Mark and his advisers were negotiating the final markup (red line) of the Definitive Agreement for the sale of Mark’s companies. Brian, CEO of the acquiring company, and his advisers, were attempting to buy them. Mark owned several nursing homes and assisted living facilities throughout three states in the Rocky Mountain region. His companies were profitable, but the ownership structure was complex. Some issues had arisen during the due diligence process that needed to be resolved by Mark and Brian and agreed upon in the definitive agreement.
Unfortunately, during the transaction process, Mark had spent little time with his advisers or reviewing the transaction documents, including drafts of the definitive agreement. After the sale price was agreed upon, he depended on his M&A advisers (an M&A intermediary, attorneys and accountants) to keep him informed of the various transaction issues. Mark had disengaged and assumed that most of the other major deal points had been worked out with the Brian, because the negotiations had gone so smoothly.
As the two sides were negotiating the final details of the markup, Mark became confused. He was not familiar with some of the legal terms, details being discussed, or provisions of the definitive agreement. Numerous, often challenging, issues still needed to be worked out between the parties. Some of the representations and warranties made by Mark became troublesome to Brian — particularly regarding the rights of his company — if Mark’s representations and warranties were untrue in any way.
Brian wanted to hold back $550,000 of the purchase price, set aside in an escrow account, for six months. The escrow account would cover any losses from accounts receivables over 90 days, and for any other undisclosed liabilities or any misrepresentations in the agreement. Mark became annoyed.
The longer the negotiations went on, the more uncomfortable Mark became. He began asking more and more questions and the more he asked, the more uninformed he appeared to all in attendance. Worse yet, Brian was getting cold feet about closing the deal. By the end of the day, Mark demanded that the parties postpone the closing date for 30 days. Ten days later, Brian withdrew from further negotiations. As a result, the deal fell apart and never closed.
How should Mark have prepared for the meeting? He should have worked closely with his advisers to fully understand the provisions of the definitive agreement and the “red line” issues that Brian was focusing on. Had Mark done this, he probably could have prevented the deal from falling apart at the last minute.
What is a Definitive Agreement?
A definitive agreement may be known by other names such as a “purchase and sale agreement,” a “stock purchase agreement” or an “asset purchase agreement.” Regardless of its name, it is the final agreement that spells out details agreed upon by buyer and seller. It includes major provisions such as those below:
- A complete description of what is being purchased (i.e. the company’s assets or stock and any liabilities assumed or excluded);
- The price (the “aggregate consideration”) to be paid by the acquirer;
- The form of the consideration (cash, stock, a promissory note, or any combination of the above)
- Terms and conditions that outline the rights and obligations of each party
- Representations and warranties;
- Baskets and caps;
Provisions further explained
For the definitive agreement to be legally enforceable, it must include an “offer,” an “acceptance” and “consideration.”
Representations are a series of binding statements (facts) about various aspects of the seller’s business. The warrant ensures that the representations are true. These statements are important as the buyer may decide to sue the seller, after the sale is closed, if the buyer discovers that the seller’s statements were materially different from the original statements. For example, if the seller had falsely stated that the intellectual property was owned solely by the seller, and it was not, then the buyer may have been harmed or the business may have been damaged in some way – particularly if the buyer was counting on using the IP as a competitive advantage for its future growth strategies. If the buyer can prove that he/she was harmed in specific ways because of misrepresentations, then the seller is liable to compensate the buyer for damages.
When negotiating representations, the seller wants to keep his representations as narrow and as few as possible, whereby, the buyer wants to make them as broad and far-reaching as possible.
Covenants are promises to perform in the future — such as loan agreements; they differ from representations. Representations are statements of past or present facts. Covenants focus on future performance. Sometimes, covenants are restrictive, preventing the buyer from selling assets, or taking on debt, so that no material adverse changes in the business performance will occur before closing.
Indemnification clauses protect the buyer/seller. An indemnification is nothing more than a promise by the buyer/seller to pay for any losses that causes harm to the other party. Indemnifications provisions sometimes include baskets and caps. They limit the liability for the seller. For example, if the basket is $100,000 and the cap is $2 million, then the buyer cannot make a claim under $100,000, and the buyer cannot claim more than $2 million in damages. If a buyer insists on establishing baskets and caps as a part of the definitive agreement, then the seller should insist on:
- Time limits on making a claim;
- Liability limits for the seller;
- A deductible that must be met by the buyer and must exceed a certain amount before a claim can be made;
- Insurance to cover any losses. The buyer must file an insurance claim before the buyer can sue the seller;
- Limits on the buyer suing the seller over anything that was disclosed in due diligence by the seller, or that was part of the representations and warranties that was not false.
As you can see, the definitive agreement is a complex document and requires a seller to study the details carefully. Although it is natural to focus on the purchase price of any transaction, the purchase price is only paid if the deal closes. Mark forgot that knowledge is power. Because Mark did not engage in the transaction process, or focus on the details of the definitive agreement, he wasn’t knowledgeable enough to make critical decisions in a timely manner. As a result, he lost the deal.
Gary Miller is CEO of GEM Strategy Management, Inc., a M&A consulting firm that advises small and medium sized businesses throughout the U.S. He represents business owners when selling their companies acquiring companies and raising capital. He has been a frequent keynote speaker at conferences and workshops on mergers and acquisitions. Reach Gary at 303.409.7740 or firstname.lastname@example.org.