This is a whole series of articles on Mergers and Acquisitions, make sure to check all other articles including:
Part 1: What Are Mergers And Acquisitions
Part 2: Synergies In M&A Deals
Part 3: Outline Of Business Valuation Techniques
Part 4: Quick Overview Of M&A Process
Part 5: Selling Business To Private Equity
Part 6: Selling Business To Venture Capital
Part 7: Letter Of Intent (or “LOI”) In Mergers And Acquisitions
Part 8: Due Diligence Process
Part 9: Principles Of Negotiating In Mergers And Acquisitions
Part 10: Sale And Purchase Agreement
Part 11: M&A Deal Closing
The sale and purchase agreement is defined not just by your LOI, which is its starting point, but by the quality of the due diligence process. This document defines the relationship between the two parties, not only after close, but in the run-up between deal signing and closing. If any issues come up, everyone will turn to the letter of intent and its spirit. If that can be invoked to resolve the matter, that is great. But if it cannot be resolved, then litigation is normally the next step.
One issue that is weakening the importance of the SPA is the trend towards less onerous representations and warranties. If your indemnity is capped at under 10% of the deal consideration, you will think hard before incurring the costs to invoke it. Another way to mitigate the risks is to take out insurance on the deal, commonly referred to as representations and warranty insurance. This can cover misrepresentation, inaccuracy, failure to disclose, or a breach of confidentiality or exclusivity. This has been particularly helpful to private equity sellers who are traditionally very reluctant to give long-term or high level representations and warranties as they want to distribute the proceeds from the sale to their partners and general partners and move on to the next deal.
Ideally, you would want to complete the due diligence before starting drafting of SPA, but short timetables preclude this. Increasingly, the first draft of the SPA is prepared directly from the LOI, which is an argument for a more detailed, long LOI. Drafting can also absorb resources in your legal firm, reducing those available for due diligence. It can be a real balancing act.
There is a saying that “he who wields the pen wields the sword”. By this, I refer to our preference to prepare the first draft of the SPA sooner rather than later. This is normally done by the buyer. The first draft can often encapsulate a position from one side’s perspective, which then the other side need to spend time arguing to change. This really applies at the level of small detail, but can be important. The more detail you can get into an LOI to prevent this, if you are the seller, the better.
The purpose of the sale and purchase agreement is fourfold:
These are included in the SPA to give the buyer confidence in the findings of the due diligence process in the event that, after signing, some aspects of the seller’s information disclosures are found to be untrue or get challenged. The representations and warranties are there to evidence what was disclosed. These are often mitigated by qualifiers and thresholds so that the scope of what is covered is limited.
There is also normally a schedule of information which has been disclosed in full and to which therefore the representations and warranties do not apply unless the information disclosed was inaccurate.
Seller’s representations and warranties are set out to cover all aspects of the business, and particularly financials, intellectual property, contracts and liabilities.
The buyer will typically warrant that he has the authority to negotiate and close the deal, that the SPA will be valid and that they have the resources to complete the transaction, that they are not at any legal risk that might threaten the transaction, and that the buyer is only liable for any finder’s fees as disclosed by them.
The seller will agree to negative and positive covenants between signing and closing, such as operating the business in the normal way. Argument is normally focused on limiting these to what is reasonable and with appropriate time constraints.
Buyers are also expected to provide covenants covering the activities they commit to do before and after completion of the deal.
These can take up a considerable amount of time. This includes issues relating to salaries, benefits, and options, conditions to closing.
Certain activities and conditions relating to compliance and consents are set out for both buyer and seller and have to be discussed and agreed.
There may be certain actions that must be completed by one or other side before the deal can close, and these are included here.
In the event of a breach of the representations, warranties, or covenants, the buyer will expect the seller to provide an indemnification. The negotiation of these is critical, and the seller’s lawyers will spend considerable time trying to limit these as much as possible. By using qualifiers, the sellers will try to move the allocation of risk from their side to that of the buyer. In essence, the buyer can only enforce the condition if the seller is aware of the problem or if the scope of the problem is greater than the agreed levels of materiality.
If there is a difference of opinion, it is always good to have a mechanism for resolving it, including binding independent arbitration. This can often prevent expensive litigation becoming the only option.
Complexities and issues arise in the twin track of due diligence you should always be on the lookout for these unexpected complexities and reflect them in the documentation that feeds SPA. Due diligence can uncover these and can have a material impact on the drafting of the agreement. You may need to bring in outside parties to give expert opinions or specialist lawyers to provide a view on a material contract issue.
Do not ignore cultural or cross-border issues. Different companies can have very different internal cultures, which can produce difficulties. But do not take a common language as the basis for cultural compatibility. And the differences between northern Europeans and southern Europeans in business cultural terms are chalk and cheese, at least in France and Italy.
If the buyer is running a dual negotiation to get the deal funded, whether with external private investors or through the capital markets, that can create its own problems. These discussions can impact the detailed terms of the SPA, particularly in the latter stages of a deal when these difficulties arise. Remember to keep emotion out of the discussions. Look back to the spirit of the deal that you struck at the beginning, and try to find a practical, no nonsense solution to the issue without damaging the trust built up on both sides. In these difficult circumstances, try to keep your eye on the final prize, and try to maintain focus on achieving the objective of the mission to close the deal.
Let’s take a look now at the key learning points in the sale and purchase agreement section. The first thing I want to emphasize is that the sale and purchase agreement is the critical document in the deal. This is the document that both sides will go back to and reference to if there is any dispute or issue arising after closing. So it is absolutely essential that you get it right because this document will be used in arbitration of any dispute.
Secondly, the whole purpose of the document is to manage the risk, and this is essentially done through the representations and warranties. So it manages the risk for the seller because he gives these warranties and representations, but he also backs it up with a list of documents that have been disclosed. So the seller is essentially saying “well, look, I already told you about this”. On the other side, that from the buyer’s perspective, the SPA is about ensuring that the buyer is getting from the seller what he is being told is he is getting. And so this helps both sides to get comfortable and feel that they are not being led down the garden path, and they will therefore want to sign the deal. You can, of course, consider representation and warranty insurance if you further want to mitigate the risk. But this is an additional step, and I do not want to go into too much detail about it, however I do mention it for educational purposes.
It is important that you do your drafting of the sale and purchase agreement concurrently with the due diligence process and any issues that come up in the due diligence process are handled promptly and brought into the drafting team to make sure that they are represented in the document. And that way the issues can be dealt with quickly and efficiently. You do not want to leave this whole pile of open issues from the due diligence right until the end when you’re trying to get the deal signed off.
If you can, and this is normally from the buyer side, take control of the drafting of the sale and purchase agreement by producing the first draft. This means your solicitors, your attorneys can put their slant on it, from your perspective. When the buyer puts together the first draft then the seller spends most of their time reviewing it and moving it back to the buyer.
It is important that you understand the various sections of the sale and purchase agreement and their purpose. I must reiterate again here the content of the SPA, being: the price and consideration and any retentions, the seller representations and warranties, and also the buyer representations and warranties, and of course, any pre-closing covenants. In addition to this, there are employment and management issues which have to be addressed in the document, any conditions to closing, any indemnifications, a clear allocation of risks in certain circumstances, any termination provisions, and a process for dispute resolution. If you are not familiar with these sections, it is worth asking your solicitors to explain them to you.
It is completely normal to expect difficulties to arrive both in the due diligence process and particularly in the drafting of the seller purchase agreement, so be prepared for them. This is a negotiation. The other side will adopt positions that you do not like, and you will have to argue about these. You may of course find third parties causing difficulties in this because particularly if the buyer has put in finance from, say the stock market or from an independent investor, these parties will probably have terms and conditions that they want brought into the sale and purchase agreement. And this will make the deal more complicated.
Be ready for it. Whatever you do, keep your head cool. Do not get emotional, just stay focused on getting the deal closed, achieving your aim which is obviously to get everything signed off, and the deal finished and finalized. So keep cool, however provocative the other side may seem. Just rise above it and as long as you do that, you will go a long way to avoid many of the pitfalls that people can fall into when they are trying to close deals.
It is a good idea, having got to the sale and purchase agreement, for you to sit down with your solicitors and attorneys and go through this agreement in detail. I want you to consider using the deal-breaker’s checklists below which highlights some of the potential risks and issues that may be facing you. It is really important that you work very closely with your lawyers on this because they are the ones who have been doing the drafting, and they are the ones who will be in command of the very small detail as well as the arcane language to help you understand exactly what is in this document. The list below is by no means exhaustive.
SPA REVIEW
DEAL-BREAKERS
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