Tuesday, June 26, 2012

Legal Issues When Buying a Business: Don't Overlook These Provisions in the Purchase Agreement.

As discussed in prior installments of this series on buying a business, there are a number important legal issues you need to consider before signing the purchase agreement.  The first installment discussed the role of the Exclusivity Agreement, the second installment examined the differences between structuring the transaction as stock purchase as opposed to a purchase of assets, the third examined the importance of escrowing a portion of the purchase price to cover any issues that may arise post closing, and the fourth discussed important aspects of due diligence and how to address legal or financial issues in the purchase agreement.  This fifth installment examines several key provisions that should be incorporated in the purchase agreement but are otherwise often overlooked.

The Purchase Agreement is a very flexible instrument giving the parties substantial flexibility not only as to the structure the transaction but with respect to the representations, warranties, disclosures and covenants that the parties can negotiate to include (or for that matter exclude) from the Agreement.  There are a number of standard provisions relating to such matters as legal ownership of/title to the assets, representations as to the corporate status and authority, disclosures as to litigation, financial and tax related representations, environmental issues and post closing obligations.  First, while these provisions may be part of a standard purchase agreement they by no means should be viewed as boilerplate. Even a slight variation in language can alter the meaning and scope of these sections, and thus all representations, warranties and covenants, no matter how standard, need to be reviewed carefully.  Second, below are a number of provisions which are often overlooked but you should consider incorporating in the Purchase Agreement.

1.  Intellectual Property.
Of course it is standard to include representations regarding the seller's title and ownership of the intellectual property, but make sure the Agreement:

              (a)  Covers licensed rights as well as often the seller does not own but licenses key IP.  In  the same vein, confirm the licenses are assignable and if consent of the licensor is required that the Seller obtain the consent as a condition of closing.

              (b) Addresses rights to the domain names and company websites and requires transfer of these rights to the buyer as a condition of closing.  It is not unusual for the buyer to forgot about the transfer of the domain and then have to coax the seller into compliance after the sale.

             (c)  IP rights should include not only registered marks or issued patents, but pending applications, unregistered rights, royalties, licenses and, significantly, awards, damages or pending claims and litigation.

             (d)  Incorporates provisions relating to software, requires the turn over of source code, manuals, passwords, license keys and all other documentation.

2.  Litigation

Representations relating to pending or threatened litigation are typical in a Purchase Agreement, but be sure:

            (a)  There are sufficient disclosures about pending and threatened litigation, including the status of such matters.

            (b)  Decide how litigation is to be handled post-closing.  Will your lawyer take over the matter or will the Seller's lawyer continue to handle it; who will be responsible for the legal fees and costs; include a right to periodic updates as to the status of any legal matters; and set forth any rights as to damages, awards, insurance proceeds and to settle the matter and any indemnification in the event of an unfavorable outcome.
3.  Financial/Tax Matters

In addition to the typical representations and warranties concerning financial and tax issues, include:

          (a)  Financial

                  (i) Require that the seller update the financial statements on or prior to Closing;
                  (ii) Include a formula for adjusting the purchase price if there are material changes to the financial statement;
                  (iii) Although often used, try to avoid using an earn-out (post-closing payment contingent on certain financial milestones) as they are difficult to negotiate, document and manage once the buyer assumes the reins of the business, and as a result they are a major source of post-closing disputes.  If an earn-out cannot be avoided, make sure you have counsel who has experience negotiating and drafting earn-outs.

         (b)  Taxes

                (i) The representations and warranties should not only cover federal and state taxes, but sales and any other applicable taxes for all relevant jurisdictions.
                (ii) The seller should provide all filings and disclose any past, pending or threatened audits/assessments.
                (iii) Require the seller provide post-closing assistance for any filings relating to periods of time the seller controlled the business.
                (iv)  Include appropriate indemnifications for tax liabilities.

4.  Transition

Is there a switch in your house that you have no idea what it does, and since the seller is long gone you have no way of finding out?  Well, think how that issue is magnified exponentially if you purchase a business and don't have the seller to assist with the transition.  The assistance is important not only as to obvious issues, like computer systems, financial records, and where the keys to the third floor supply closet are located, but making a smooth transition as far as clients/customers, introduction to vendors/suppliers, establishing a good relationship with employees/consultants, ensuring an understanding of business processes and procedures that are essential for operation of the business.  Therefore, the Purchase Agreement can require the meaningful assistance of the seller or even include compensation to the seller for post-closing assistance and continued employment with the company for a reasonable period of time.

5.  Material Adverse Change   

Undoubtedly the Purchase Agreement will include a Material Adverse Change clause essentially providing the buyer with certain rights and remedies (including possibly termination of the transaction) in the event of a material adverse change with respect to the business.  The clause is one of those tricky provisions which, if not properly drafted, can result in substantial disputes.  The key is to avoid ambiguity by incorporating specific criteria as to when the Material Adverse Change clause is implicated, such as decline in sales, the loss of certain amount of or even specifically named customers, a decrease in EBITDA or termination of a manufacturing or supplier relationship.

6.  Employment/Labor Matters  
Provisions relating to Employment and Labor matters are standard, but also make sure the representations and warranties include:

         (a) Existence of confidentiality, invention assignment and non-competes, and get copies for each employee and consultant.

         (b) Confirmation that consultants are truly consultants and not employees (which can give rise to substantial tax liabilities).

         (c)  Details and disclosures regarding any employee plans (stock, pension, etc.) and vesting status f each employee.

         (d)  Disclosures with respect to any collective bargaining any other labor matters.

7.  Operations in Foreign Countries

Establishing the right of the company to operate in any foreign jurisdictions where it does business should be obvious, but compliance with the Foreign Corrupt Practices Act is far less familiar to most people.  The FCPA prohibits various behavior relating to operating in foreign jurisdictions, including paying bribes to obtain contracts, business, etc.  Violation of the FCPA carries substantial civil and criminal liability.  As a buyer, you might not think much about the FCPA, but if you manufacture in China, for example, you better pay attention and therefore incorporate a representation that no unlawful payments have been made by seller or its agents.

8.   Covenants

The Purchase Agreement should contain covenants relating to:

        (a) Non-solicitation of employees, customers and clients and non-interference with existing vendor/supplier relationships.

        (b) In certain circumstances, a Non-Compete that complies with the narrow limitations imposed by applicable state law.

        (c) As discussed in prior posts, clear indemnification and escrow terms to address post-closing liabilities.

        (d) Confidentiality.

        (e) Obligation of the Seller to notify the buyer upon the occurrence of material events arising at any time prior to closing.

        (f)  Resignations of officers, directors, responsibility of the seller as to termination of some or all employees/consultants.

9.  Termination

There will be grounds for either party to terminate the Agreement prior to closing.  The termination provisions should not only provide specifics as to when the right can be invoked by a party, but also the liabilities, if any, resulting from termination and the effect of termination.

10. Survival

Give careful consideration to how long any of the representations, warranties and covenants will survive avter closing.  The seller will push for no or a very short period while the buyer will want them to survive until the chance of any liability no longer exists.  A compromise will almost always be necessary, and remember not all of the provisions need to survive for the same period of time

The above are by no means an exhaustive list of key provisions in a purchase agreement, and they will certainly vary depending on the nature of the business involved -- for example, if you are buying a gas station the environmental disclosures, reps and warranties will be substantial.  What is obvious that you cannot accept a boilerplate purchase agreement and instead the provisions need to be tailored to the particular transaction.

Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters