Negotiating the Purchase Agreement

There are many schools of thought when it comes to negotiating the purchase agreement. In this section, I’ll describe the factors that affect the negotiations, what the negotiation process looks like, and offer tips to ensure you receive the best deal possible. 

Scope of Negotiations

These are some of the factors that can affect the scope of the purchase agreement negotiations:

  • Negotiating Skills and Posture: The negotiating skills of each party can make a difference, as can the negotiating posture and bargaining strength of each party.
  • Legal Structure: Whether the deal is structured as an asset sale, stock sale, or merger will also affect the scope. The purchase agreement usually offers more protections to the buyer in a stock sale than in an asset deal.
  • Financial Strength and Credibility of Seller: You can expect more favorable terms if the buyer has a positive perception and assessment of your character. If the selling shareholder group is dispersed and the selling entity will cease to exist after the closing, the buyer will seek other protective deal measures such as escrow.
  • Industry: Businesses with more operational risks will be subject to more stringent reps and warranties. Impacting this factor will be the level of the buyer’s knowledge of your business and industry, and their perception of your business’s threats.
  • Due Diligence: The more thorough the due diligence, the weaker the protections in the purchase agreement can be, at least in theory. That’s why the buyer’s ability to conduct thorough due diligence comes into play, as does the extent of the issues discovered during due diligence. 

The scope of negotiations regarding the purchase agreement varies significantly from transaction to transaction. For example, a stock sale may require more comprehensive protections than an asset sale. Likewise, a buyer who is intimately familiar with an industry and is, therefore, more confident in their ability to conduct due diligence may demand fewer protections than a buyer who isn’t familiar with the industry. No two negotiations are alike.

Impact of Market Conditions on Negotiations

The current state of M&A activity and the extent to which it’s a seller’s or buyer’s market heavily influence the scope of negotiations over the purchase agreement. Market conditions not only impact the price and terms of the transaction but may also dictate the prevailing definition or notion of what may be considered reasonable or fair.

For example, in a seller’s market, you can expect to sign reps and warranties that are far less broad in scope than in a buyer’s market. In recessionary periods, sellers must often have to agree to extremely restrictive language in both the letter of intent and the purchase agreement. Once the market gains traction, the scope of these restrictions loosens up. 

Current market conditions can influence the following:

  • Price and Terms
    • EBITDA multiples
    • The amount of cash down and amount of equity purchased vs. rolled over
    • Amount of contingent payments, such as earnouts 
  • LOI Terms
    • Exclusivity periods, which are less restrictive in a seller’s market
  • Protective Mechanisms
    • Scope of indemnification
    • Size of escrow or holdback
    • Indemnification limitations, including baskets and caps
Market conditions not only impact the price and terms of transactions but may also dictate the prevailing definition or notion of what may be considered reasonable or fair.

Negotiating Tips

Here are tips for negotiating the purchase agreement.

Make Concessions Known

Never make a silent concession. In other words, never give the buyer something without the buyer becoming aware of it. 

Be Prepared To Give In at Times

Be prepared to negotiate and occasionally give in on some points. You must weigh the cost of a dispute vs. the potential benefits to be gained. Disputes are expensive and time-consuming, and even if you win, you lose. No deal is perfect, and you can reasonably expect to encounter at least one substantial dispute in nearly every transaction. For immaterial matters, it may be most prudent to simply split the difference. 

Understand the Purpose of the Protections in the Purchase Agreement

Both parties must recognize that no business is perfect. There are bound to be a variety of problems in any company, no matter how meticulously it has been operated. For example, few businesses comply with literally every law. The purchase agreement can’t insulate the buyer from every imaginable problem that can arise. The purpose of the protections in the purchase agreement is to protect the buyer from undisclosed, material risks that occur outside the ordinary course of running the business. 

Maintain an Excellent Relationship

A Japanese proverb holds, “One kind word can warm three winter months.” 

You should attempt to maintain a strong working relationship with the buyer after the closing. The transaction must be a win-win for both parties. If the buyer later suffers from buyer’s remorse, they’ll have sufficient opportunities to obtain revenge through numerous protections afforded to them in the purchase agreement. Such protections include escrows, post-closing purchase price adjustments such as working capital adjustments, inventory adjustments, collection of accounts receivable, reps and warranties, earnouts, bonuses, and the like.

The best antidote for disputes is prevention. How does that work? Maintain an excellent working relationship with the buyer – not just professionally but personally, as well. It’s much easier to work out problems with a friend than a foe, and given the complexity of businesses there are guaranteed to be problems after every closing. 

Understand Underlying Motivations

Buyers propose language in a purchase agreement for specific reasons. You, as the seller, need to find out these reasons and address the buyer’s concerns directly. Often, the problem can be resolved through other creative measures, or the buyer may have a misunderstanding of the underlying risk the representation is intended to address. This can open a dialogue to educate the buyer on the risk and other methods for mitigating it.

Negotiating Process

Here’s a summary of the negotiation process of the purchase agreement:

  • Due Diligence: The breadth and depth of the protections offered in the purchase agreement are based on facts discovered during due diligence. The purchase agreement should be prepared in tandem with the due diligence process so the parties can negotiate the language as soon as possible in the transaction.
  • Buyer’s Attorney: The buyer’s attorney prepares the purchase agreement, which includes a standard list of protections focused on the likelihood and amount of potential exposure. 
  • Seller’s Attorney: Your attorney lists any exceptions to the reps and warranties in the disclosure schedules.
  • Negotiations: Reps and warranties are one of the most hotly negotiated components of the purchase agreement, other than price and terms, especially when the seller wishes to retire and avoid lingering obligations. The scope of negotiations is based on the aggressiveness of the buyer’s initial draft and the bargaining positions or alternatives for each party. The current state of the market impacts not only the price of companies but also the terms of the transactions. Buyers aim for a long exclusivity period to reduce your bargaining power later in the process when the purchase agreement is being negotiated. Your leverage vanishes once the LOI is signed.
  • LOI vs. Purchase Agreement: When negotiating an LOI, the buyer hasn’t yet performed due diligence and has limited information on your business; therefore, the buyer is unable to know exactly what protections they’ll request from you. This results in two negotiations – the LOI and the purchase agreement. This is why protections such as the reps and warranties are so hotly negotiated – you have already struck a deal, but now you must negotiate a second time. 
  • Content: The purchase agreement contains more representations concerning you because the buyer has much more to lose. 
  • Survival: Reps and warranties almost always survive the closing and can have implications for both parties for years thereafter. The other elements of the purchase agreement, such as the price and terms, conditions, and covenants, have no further implications after closing has taken place. Transactions involving publicly traded companies include reps and warranties, but they don’t survive the closing.
  • Closing: For you, the seller, the “real closing” hasn’t occurred until the following has transpired:
    • You’ve fulfilled your transition obligations.
    • Post-closing adjustments have been made, such as working capital adjustments.
    • You’ve received all the money due.
    • Earnout periods have expired.
    • You’ve satisfied the terms of employment and consulting agreements.
    • The indemnification period has elapsed.