Overview of the Purchase Agreement

Following is a summary of the key elements of a purchase agreement. I’ll cover each in greater detail later in the chapter. 

General Clauses

  • Definitions: Any well-written purchase agreement contains definitions of the key terms used throughout the document. It can clarify the differences between closing, change of possession and change of possession date, and other important terms. Thoroughly documented definitions help avoid potential issues stemming from questions related to any key terms.

Price and Terms

  • Purchase Price: This defines the amount of the purchase price and the form of consideration (i.e., how the purchase price will be paid), such as the cash down payment, stock, debt or liabilities assumed, amount of seller financing, third-party financing, earnouts, and how much of the purchase price will be heldback in escrow. 
  • Allocation of Purchase Price: This includes how the purchase price will be allocated for tax purposes.
  • Working Capital: This section contains a description or definition of net working capital (NWC). This may also specify who will count the inventory – the buyer, the seller, or an inventory valuation service. It also provides adjustments to the purchase price based on differences in the value of working capital between signing and closing, and a representation of the condition and salability of the inventory.
  • Closing Costs and Prorations: This area of the agreement explains who will pay which closing costs. Most closing costs are split equally between you and the buyer, with each party paying their own advisors.
  • Transition Period: This section outlines the length and form of the transition agreement. Being highly specific regarding the length of the transition agreement – including how many hours and on what terms – is a good practice. Not being specific can lead to post-sale disagreements and helps prevent the buyer from suing you for failure to properly transition the business.

Reps and Warranties, Indemnification, and Escrow

  • Reps and Warranties: Reps and warranties are promises and disclosures made by each party that serve as “insurance” if a representation later proves to be untrue. For example, you will warrant that you’ve paid all taxes due and there’s no outstanding litigation. Reps and warranties comprise most of the content in a purchase agreement and vary significantly based on the type of business. Manufacturing businesses, for example, will primarily have environmental and employee concerns, while technology companies will have IP concerns.
    • Knowledge and Materiality Qualifiers: If you aren’t 100% sure regarding a representation, that representation should contain a knowledge qualifier such as “to the best of Seller’s knowledge” or “to Seller’s knowledge.” 
    • Exclusions: Reps and warranties are worded in the affirmative, and your attorney will list any exceptions in disclosure schedules.
    • Survival Periods: The reps and warranties normally expire after 12 to 24 months. Some, such as those related to tax matters, survive indefinitely.
  • Indemnification: This section governs how disputes will be handled and includes an obligation to reimburse the other party for breaches of contract. Indemnification is usually covered by holding 10% to 15% of the purchase price in an escrow account for 18 to 24 months following the closing. The amount of indemnification is limited by baskets, or minimums, and caps, or maximums.
    • Basket – Minimum: A basket operates like an insurance deductible and is a minimum threshold that must be exceeded before indemnification is triggered. The average size of a basket is 0.75% of the purchase price. Baskets can be tipping, in which the liability starts from $0, or non-tipping, in which the liability starts from the amount exceeding the deductible.
    • Cap – Maximum: A cap is the maximum limit of indemnification. The average cap is 10% to 20% of the purchase price.
    • Parties: The buyer will often seek to obtain protection, or indemnification, from as many parties as possible, such as all shareholders and key managers. If multiple shareholders exist, ideally they should avoid agreeing to “joint and several liability.” 
    • Remedies: The purchase agreement should also address if indemnification is the exclusive remedy for the parties.
    • Indemnification Process: The purchase agreement will also address how indemnification claims are handled.
  • Escrow Account: The escrow amount usually ranges from 10% to 20% of the purchase price. The size of the escrow is based on the likelihood and magnitude of potential risks.
    • Time Period: Most escrows range from 12 to 24 months. 
    • Conditions: The purchase agreement should also address who controls its release and how disputes are handled. 

Miscellaneous Legal Provisions

  • Form of Transaction: The legal form of the transaction – asset sale, stock sale, or merger.
  • Conditions and Covenants:
    • Contingencies and Conditions: The purchase agreement contains contingencies if signed before closing. Contingencies are events that must occur before a closing can take place, such as financing or landlord approval. A common condition for closing is also that the reps and warranties must be true as of the closing date – called a “bring-down.” 
    • Covenants: Covenants are responsibilities of the parties during the period between signing the purchase agreement and the closing. For example, you will agree to operate the business as normal and agree to fulfill outstanding purchase orders, and so on. Covenants are rarely negotiated.
  • Default and Remedies: This includes conditions for canceling the agreement and penalties for defaulting, such as a break-up fee.
  • Miscellaneous Legal Provisions: This section contains miscellaneous legal provisions, such as those related to attorney fees, mediation, indemnification, entire agreement, severability, assignment, waivers, governing law, notices, risk of loss, and other provisions that generally apply to all legal agreements.