity, such as a corporation or LLC. The purchase agreements to acquire those assets can take two general forms:
- Stock Purchase Agreement – This transfers the shares of the entity, otherwise known as a corporation or LLC, that owns the assets of the business. By purchasing the shares of stock owned by the entity, the buyer then owns the assets that were previously owned by the entity. Shares in an LLC are technically called “membership interests.” However, for sake of simplicity, most parties refer to the transaction as a “stock sale.”
- Asset Purchase Agreement – This agreement transfers the individual assets from the seller to the buyer. However, the seller retains ownership of the shares of the entity, and the buyer typically forms a new entity for the assets he or she bought.
Typical clauses in a definitive purchase agreement include the following:
- Definitions – Any well-written purchase agreement contains definitions of the key words that are used throughout the document. For example, what is the “closing”? Is it the same date as the “change of possession” date?
- Purchase Price and Financing – This defines the amount of the purchase price, typically broken down by the earnest money deposit, the down payment, the additional funds needed upon conclusion of due diligence, amount of seller financing, third-party financing, and the hold-back amount. It outlines if financing is a contingency, and if so, it defines how long the buyer will have to obtain third-party financing. It also details whether an earn-out is involved.
- Solicitation – This area details whether or not the parties are negotiating exclusively with another. “No shop” or “go shop” clauses may be included in this section.
- Inventory – This section includes a description of the inventory included in the sale, as well as who will count the inventory, the buyer, the seller, or an inventory valuation service. It also provides adjustments to the purchase price based on the difference in inventory between signing and closing and a representation discussing the condition and salability of the inventory.
- Contingencies – The purchase agreement sometimes contains contingencies if a substantial period of time passes between signing and closing. Buyer contingencies can hinge on obtaining financing, obtaining a license, transferring a lease, or getting franchise approval. The agreement may also be contingent on the seller approving the buyer's credit and financial position, if the seller is offering the seller financing.
- Earnest Money Deposit – The agreement outlines who holds the earnest money deposit, whether it is refundable or non-refundable, and the conditions for refunding the deposit.
- Closing Costs and Pro-Rations– This area explains who will pay which closing costs. Many closing costs are split equally between buyer and seller with each party paying their own advisors.
- Training and Transition Period – This section outlines in detail the length and form of the training agreement. It is good practice to be highly specific regarding the length of the training agreement, including how many hours and on what terms. Not doing so can lead to post-sale disagreements, and buyers sometimes sue sellers for failure to properly train the new buyer.
- Representations and Warranties – The seller’s representations are often more thorough than the buyer’s representations. Examples of the seller’s representations include: all assets are in good repair; all taxes will be paid at closing; seller has the legal capacity to sign the agreement; and seller has complied with all laws. Representations and warranties (reps and warranties) are heavily negotiated in larger transactions. Reps and warranties are used by many buyers to flush out potential problems. Unfortunately, some sellers will sign anything, take the money and run.
- Confidentiality – This clause is sometimes included, even though a confidentiality agreement may already exist.
- Default and Remedies – This area includes conditions for cancelling the agreement and penalties for defaulting, including a break-up free.
- Miscellaneous Legal Provisions Common to All Legal Agreements – This section can include attorney fees, mediation, indemnification, entire agreement, severability, governing law, risk of loss, and time is of the essence, among others.
Supporting documents are attached to the definitive purchase agreement as exhibits. Typical supporting documents include:
- Corporate Resolution – A corporate resolution is required in an asset sale, if the seller is an entity and is selling a majority of the assets of the company. Technically, the seller in an asset sale is the entity (corporation or LLC), and a corporate resolution is typically required in the Corporate Bylaws for taking major actions, such as selling all assets of the company. This resolution is not required if the buyer is selling the entity, such as in a stock sale.
- Bill of Sale (if selling the entity) – This document transfers the individual assets of the company, similar to when you sell a car and must sign a bill of sale. The bill of sale should list all assets included in the sale, along with a detailed description. Some advisors list intangible assets separately and transfer them using a separate set of exhibits.
- Deed of Sale of Entity (if selling the entity or stock) – This document is required if the seller is selling the shares in the entity.
- Non-Competition Agreement – The non-competition agreement contains a description of what the seller may and may not do, as well as specifying the length of time the agreement stands. Almost all sales include a non-compete agreement. Sometimes, this agreement is included as a clause in the purchase agreement, and sometimes it is listed as an exhibit. The non-compete agreement should be voided if the buyer defaults on payments to the seller.
- Training Log – It is good practice to log the completion of the training period to prevent potential future litigation.
- Promissory Note, Security Agreement (if the seller is financing the sale, asset sale) – This document is required for asset sales or if seller financing is involved. The promissory note outlines the terms of repayment, and the security agreement is a document allowing the seller to place a lien on the assets of the business until the buyers pays in full. A UCC-1 also needs to be filed to perfect the lien.
- Share Pledge Agreement (if the seller is financing the sale, stock sale) – For stock sales, shares of the entity can be held in trust or escrow until the seller is paid in full, which is similar to placing a lien on assets of the company. However, it is good practice to have a third-party physically hold onto the shares until the loan is paid in full.
- Assignment of Shares (for a stock sale) – The assignment of shares transfers shares of the entity, and it is used for stock sales only.
- Allocation of Purchase Price (for asset sales) – This document breaks down the purchase price into separate asset classes for IRS purposes. It is only used for asset sales. The tax implications can be substantially different for asset and stock sales.
- Independent Contractor Agreement – The independent contractor agreement is necessary if the seller is to continue working for the buyer in some capacity, though it can also take the form of an employment agreement.
- Assignment of Contracts – This document transfers third-party contracts from the seller to the buyer upon closing. This document may not be necessary for stock sales, as some agreements are transferable despite a major change in ownership of the entity.
- Assignment of Equipment Lease – The assignment of equipment lease transfers the lease for the premises. The seller usually remains on as a guarantor for the lease until the lease expires. This document must be signed for the landlord, though it is not necessary if a new lease is created. A different agreement is necessary if the space will be sub-leased from the seller to the buyer.
- Assignment of Intellectual Property – An exhibit that transfers any intellectual property from the seller to the buyer, such as patents, trademarks, or other registered intellectual property. It can also transfer non-registered intellectual property, such as phone numbers, websites, and content.
- List of Assets – The list of assets is a detailed list of all tangible assets that are transferred. It is not necessary for stock sales, though it does not hurt to be clear regarding which assets are owned by the corporation or LLC. Doing so can help prevent litigation regarding which assets were included in the sale.
- List of Intangible Assets and Intellectual Property- This exhibit includes a list of intangible assets, such as phone numbers. Providing clarity in this area can prevent future litigation and disputes.
- List of Titled Property – It includes a list of titled property, such as real estate or vehicles. These assets requires a separate set of transfer procedures.
- Seller’s Disclosure Statement – A statement made by the seller regarding any adverse conditions of the business the buyer should be aware of. It is critical to notify the buyer in writing of any material, adverse conditions of the business. Doing so prevents potential litigation.
- Release of Holdback – Savvy buyers will request that a percentage of the purchase price is held in escrow until the training period is complete. In some middle market transactions, this amount can be held in escrow for up to 12-24 months to cover any additional unknown variables, such as customer warranty claims, gift certificates, etc. This varies from 5-20% (or more) of the purchase price.
The Process – Small Businesses (Less than $1-3 Million)
Many small business purchases are handled with only one agreement. The same document that is used to make an offer on the business is often the final agreement that is signed at closing. A buyer makes an offer to purchase the business, along with an earnest money deposit. The buyer and seller then complete due diligence. The same agreement that was originally submitted to make an offer on the business is then used at closing to transfer the assets.
Parties in a small business transaction are often not as sophisticated as those involved in larger transactions and using one agreement simplifies the process. Additionally, many business brokerage offices hire untrained business brokers, and they simplify the process by using fill-in-the-blank PDF forms. Doing so may not be best for the buyer and the seller, but using fill-in-the-blank forms simplifies the process for the business broker offices. Many franchised business brokerage offices operate this way.
The Process – Mid-Sized Businesses ($3-25 Million)
The process for a mid-sized business is a bit more complicated, requiring the paperwork outlined below.
Letter of Interest – Most mid-sized transactions begin with either a letter of interest or letter of intent. Whether the process opens with a letter of interest varies based on whether the process is an auction or not, and it also depends on the parties’ preferences.
Letter of Intent (LOI) – At some point, a letter of intent is offered, often without an earnest money deposit. Sophisticated buyers make a substantial investment in professional advisory fees during due diligence, and most view it as unnecessary to make an earnest money deposit. Additionally, almost all middle-market buyers are either corporations or financial buyers, such as private equity groups, and most are credible and can be easily researched. Letters of intent are usually non-binding. Sophisticated buyers don’t want to waste their time or money on due diligence, so few sellers require a binding agreement.
Due Diligence – Due diligence then begins, typically lasting 30-60 days. Most due diligence for middle market deals is done online through a virtual data room. Most parties invest a significant amount of time and money at this stage. Additional negotiation often occurs after completion of due diligence if the findings differ from the seller’s initial representations.
Definitive Purchase Agreement – Due diligence then concludes and the parties’ attorneys draft a definitive purchase agreement, which is signed before the closing. This time period involves the execution of many agreements. Occasionally, additional contingencies remain prior to the closing.
Closing – The closing is anticlimactic and can either be a round-table closing or a virtual closing. The closing simply involves a virtual or physical meeting of the parties.
Much of what is in the definitive purchase agreement is boilerplate language. That is, it is taken from previous templates, but the agreements may differ substantially between deals. A savvy advisor can quickly spot these differences. A cheap laywer may actually be more expensive than an “expensive” lawyer because he is learning along the way. When being involved in one of the most important transactions of your life, it pays to hire experienced advisors, including your intermediary, attorney, and CPA.