Tax Treatment of Indemnification Payments
What is Tax Treatment of Indemnification Payments? The parties use this section to address how indemnification payments will be treated for tax purposes.
The Middle Ground: This provision states that indemnification payments made under the Agreement are to be treated as an adjustment to the Purchase Price for tax purposes, so long as such treatment is allowed by law.
Purpose: This is a technical term that allows the Indemnified Party to avoid paying tax on indemnification payments. It provides a benefit to one party without harming the other, and either party could be in the beneficial position at some point, so neither side will object to its inclusion and it likely won’t even be explicitly discussed.
Buyer Preference: None.
Seller Preference: None.
Differences in a Stock Sale Transaction Structure: None.
Payments
What are Payments? Here, the parties focus on the specific issue of when payments must be made following a valid indemnification claim.
The Middle Ground: This section provides a deadline for when indemnification payments must be made, how they must be made (e.g. by wire transfer), and dictates that interest is to accrue if the payment deadline is missed.
Purpose: This section is purely procedural and, standing alone, has little effect on deal value (and no effect on the other two classification factors). The parties may devote a small amount of negotiation time to determining the payment window and the interest rate that applies if that window is missed. However, those issues will typically be agreed upon quickly given the fact that they may never come into play and, even if they do, they don’t present a particular hardship to either side so long as the terms are reasonable. Furthermore, since either side could end up as the Indemnifying Party it is in both their best interests to institute reasonable and impartial payment terms.
Buyer Preference: The Buyer typically prefers a shorter payment period and a higher interest rate, but that preference will be tempered by the fact that it may end up making a payment subject to those terms.
Seller Preference: The Seller favors a longer payment period and a lower interest rate, but it will also want the terms to be reasonable since it could wind up on the receiving end of indemnification payments.
Differences in a Stock Sale Transaction Structure: None.
Certain Limitations
What is the Certain Limitations section? If no limits are set on the right to indemnification it is a tool that can be abused by the parties, especially in situations where there is not a working relationship between the Buyer and Seller after the Closing. Here, the parties implement boundaries around indemnification to avoid the problems caused by abuse of indemnification rights.
The Middle Ground: This provision limits the indemnification claims that can be brought by setting “Caps” and “Baskets” around the right to indemnification. A Basket sets a minimum amount of damages that must be incurred before an indemnification claim can be brought, and it is typically limited to claims based on breaches of the representations and warranties in the Agreement. Typically, the Basket sets a minimum threshold for making a claim and once that threshold is reached the injured party is eligible to receive 100% of the damages it suffered. A Cap may also be included, and it serves as an upper limit on the amount that will be paid in the event of a claim or the aggregate amount that will be paid out for all indemnification claims of a party.
Purpose: The purpose of a Basket is to prevent one party from trying to recapture some of the value given up in the deal by making numerous “nickel and dime” claims against the other side. In other words, it prevents the parties from abusing their indemnification rights. By doing so, the provision protects the parties’ expectations regarding their risk exposure and the value received from the transaction. Caps are also used as a tool to manage overall risk exposure, and they are especially important in situations where there is a reasonable potential for one of the parties to make a large indemnification claim. In addition to their risk management function, Caps and Baskets also increase the chances that the transaction will be completed by encouraging the parties to provide expansive indemnification rights since they know those rights are not subject to abuse and will not create unlimited liability.
Buyer Preference: The Buyer is the party most likely to bring an indemnification claim, which has a number of implications for how it wants to structure this provision. At the most basic level, it wants the Basket to be small (to allow for the payment of moderate claims) and the Cap to either be large or nonexistent. It may also want to tailor the Cap to its specific concerns; if the potential Losses based on one representation are much greater than for the other representations, the Buyer may be better off negotiating for a significantly higher Cap (or no Cap at all) in that area and a smaller Cap in the other areas than for a moderate Cap applicable to every representation. It certainly wants no Cap regarding any liabilities kept by the Seller, as it has no control over those liabilities. It also wants to carve out certain fundamental representations from the Basket and Cap, such as the Organization and Authority representations.
The Buyer wants to resist additional limitations on indemnification payouts, such as a Duty to Mitigate or a requirement to subtract from such payouts any tax or insurance amounts. However, when a Basket is included in the Agreement the Buyer is more likely to seek a “materiality scrape,” which is a provision that removes any materiality qualifiers from the representations and warranties for indemnification purposes. When a materiality scrape is used, the materiality qualifiers used in the representations and warranties still apply to limit what the Seller must disclose in the Agreement, but they do not apply for purposes of determining whether an indemnification claim can be brought and what the damages for the claim will be. The reasoning underlying the use of a materiality scrape in this context is that the Basket already screens out any non-material claims, so including an additional materiality requirement will likely complicate the indemnification process and lead to needless disputes.
Seller Preference: Since the Seller is going to be paying out an indemnification claim in most cases, it will typically seek a high Basket and a low Cap. In addition to this basic position, the Seller will also prefer a “deductible” Basket rather than a “dollar one” or “tipping” Basket. The distinguishing factor about deductible Baskets is that the Basket amount is more than just a threshold, it is also the amount deducted from the total damages to determine the required payment. To put it another way, with a deductible Basket the side making the claim is only entitled to the amount of damages exceeding the Basket amount. In lieu of a deductible Basket, the parties could settle on a hybrid approach, in which the amount deducted from the payout is less than the threshold amount but more than zero. Another beneficial option for the Seller is to include one or more “mini-baskets” that require damages from a particular representation to reach a certain amount before they are counted toward the overall Basket.
Over and above changing how the Basket functions, the Seller could also try to have the Basket apply to all representations, warranties, covenants, and obligations contained in the Agreement, not just the selected representations and warranties. Similarly, the Seller can try to negotiate for the Cap to extend to all indemnification claims. If unsuccessful on that front, the Seller can argue that some Cap (e.g. the Purchase Price amount) should be placed on payments for breach of fundamental representations and warranties, as well as the remaining covenants and obligations in the Agreement, even if that Cap is higher than the Cap applied to the non-fundamental representations and warranties.
Furthermore, the Seller can avoid a “double recovery” situation by including language reducing any indemnification payments by the amount of any insurance money paid to the Buyer for the claim, and it can make the language more effective by requiring the Buyer to use its reasonable best efforts to pursue any viable insurance claim. Another way to avoid double recovery is to reduce the amount of any indemnification claims that result in a tax benefit to the Buyer by the amount of the tax benefit. For instance, if the Seller breaches a representation and the Loss from that breach causes the Business to sustain a net operating loss (NOL) for the year, the amount of the indemnification claim would be reduced by the tax value of the NOL. One final way to limit double recovery applies in situations where the Agreement allows for a Purchase Price Adjustment, and the goal is to ensure that any such adjustment is subtracted from the Losses payable based on an indemnification claim. The Seller could also seek to impose on the Buyer a “Duty to Mitigate,” meaning the indemnified party would be required to try to reduce its damages from a breach by taking some sort of corrective action.
Finally, if the Agreement contains an escrow provision, the Seller can negotiate for its money held in escrow to be paid out to satisfy a claim for indemnification before it is required to pay money out of its own pocket to do so.
Differences in a Stock Sale Transaction Structure: None.
Survival
What is the Survival section? This section allows the parties to use indemnification to resolve post-Closing disputes. But what is indemnification? In short, it is a built-in enforcement mechanism that allows the parties to be made whole following a breach of the Agreement without going through the costly and time-consuming legal system. Rather than enforcing the representations and warranties (and, potentially, other areas of the Agreement) through litigation, the parties agree that certain breaches will be handled between the parties without going to court. For example, if the Buyer breaches a portion of the Agreement that is subject to indemnification, the Seller calculates the damage suffered because of the breach and makes a claim to the Buyer for payment. The Buyer can accept the claim and make the payment, or object and it is resolved by an agreed upon dispute resolution process (one that is meant to be faster and cheaper than litigation).
The Middle Ground: The Survival provision states that the representations and warranties (and any other provisions) subject to indemnification under the Agreement will survive after the Closing, and provides an explanation of when each representation is no longer applicable. Typically, the general survival period is anywhere between one and two years, with certain specified representations lasting for a longer period of time. The portions of the Agreement that tend to last longer than the baseline survival period include representations regarding fundamental corporate matters (i.e. organization and authority of both parties), Title to Purchased Assets, the Condition and Sufficiency of Assets, Taxes, Environmental Matters, and Employment Matters.
Purpose: Since most purchase agreements terminate at the Closing, certain portions must be identified for “survival” in order to remain effective after Closing. The indemnification provisions are some of the most important to survive termination of the Agreement. Without this survival clause, any cause for indemnification would have to be discovered prior to Closing, and that is simply not a reasonable expectation, especially for the Buyer who won’t take control of the Business until after the Closing. So, the Survival section is used to show how long claims for indemnification are available and ensures that those claims can be made after the ownership transition has taken place.
Buyer Preference: Ideally, the Buyer would be able to negotiate for indefinite survival of all representations, warranties, and covenants made by the Seller. In practice, that’s probably not going to happen since the Seller does not want to perpetually plan for the possibility of a claim, and because some states do not allow for contractual extension of a statute of limitations. To address the second concern, the Buyer has a couple options: (1) it can negotiate to change the governing law provision to a state with a longer statute of limitations or to a state that allows for contractual extension of the statute of limitations, or (2) state explicitly in the Agreement that a claim for indemnification does not accrue until the wrongdoing is discovered or should have been discovered. In addition to these general strategies, the Buyer wants to assess which representations, covenants, etc. present the greatest loss potential down the road and negotiate for the extended survival of those provisions. For example, whether companies are properly collecting sales tax has arisen as a major issue for buyers of e-commerce businesses, so the Buyer in that situation wants the representation relating to sales tax to survive for as long as it could be exposed to pre-Closing sales tax liability.
Seller Preference: Other than the payment provisions that favor the Seller and extend past the Closing, the Seller will prefer a short survival period for the representations, warranties, and covenants contained in the Agreement. That is because, by the nature of the transaction, the Buyer is more likely to bring a claim for indemnification than the Seller. In some jurisdictions, simply limiting the survival period is not enough to prevent an indemnification claim during that period; the survival language must actually limit the time in which a claim can be brought for a breach. Unlike the Buyer, the Seller should have intimate knowledge of where its risk lies regarding the Purchased Assets, so its top priority on this point is to attempt to limit the survival periods in those areas.
Differences in a Stock Sale Transaction Structure: None.
Transfer Taxes
What are Transfer Taxes? Some states tax certain aspects of a business acquisition, such as imposing taxes on the transfer of Owned Real Property. Here, the parties identify the party responsible for paying those taxes and taking care of any associated obligations.
The Middle Ground: This covenant requires the Seller to pay all taxes and fees incurred in connection with the transfer of the Purchased Assets (“transfer taxes”) when such taxes come due, and calls for the Buyer to reimburse the Seller for 50% of the taxed amount. It also requires the Seller to make any necessary filings in relation to transfer taxes, with the Buyer’s cooperation.
Purpose: This main function of this requirement is to ensure that someone pays the transfer taxes so that neither side has to deal with fines or other penalties resulting from one or both parties overlooking their tax obligations. The likelihood is that the Buyer and Seller will not even discuss it and will simply accept the local custom to determine who pays.
Buyer Preference: The Buyer wants the Seller to pay the transfer taxes, but will usually settle for either splitting the bill or allowing local custom to dictate the outcome.
Seller Preference: Similarly, the Seller wants this obligation to fall on the Buyer but will typically agree to a 50-50 split or to defer to local custom.
Differences in a Stock Sale Transaction Structure: None.
Non-Solicitation of Employees and Clients
What is Non-Solicitation of Employees and Clients? In addition to limiting the Seller’s ability to compete, this covenant is another way for the Buyer to protect the value of the Business post-Closing. Because non-compete covenants are limited to a certain geographic area, buyers include this covenant to protect relationships with customers and employees in case the Seller decides to compete in a geographic area that is not covered by the non-compete restriction.
The Middle Ground: This covenant prevents the Seller and its Affiliates from attempting to lure employees away from the Business. It may also prevent the solicitation of clients and prospective clients of the Business, if that restriction is not included in the Non-Competition covenant. In regard to employees of the Business, the restriction is typically aimed at employees who have been offered employment by the Buyer, but does not apply to general solicitations, employees terminated by the Buyer, or employees who terminated their own employment with the Business after a specified time period.
Purpose: The Seller has a massive informational advantage over the Buyer in being able to identify the key employees and clients of the Business. If the Seller were allowed to poach them away from the Business, it could easily decimate the value of the Buyer’s investment. Put another way, the Buyer agrees to a Purchase Price based on expectations for how the Business will perform in the future, and the purpose of this covenant is to protect those expectations.
Buyer Preference: Similar to other restrictive covenants, the Buyer wants this covenant to be as broad as possible while still being enforceable. That means any and all restrictions should be rationally related to protecting the Business. The Buyer may also seek to prevent the general solicitation of employees (and will surely want to do so for clients), and it will want the restrictive language to apply to the Seller’s affiliates and to indirect attempts to solicit employees.
Seller Preference: The Seller wants to include all exceptions contained in the middle ground term, and additionally it might try to reduce the waiting period required to hire any employees who leave the Business of their own volition. It may also want to reduce the effective period for this covenant, if there is a logical reason for it to be shorter than the effective period for the non-compete covenant (generally the Buyer wants the time periods to mirror one another for ease of enforcement). An ambitious Seller may want to avoid this covenant altogether, but most Buyers will refuse to make an acquisition without some protection regarding clients and employees of the Business.
Differences in a Stock Sale Transaction Structure: None.
Non-Competition
What is the Non-Competition section? One of the ways a Buyer protects its investment is by limiting future competition by the Seller, who is more knowledgeable about the Business (and often the industry) than the Buyer. By limiting competition from the Seller, this covenant protects the Business’s relationships with customers, suppliers, employees, and other stakeholders.
The Middle Ground: In most acquisitions, the Seller agrees not to compete with the Business after the Closing. The covenant terms describe who is not allowed to compete (generally, the Seller and its Affiliates); the duration of the restriction, which varies from state to state based on differences in state law (typically anywhere from 1-10 years); the specific acts that are restricted, either defined in detail or by reference to the acquired Business (e.g. any business that directly or indirectly competes with the Business); the geographic scope of the restriction, which is also either defined in detail or based on where the Business operates; and any exceptions to the restriction on competition. The covenant will likely also prevent the Seller from inducing any current or prospective clients to end their relationship with the Business, although this restriction is sometimes included in a separate non-solicitation covenant.
Purpose: This covenant is an essential component of the Agreement because of its impact on the value of the deal to the Buyer. In small to mid-sized businesses, much of a company’s value is derived from the owner’s relationships with customers, suppliers, and others in the community. Significant value also stems from the owner’s know-how and familiarity with the industry. If the owner were to go out and start a competing business following the acquisition, the value of the Business in the hands of the Buyer would likely plummet.
Buyer Preference: The Buyer wants each term in the covenant other than the exceptions to be defined as broadly as possible while still being enforceable. Restrictive covenants such as non-compete agreements are disfavored by the courts. In this context, that means overbroad restrictions that don’t directly protect the acquired Business will likely not be enforced. Whether a restriction goes too far depends on the facts and circumstances surrounding the particular acquisition, as well as the state law that governs the Agreement, so it’s important to tailor the covenant terms to the situation.
Seller Preference: Whether the Seller wants to spend significant time and effort negotiating these terms depends on its post-acquisition plans, but in general it wants the restrictions to be as limited as possible and the exceptions to be plentiful. More specifically, if the Seller plans to invest in other ventures following the acquisition it wants to make sure that this covenant does not prevent it from doing so. Some investments will undoubtedly be restricted (e.g. investing in a direct competitor), but the Seller wants to make sure that any such restrictions are directly related to protecting the value of the Business. If the Seller is only selling a division of its business, it also needs to make sure none of the restrictions affect its ongoing operations.
Differences in a Stock Sale Transaction Structure: None.
Confidentiality and Non-Disparagement
What is the Confidentiality and Non-Disparagement section? All businesses possess information that is beneficial to them because it is not known by the public (e.g. customer lists, trade secrets, etc.). Prior to the Closing, the Seller protects that information by requiring the Buyer to keep non-public information confidential. Post-Closing, the Buyer wants to place a similar confidentiality requirement on the Seller, and this covenant is used to accomplish that goal.
The Middle Ground: This covenant requires the Seller, its Affiliates, and its Representatives to use their reasonable best efforts post-Closing to keep confidential all information about the Business that is not otherwise publicly available. It also requires the Seller to take certain precautions if it is required by law to disclose the information, such as only providing information it is legally required to provide (as advised by legal counsel) and taking steps to limit who is able to access the confidential information that is disclosed. The parties also agree not to make negative or disparaging comments about each other to third parties.
Purpose: This covenant is intended to protect the value of the Business after the transfer of ownership has occurred by protecting the confidential information of the Business. For a serial buyer such as a private equity firm, it also protects future deals by preventing the Seller from providing potential future sellers with information about terms the Buyer is willing to accept and/or the Buyer’s negotiation strategies.
Buyer Preference: The Buyer wants to pay close attention to the definitions of Affiliates and Representatives to ensure that everyone who has access to the information sought to be protected has a duty of confidentiality with regard to that information. If the sale was initially conducted by auction, expansive definitions of Affiliates and Representatives may not adequately protect the Buyer’s risk, so the Buyer can have the Seller assign the confidentiality agreements signed by the other auction participants to protect the Business’s sensitive information. The Buyer also wants to be able to enforce this covenant using an injunction rather than indemnification, because preventing a violation is more valuable than receiving monetary compensation after one has occurred. To achieve that goal, the Buyer should explicitly carve out this covenant from the Exclusive Remedies provision.
Seller Preference: The Seller may want to include language indicating that the Buyer’s confidentiality obligations (often originating in the Letter of Intent) apply to information disclosed pursuant to the Agreement and that the Buyer’s confidentiality obligations survive termination of the Agreement. Essentially, such language provides protection for the Seller if the deal does not go through. The Seller will also pay attention to the scope of the disclosure restrictions so it can avoid being penalized for sharing information that doesn’t have the potential to hurt the Business or the Buyer.
Differences in a Stock Sale Transaction Structure: None.
Notice of Certain Events
What is Notice of Certain Events? The Buyer makes its decision to invest based on the information available to it, but new or changed information could lead to a different decision. The Buyer can use this section to identify the types of information that may change its decision and to ask the Seller to communicate such information as it is received.
The Middle Ground: This covenant requires the Seller to notify the Buyer if certain events occur and provides a list of events for which notice is required. That list includes events that would or have had a Material Adverse Effect on the Business, anything that would make a Seller representation or warranty untrue, and anything that prevents the Seller from satisfying its Conditions to Closing, among others. The covenant also explicitly states that providing notice of the listed events does not result in the Buyer losing its right to make an indemnification claim or terminate the Agreement.
Purpose: Without this notice requirement, the Buyer would be forced to spend considerable time and money checking on the status of its potential investment at a point in time when someone else (the Seller) has much better knowledge and access. In that scenario, the cost and risk are all on the Buyer, who would likely pass along some of those costs to the Seller by lowering the Purchase Price. With this covenant, the Seller monitors the Business and the Buyer’s cost of obtaining the information is eliminated, as is some of its risk, which means more money in the Seller’s pocket and a safer investment for the Buyer.
Buyer Preference: The Buyer does not want a disclosure under this covenant to prevent it from claiming indemnification or terminating the Agreement, so an explicit statement that the covenant does not affect those rights is in the Buyer’s best interest (and may be necessary, depending on the circumstances and governing state law). If the Seller insists on limiting the Buyer’s indemnification rights for information known prior to the Closing, the Buyer can compromise by negotiating for a Cap and/or Basket on the indemnification rights stemming from any such information.
Seller Preference: If notice is given based on this covenant that corrects an inaccuracy or breach of one of the Seller’s representations or warranties, the Seller wants the notice to serve as a cure for that inaccuracy or breach to prevent an indemnification claim. If the Buyer wants to reserve its right to terminate the Agreement or bring an indemnification claim, the Seller can try to negotiate (1) for a limited time period to terminate the Agreement or make a claim, (2) to impose a materiality or Material Adverse Effect standard on cured representations and warranties, or (3) to institute a procedure for resolving these disputes before the Buyer is allowed to terminate the Agreement.
Differences in a Stock Sale Transaction Structure: None.
Conduct of Business Prior to Closing
What is Conduct of Business Prior to Closing? The Buyer’s due diligence investigation and, ultimately, its decision to buy the Business assume that the Business will continue to operate as it has in the past until the Closing Date (i.e. while the Seller is still in charge). Here, the Seller promises not to make any major changes to the Business without the Buyer’s consent.
The Middle Ground: This covenant requires the Seller to conduct the Business consistently with how it has been conducted in the past and to use reasonable best efforts to maintain the Business’s operations and relationships prior to the Closing. In addition to those general directives, the Seller agrees not to deviate from certain practices without the Buyer’s consent, such as paying debts and taxes when due and performing its duties under the Assigned Contracts.
Purpose: The Buyer bases its valuation of the Business in part on how it has been conducted by the Seller in the past. The best way to protect that value is to ensure that the Business is operated the same way between the signing and Closing as it was in the past. Without this provision, the Buyer would be stuck with the risk stemming from some fundamental change in the Business that occurs after the Buyer signs the Agreement. With it, that risk is shifted to the Seller, who is in the best position to prevent those changes from taking place.
Buyer Preference: Here, the Buyer may want to include a comprehensive list of both the actions the Seller is required to take prior to the Closing and those it is forbidden from taking. If the Buyer is financing the acquisition, the list should also include anything the Seller must do in order for the Buyer to obtain financing. For maximum protection, the Buyer can require consent on all material operational decisions, but there are two important limits on such a requirement. From a practical standpoint, the Buyer may not have the time or expertise to make those decisions, and it would be best served by letting the Seller continue ordinary operation of the Business. From a legal standpoint, if the Buyer and Seller operate in the same industry they must be careful to avoid violating antitrust law by consolidating control before they obtain the proper approval (if governmental approval is required).
Seller Preference: The Seller wants as few restrictions listed here as possible so that it does not inadvertently violate the Agreement. It also wants language in the covenant that allows it to back out of a particular duty if the Buyer consents, with the Buyer’s consent governed by a standard of reasonableness (e.g. the Buyer cannot unreasonably withhold or delay consent). The Seller may also try to mitigate some of the Buyer’s requested restrictions by narrowing their applicability where it makes sense to do so. Both parties want to avoid antitrust issues, so they may include a “No Control of Other Party’s Business” clause if the list included here is particularly comprehensive and/or restrictive.
Differences in a Stock Sale Transaction Structure: None.
Absence of Certain Changes, Events, and Conditions
What is This? In this section, the Seller provides information regarding the current state of the Business. It is part of the Representations and Warranties of Buyer section.
The Representations and Warranties of Buyer portion of the Agreement is used to save the Seller time and money. Rather than require the Seller to go through third parties to find certain information, the Buyer provides the information and must reimburse the Seller for any Losses it suffers if the information is false or misleading.
The Middle Ground: In this provision, the Seller represents that certain aspects of the Business (e.g. accounting practices) have not changed, or certain events or conditions have not occurred, since the Balance Sheet Date. The most important inclusion in this section is the representation that nothing has occurred since that date that could reasonably have a Material Adverse Effect on the Business. The representation excludes changes, events, and conditions that occur in the ordinary course of business and are consistent with the Seller’s past practices.
Purpose: A Buyer’s decision to invest in a business involves the consideration of dozens of different factors, and sometimes it is just one of them that tips the balance from a “pass” to a “buy.” If the Business undergoes a significant change after the investment decision is made, the Buyer may want to reassess its calculation. This clause allows the Buyer to identify the changes it is most concerned about, and in doing so, it requires the Seller to disclose such changes or represent that they have not occurred.
Buyer Preference: The Buyer wants the list of prohibited changes, events, and circumstances to be comprehensive. It may also want to prevent changes to the Seller’s cash management and accounting practices, especially if the deal involves a Purchase Price adjustment that could be manipulated by varying such practices. In defining Material Adverse Effect, the Buyer wants to strike a balance between a broad definition that encompasses the Buyer’s major concerns and a definition that is relatively easy to measure and enforce. Many buyers are uncomfortable with the vague nature of the materiality standards used, and instead use dollar amount thresholds to qualify certain aspects of the list.
Seller Preference: The Seller wants a short list of prohibited changes, events, and circumstances, especially if they are not likely to affect the Buyer or the Purchased Assets after Closing. The Seller is typically more comfortable with the Material Adverse Effect standard than is the Buyer because it is difficult to enforce, and the same can be said for the other materiality standards in this section. However, if the Buyer insists on dollar thresholds, the Seller will want those thresholds to be as high as possible.
Differences in a Stock Sale Transaction Structure: The list of prohibited changes is likely to be longer in a stock sale because the Buyer is purchasing the entire business instead of certain assets.
Employment Matters
What are Employment Matters? In this section, the Seller provides information regarding its responsibilities to employees and compliance with various employment-related laws. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: In the Employment Matters representation and the related Disclosure Schedules, the Seller provides the name and other employment-related information for all employees, independent contractors, and consultants of the Business. The Seller then represents that:
(1) All compensation has been paid to those employees, contractors, and consultants, and there are no related ongoing financial commitments except for those listed in the Disclosure Schedules;
(2) It is not bound by any collective bargaining agreement or other contract with a labor union and that no such union or group of employees has sought to organize for the purpose of collective bargaining (again, exceptions are provided via the Disclosure Schedules);
(3) It has no duty to bargain with any union, and its employees have not been involved in any concerted refusals to work;
(4) The Business complies with all applicable employment laws and no employment-related claims are pending or, to the Seller’s knowledge, have been threatened or filed against the Business;
(5) It has complied with the WARN Act and has no plans to undertake any action that would trigger the WARN Act provisions (if the WARN Act is applicable to the Business); and
(6) It complies with all regulations required of government contractors and it has not been the subject of an investigation, audit, or enforcement action by any Governmental Authority in connection with a Government Contract.
Purpose: These representations and disclosures give the Buyer a good sense of its employment-related risk and allow it to shift some of its risk to the Seller (namely, the risk stemming from one of the situations outlined above). This information also helps set the Buyer’s expectations in terms of overall employee-related costs and the level of formality required when addressing compensation issues with employees.
Buyer Preference: The Buyer wants this section to be expansive, with no knowledge qualifiers or time restrictions for the disclosures and representations. Additionally, if the Seller is in fact a government contractor, the Buyer will want to include representations that speak to the Business’s compliance with government-mandated employment requirements.
Seller Preference: It’s quite likely that not every representation listed here will apply to the Business (e.g. it is not a government contractor or the WARN Act does not apply). At a minimum, the Seller wants to exclude those inapplicable representations. The Seller also wants to cap the time periods to make certain disclosures, such as the disclosures relating to union organizing activity, as a way to keep transaction costs under control and limit the risk from an immaterial misrepresentation. The Seller can also limit its risk by including materiality or knowledge qualifiers when appropriate.
Differences in a Stock Sale Transaction Structure: None.
Employee Benefit Matters
What are Employee Benefit Matters? In this section, the Seller provides information regarding employee benefits. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The disclosures and representations made by the Seller in this section include:
(1) The disclosure of all Benefit Plans, written or unwritten, to which the Seller has contributed or under which the Seller or Buyer may have (or reasonably expect to have) any liability;
(2) That the Seller has provided to the Buyer, for each Benefit Plan, accurate and complete copies of the following: (i) the plan documents and amendments for plans that are in writing; (ii) for unwritten plans, a written summary of the material plan terms; (iii) copies of trust agreements or other funding arrangements, insurance contracts, administration agreements, investment agreements, and custodial agreements that are currently in effect or required in the future; (iv) written communications relating to any Benefit Plan, including summaries of plan descriptions and any material modifications to the plan; (v) correspondence from the IRS regarding any Benefit Plan that is intended to be qualified under Internal Revenue Code (the “Code”) §401(a); (vi) a copy of the two most recently filed Form 5500s (if applicable), with attached schedules and financial statements; (vii) recent actuarial valuations for applicable Benefit Plans; (viii) the most recent nondiscrimination tests performed under the Code; and (x) copies of material notices and correspondence from any Governmental Authority relating to the Seller’s Benefit Plans;
(3) Each Benefit Plan (and any related trusts) has been established and maintained in compliance with all applicable laws; nothing has occurred that has subjected or reasonably could subject the Seller or any of its ERISA Affiliates, or the Buyer or its Affiliates, to a penalty or tax under ERISA or the Code; all benefits, contributions, and premiums have been timely paid; and all benefits accrued under any unfunded Benefit Plan have been paid or accrued and reserved for in accordance with GAAP, if the Business follows GAAP;
(4) Neither the Seller nor any of its ERISA Affiliates has (i) incurred any material liability with respect to Title I or Title IV of ERISA or any related Code provisions or local laws; (ii) failed to timely pay premiums to the Pension Benefit Guaranty Corporation; (iii) withdrawn from a Benefit Plan; or (iv) engaged in any transaction that would give rise to liability under §4069 or 4212(c) of ERISA;
(5) With respect to each Benefit Plan: (i) any Multiemployer Plans in which the Seller participates have been disclosed, all premiums have been timely paid, and no withdrawal liability is outstanding or will be incurred upon a future withdrawal from the plan; (ii) no plan is considered a “multiple employer plan” under §413(c) of the Code or a “multiple employer welfare arrangement” under ERISA; or (iii) the Pension Benefit Guaranty Corporation has not taken any action to terminate or appoint a trustee to any such plan; (iv) no such plan is subject to the minimum funding standards or ERISA and none of the Purchased Assets are, or may reasonably be expected to become, subject to a lien arising under ERISA or the Code; and (v) no “reportable event” as defined in ERISA §4043 has occurred with respect to any such plan;
(6) Except as disclosed, no Benefit Plan or other arrangement involving the Seller requires it to provide post-termination or retiree welfare benefits to any individual;
(7) Except as disclosed, there is no pending or, to Seller’s knowledge, threatened Action relating to a Benefit Plan (other than routine benefits claims), and no Benefit Plan has been the subject of an examination or audit by a Governmental Authority or is involved in an amnesty or similar compliance program sponsored by any Governmental Authority;
(8) There has been no change in relation to any Benefit Plan, and Seller has not agreed to make any change in the future with respect to any such plans, that would increase the annual expense of maintaining such plan in comparison to the most recently completed fiscal year. Furthermore, neither Seller nor its Affiliates have committed to adopt, modify, or terminate any Benefit Plan currently in effect;
(9) Each Benefit Plan that is subject to §409A of the Code has been administered in accordance with that section of the Code and Seller does not have any monetary obligations to any third party in relation to §409A;
(10) Except as disclosed, execution of the Agreement or any transactions pursuant to the Agreement will not materially alter the Business’s obligations arising out of any Benefit Plan.
Purpose: By making these representations, the Seller is accepting the risk of any outstanding liabilities under its benefit plans, including the risk of non-compliance with ERISA or the Code. However, the representations do not relieve the Buyer from potential liability for ongoing violations that persist after the sale, so it should pay special attention to the disclosures made in this section of the Disclosure Schedules if it is adopting the Seller’s plan(s). In terms of deal value, the transaction costs of both parties will increase based on this section because it requires review by a benefits plan expert (or, more accurately, an expert review is highly recommended). However, the experts’ review will limit the risk associated with the Benefit Plan(s), making it a sound investment for both sides.
Buyer Preference: The Buyer may want to retain an employee benefits specialist to determine which of these representations need to be included for each specific situation. In general, the Buyer wants robust disclosure requirements and comprehensive representations that do not include knowledge or materiality qualifiers.
Seller Preference: The Seller may want to retain an employee benefits specialist to assess whether the Seller has been compliant with its plans and to advise as to which representations should and should not be included in the Agreement. In most situations, its interests will be the opposite of the Buyer’s; the Seller will want limited representations that ignore immaterial issues and that are based on the Seller’s knowledge.
Differences in a Stock Sale Transaction Structure: The Buyer will typically want more comprehensive disclosures and representations in a stock sale because the Buyer is assuming the Seller’s liabilities. In an asset acquisition, liabilities relating to any Benefit Plan of the Seller are usually expressly excluded from the transaction.
Accounts Receivable
What are Accounts Receivable? In this section, the Seller provides information regarding the Business’s Accounts Receivable. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The typical representations in this section include: (1) Accounts Receivable figures are based on legitimate transactions that are consistent with past practice; (2) the amounts are not disputed by the person or business on the other side of the transaction; and (3) the amounts will be collectible within some standard time frame, taking into consideration the company’s “bad debt allowance” that has been computed based on prior experience.
Purpose: The Accounts Receivable portion of the balance sheet indicates the strength of a company’s incoming cash flow and provides the Business with some assurance that it will be able to pay future debts. It is an essential component of the working capital calculation, which is often directly tied to the valuation of the Business. Therefore, it has a significant impact on the final Purchase Price. Additionally, if a company has sold its Accounts Receivable to another company (called a “factoring relationship”), that can have a substantial negative effect on a company’s value.
Buyer Preference: The Buyer wants to include the middle ground term as a baseline representation and may want to include additional receivables accounts if they make up a significant portion of the business.
Seller Preference: Since Accounts Receivable is an item on the Balance Sheet, the Seller wants to exclude this representation on the grounds that it is covered by the Financial Statements representation. In lieu of complete removal, the Seller may try to remove the language referencing collectability of Accounts Receivable since the ability to collect payment within a set time frame relies largely on the actions of third parties over which the Seller has little or no control.
Differences in a Stock Sale Transaction Structure: None.
Inventory
What is Inventory? In this section, the Seller provides information regarding the inventory of the Business. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The Seller represents that the inventory held by the Business is consistent with the Business’s past practices, in terms of both quality and quantity. The Seller also represents that the inventory does not have any Encumbrances that would prevent its sale.
Purpose: Inventory is another area that drives some companies but is utterly irrelevant for others. If inventory is a necessity it will receive significant attention during the due diligence process. Buyers want to know everything about it: how much there is, how often it comes in and goes out, how is it accounted for, etc. On the other end of the spectrum, inventory is a non-issue on which neither side will spend much time or money.
Buyer Preference: The Buyer wants this representation included if inventory is an essential part of the Business, and it wants to be specific about the representation to ensure that the inventory referred to is sufficient to satisfy customer needs and expectations.
Seller Preference: The Seller likely wants to exclude this representation entirely. Since inventory is an item listed on the balance sheet, the Seller may argue that the issue is adequately covered by the financial statement representations contained elsewhere in the Agreement.
Differences in a Stock Sale Transaction Structure: None.
Intellectual Property
What is Intellectual Property? In this section, the Seller provides information regarding the intellectual property used by the Business. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: This section requires the Seller to make a number of disclosures and representations relating to the Intellectual Property (“IP”) used in the Business. Specifically, the Seller will be asked to provide lists in the Disclosure Schedules of:
Registered IP;
Unregistered IP Assets;
All IP Agreements; and
All joint owners of IP Registrations and/or IP Assets;
The Seller will be asked to represent that:
All required filing fees and administrative tasks relating to the Registered IP have been taken care of;
It has provided all documentation relating to the Registered IP to the Buyer;
Each IP Agreement is valid, binding, and is currently in full force and effect;
It is not in breach or default of any IP Agreement and, to its knowledge, neither is any other party to those agreements;
No party to the Seller’s IP Agreements have indicated a desire to terminate those agreements;
No events have occurred that would cause default of, result in termination of, or otherwise alter the rights of any party to any of the Seller’s IP Agreements;
It is the sole owner of all IP Registrations and IP Assets used in the Business, other than those disclosed in the Disclosure Schedules;
It has the right to use the IP disclosed in the Disclosure Schedules in the Business, free and clear of Encumbrances other than Permitted Encumbrances;
It has entered into written agreements with every current and former employee and independent contractor to (i) assign to the Seller any rights related to IP used in the Business, and (ii) acknowledge the Seller’s exclusive ownership in any such IP;
The IP Assets and the IP licensed under the IP Agreements, taken together, constitute all the IP necessary to conduct the Business as previously conducted;
The transaction does not create additional requirements for the Buyer to use the IP as it is currently used to conduct the Business;
Its rights in the IP Assets are valid and enforceable, and it has taken all reasonable steps to protect the confidentiality of all IP Assets, including requiring all Persons with access to trade secrets to sign written non-disclosure agreements;
The Business’s use of IP does not violate the IP rights of any Person, and no Person has violated the Business’s IP rights;
There are no settled, pending, or threatened Actions (i) alleging infringement by the Seller of third party IP, (ii) challenging the validity or enforceability of the IP Assets or the Seller’s rights to the IP Assets, or (iii) brought by the Seller alleging infringement or any other violation of the IP Assets; and
There is no outstanding or prospective Governmental Order restricting the Seller’s use of the IP Assets in any way.
Purpose: Much like real property, intellectual property can drive the value of a business or it can be next to irrelevant. Without its famous trade secret protections, Coca-Cola would have lost its main competitive advantage (its distinctive taste) long ago. Disney relies heavily on copyright protection to maximize the profits from its most famous characters, which is why they have repeatedly sought to extend the term for copyright protection. Any company that relies on its brand name or logo as a source of competitive advantage is enjoying the protections of trademark law, even if their trademark is not registered. On the other hand, some businesses rely almost entirely on product or service quality to succeed. If their quality drops for any significant period of time, their competitors will simply eat up their share of the market. Therefore, in some transactions the parties will rightly spend extensive time and money to make sure the Seller’s IP is protected and properly transferred. In others, the topic will be an afterthought.
Buyer Preference: The Buyer wants these representations to be as broad as possible to encompass all IP used by the company. On the whole, and particularly with respect to infringement, the Buyer also wants to exclude knowledge or materiality qualifiers. If the Seller’s statements and disclosures are qualified, the Buyer either has to expend extra resources to verify ownership and/or non-infringement, or it has to live with a significant amount of additional risk. From the Buyer’s perspective, the risk of IP infringement or non-ownership should rest with the one who created and/or has controlled the IP.
Seller Preference: The Seller wants to include a materiality qualifier for these disclosures, and it may also want its representations in this section to include a knowledge qualifier. Both approaches help the Seller limit its costs, while providing the Buyer with the information necessary to operate the business. As a minimum precaution, the Seller wants to limit the third-party infringement representation using a knowledge qualifier, as conclusively verifying that no third-party infringement has occurred may be practically impossible.
Differences in a Stock Sale Transaction Structure: The representations relating to intellectual property will not be as extensive in a stock sale as in an asset acquisition. For example, the Seller’s ability to assign the IP it uses is not an issue in a stock sale because there is no need to transfer the IP to a new entity.
Real Property
What is Real Property? In this section, the Seller provides information regarding the real property used by the Business. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: In the Real Property representation and the corresponding Disclosure Schedules, the Seller discloses the Owned Real Property and Leased Real Property used by the Business and represents that: (1) it has not received notice of any building code violations, zoning ordinance violations, or violations of any other laws or governmental restrictions; (2) there are no existing, pending, or threatened condemnation proceedings affecting Real Property used by the Business; (3) the disclosed Real Property is sufficient to conduct the Business as conducted prior to the Closing; and, (4) no other real property is necessary to conduct the Business as conducted prior to the Closing.
With respect to the Owned Real Property, the Seller represents that it has marketable fee simple title free of any Encumbrances other than those listed in the Disclosure Schedules and the Permitted Encumbrances, that it has not leased the property or given anyone permission to use it (other than as disclosed in the Disclosure Schedules), and that no one holds any option rights on the property (e.g. rights of first refusal or rights of first offer).
With respect to the Leased Real Property and each individual lease, the Seller represents that the lease is valid and possession of the property is undisturbed, all rent due has been paid and nothing has occurred that would result in breach or default, there has been no notice given regarding termination of the lease, and the Seller has not created an Encumbrance on its interest in the property.
Purpose: For some businesses, real property such as office space is merely a necessary but fungible tool. With a little planning, the business could easily move down the street or to another part of town without breaking stride. For other companies, the real property they own or lease is itself the business, and the company would not be nearly as valuable if that specific property was not included in the transaction. The result is that some acquisition negotiations will focus heavily on real property and will require the input of real property experts, while others will deal with real property issues quickly and move on.
Buyer Preference: If the Real Property held by the Business is an important aspect of the deal, the Buyer will want to consult a real property attorney regarding the content of the Seller’s representations, the mechanics of transfer, and necessary due diligence procedures. Generally, as the importance of property to the Business increases, the Seller’s representations and Buyer’s property-focused due diligence will increase as well.
Seller Preference: The Seller wants to limit its representations as much as possible. For example, the representation regarding notice of building code or zoning ordinance violations is arguably covered by the more general “Compliance with Laws” representation, so the Seller may try to exclude the more specific representation contained in this section. The Seller can also constrain its representations by adding materiality or knowledge qualifiers, and by limiting its title representation to “valid” or “insurable” title rather than “marketable” title.
Differences in a Stock Sale Transaction Structure: Because a transfer of property is not necessary in a stock sale, representations regarding Owned and Leased Real Property are included with the Title to Purchased Assets representation (i.e. the property is treated, for the most part, as just another asset). There are a few representations that pertain only to the Seller’s Owned Real Property, but they are more focused on providing the administrative information necessary to operate the Business rather than focusing on the transferability of the property.
Condition and Sufficiency of Assets
What is the Condition and Sufficiency of Assets? In this section, the Seller provides information regarding the usefulness of the Purchased Assets. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The Condition and Sufficiency of Assets representation asserts that each asset being transferred is in good operating condition and, other than the need for ordinary maintenance and non-material repairs, is suitable for use in the same way as it was being used in the Business prior to the transaction. It also states that the Purchased Assets are sufficient to conduct the Business in the same manner as it was conducted prior to the transaction.
Purpose: This representation gives the Buyer comfort that it is purchasing everything necessary to conduct the Business as previously conducted, and if that’s not the case the risk of loss will fall on the Seller. As the party with vastly superior knowledge on the issue, the Seller is in the best position to take on that risk, and allocating the risk this way also ensures that the Buyer receives the full value of the bargained-for assets.
Buyer Preference: Although the “Sufficiency of Assets” portion of the representation states that the Purchased Assets are sufficient to operate the business as previously conducted, as a safeguard the Buyer may want to add a representation that none of the Excluded Assets are material to operation of the Business.
Seller Preference: The Seller would prefer to limit this representation to the statement that the Purchased Assets are sufficient to operate the Business. Instead of attesting to the condition of the Purchased Assets, the Seller can allow the Buyer to inspect the property and assets. The Seller also wants to omit the representation regarding the Excluded Assets because it addresses the same concern as the Sufficiency of Assets representation.
Differences in a Stock Sale Transaction Structure: In a stock sale where the business being purchased is an independent entity as opposed to being part of a larger group, the Sufficiency of Assets representation is not necessary. However, if the stock purchase relates to a company that is part of a parent/subsidiary structure that shares the use of certain assets, the Sufficiency of Assets representation should be included in the Agreement.
Title to Purchased Assets
What is the Title to Purchased Assets? In this section, the Seller provides information regarding its ownership of the Purchased Assets. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: Here, the Seller represents that it has good and valid title to, or a valid leasehold interest in, all of the Purchased Assets (i.e. it is the legal owner or lessee of all the Purchased Assets). It also represents that the Purchased Assets are free and clear of any Encumbrances other than Permitted Encumbrances. The remainder of the clause is devoted to defining Permitted Encumbrances (usually in list form). Permitted Encumbrances are generally limited to Encumbrances that are not material to the Business or the Purchased Assets, either individually or when taken together.
Purpose: In an asset sale, the Buyer is purchasing every single asset for a reason, so it’s important that the Seller is able to transfer every single asset according to the transaction terms. Its failure to do so could meaningfully alter the value of the deal for the Buyer. This clause and the Indemnification section of the Agreement place the risk of that failure squarely on the Seller’s shoulders so that the Buyer is compensated for any such loss in value.
Buyer Preference: The Buyer wants this section to apply to all the Purchased Assets to avoid receiving assets with Encumbrances other than the Permitted Encumbrances. Furthermore, it wants to limit the list of Permitted Encumbrances to those Encumbrances that do not impede the use or reduce the value of the Purchased Assets. The Seller may insist on excluding Intellectual Property Assets from this representation because they are addressed in a separate section of the Agreement, and if that is the case the Buyer wants to make sure there is a similar representation included in the Intellectual Property section.
Seller Preference: The Seller wants to limit this representation to tangible personal property (which excludes Intellectual Property). If Intellectual Property is included in this representation, the Seller wants to make sure that the representation does not exceed the scope of what is required by the Intellectual Property section of the Seller Representations and Warranties. Also, instead of qualifying the Permitted Encumbrances using a general materiality standard, the Seller may want to argue for the narrower Material Adverse Effect standard. The Seller also wants an expansive definition of Permitted Encumbrances, including a catchall clause for any Encumbrances that would not have a Material Adverse Effect on the Business.
Differences in a Stock Sale Transaction Structure: There is a minor drafting difference when using a stock sale structure, which is that use of the phrase “purchased assets” is not accurate since the entire company, not just the assets, is being purchased.
Material Contracts
What are Material Contracts? In this section, the Seller provides information regarding the Business’s contracts. It is part of the Representations and Warranties of the Seller section.
The Representations and Warranties of Seller portion of the Agreement is used to save the Buyer time and money. Rather than require the Buyer to go through third parties to find certain information, the Seller provides the information and must reimburse the Buyer for any Losses it suffers if the information is false or misleading.
The Middle Ground: The Material Contracts provision defines the term “Material Contracts” and requires the Seller to list all the Material Contracts affecting its Business in the Disclosure Schedules. It also includes a Seller representation that those contracts are valid, binding, and in full force and effect and that the Seller is not in breach or default under them. The representation also states that there are no material disputes, pending or threatened, related to the Material Contracts.
Purpose: This representation plays a major role in allocating the risk that stems from the Business’s Material Contracts. For many companies the Material Contracts will make up the bulk of its business, so the representation that those contracts are valid, have not been breached, and are not the subject of any material disputes is a valuable one. In addition to the representation, having access to the contracts themselves gives the Buyer extensive insight into the Seller’s operations and standards – information that is tremendously important during the transition phase.
Buyer Preference: The Buyer wants to carefully consider what constitutes a Material Contract in the target’s industry and Business and include those attributes in the definition of Material Contracts. In addition to the list of attributes, the Buyer wants to include a catchall category that uses a materiality standard to encourage disclosure in borderline situations. Because non-Assigned Contracts may affect the value of Assigned Contracts, it is best for the Buyer if Material Contracts are not limited to Assigned Contracts. A Buyer may also want a representation that no party is in breach or default of any Material Contract.
Seller Preference: The Seller wants to limit this disclosure to Assigned Contracts since those are the contracts with which the Buyer will be involved. It also wants to limit its representation regarding breach or default under the Material Contracts to its own breach or default rather than speaking for all contract parties. As a compromise, it may allow the representation to be included for all parties if a knowledge qualifier is added.
Differences in a Stock Sale Transaction Structure: None.