I’m buying a company. How do I know exactly what I’m getting?
An acquisition often holds surprises akin to a box of chocolates—you might encounter unexpected liabilities even in an asset purchase. For instance, a seller’s insolvency or the breach of laws during asset transfer could expose you to claims from the seller’s creditors.
Conversely, even in mergers or stock purchases, you might not obtain all the assets you anticipated. Encumbrances on stock or reliance on shared assets not transferred to you could impact the deal.
Yet, there are strategies to protect yourself. Although it’s impossible to entirely eliminate these risks, an experienced M&A lawyer can provide various mechanisms to mitigate them. These mechanisms include:
due diligence,
representations and warranties,
pre-closing covenants,
certifications,
legal opinions,
conditions to closing and termination rights,
indemnification rights / breach of contract claims and
post-closing covenants.
The law provides certain safeguards through state common and statutory laws, along with federal regulations like the securities laws, especially for public M&A targets. However, I won’t delve into these legal aspects in this post.
Instead, I’ll focus on introducing various tools mentioned earlier that offer additional protection beyond the basic legal safeguards. In future posts on The M&A Lawyer Blog, I’ll explore each of these tools in more depth.
You’re buying a company: here’s how you protect yourself
Tool No. 1: Due Diligence
M&A due diligence is the process of thoroughly inspecting a company's assets, liabilities, operations, and financial standing before completing a purchase. It involves a comprehensive review by the transacting party, advisors, and specialists to assess value, identify risks, confirm claims, and uncover assets and liabilities.
Legal due diligence involves scrutinizing organizational documents, contracts, property records, regulatory filings, intellectual property, financial documents, employee plans, litigation details, and more. This process often includes facility inspections, meetings with key staff, and is facilitated through a virtual data room.
Tool No. 2: Representations and Warranties
Representations and warranties are statements made by the seller in the transaction agreement regarding the company's past or current conditions. If these statements are inaccurate, the party making them might be liable. These statements cover various aspects of the business, including operations, assets, liabilities, and prospects.
Here’s a long list of subjects that may be addressed by seller representations and warranties:
organization and good standing
authority and enforceability
absence of conflicts
capitalization and ownership
subsidiaries
financial statements
books and records
accounts receivable and accounts payable
inventories
absence of undisclosed liabilities
absence of certain changes and events
assets
real property
intellectual property
material contracts
tax matters
employee benefits
employment and labor
environmental, health and safety
compliance with law
legal proceedings
customers and suppliers
product warranties
product liability
insurance
related-party transactions
guarantees
brokers and finders fees and
full disclosure.
In a transaction, not all representations and warranties will be included, and some may overlap. With guidance from an M&A attorney and advisors, you'll negotiate a set of seller statements that suit your deal and align with your priorities. These representations are required to be true both at the agreement's signing and at the transaction's closing, shielding you from risks arising between these points.
Inaccuracies in these statements might allow you to halt the deal before closing or seek compensation from the seller after completion. Sellers are motivated to ensure the accuracy of their representations, offering you a safeguard to ensure you acquire only the desired assets and liabilities.
Tool No. 3: Pre-Closing Covenants
If there's a gap period between signing and closing in your deal, the primary transaction agreement typically includes covenants from the seller to mitigate the risk of unexpected outcomes. One common covenant is the "Access and Investigation" clause, wherein the seller commits to granting you access to the acquired business and its records. For instance:
Between now and the Closing date, the Seller commits to ensuring that its officers, directors, employees, agents, representatives, accountants, and legal advisors, as well as those associated with the Company and its Subsidiaries, will, upon reasonable notice:
(i) Grant reasonable access, during standard business hours, to the Purchaser's officers, employees, agents, accountants, legal advisors, and financing sources. This access encompasses offices, properties, plants, facilities, books, records, and individuals with knowledge related to the Company, Subsidiaries, or Business.
(ii) Provide the Purchaser's representatives with additional financial, operational data, and other relevant information regarding the assets, properties, liabilities, and goodwill of the Company, Subsidiaries, or Business, as reasonably requested by the Purchaser.
This covenant serves to facilitate the integration of the acquired business, but it also allows for ongoing evaluation of the business before the closing and the completion of any remaining due diligence tasks.
The agreement will mandate that the seller maintains the normal operations of the acquired business in a manner consistent with its historical practices during the gap period leading up to the closing.
The Seller commits that, except as noted in Section 5.01(a) of the Disclosure Schedule, the Company and its Subsidiaries will conduct their business as usual until the Closing, consistent with their customary practices. This includes continuing advertising, pricing, and purchasing practices, maintaining regular payment schedules, preserving their organizational structures and employee services, keeping existing insurance policies intact, maintaining current relationships with customers and suppliers, and exercising lease renewal rights with prior approval from the Purchaser. Additionally, they must refrain from any actions that could render Seller's statements untrue or breach Seller's commitments outlined in this Agreement.
Such clauses often entail detailed lists of actions sellers must or must not undertake. In essence, the more detailed and comprehensive the list, the more advantageous it is for the buyer. These clauses aim to maintain the purchased business in a state similar to that assessed during due diligence. Should the seller fail to adhere to these stipulations, it could potentially allow the buyer to terminate the transaction and seek damages from the seller.
The final member of our troika of gap period buyer protections is a requirement that the seller notify you of certain material developments impacting the acquired business or the transaction. A pro-buyer example may provide:
Before the Closing, the Seller and the Company will promptly inform the Purchaser of any event or non-occurrence that might reasonably affect the accuracy of any Seller representation or warranty in this Agreement, any failure to fulfill any Seller or Company obligation, or any failure to meet conditions for the Purchaser's responsibilities in this Agreement. Notifying under this section won’t alter the Seller Disclosure Schedule, address misrepresentations or breaches, or limit the Purchaser's rights or remedies under Article 7 or Article 9.
The importance of this wording in relation to the subject discussed is clear. Pay attention to the final sentence, emphasizing that providing notice won't be considered as amending or rectifying any statement, promise, commitment, or condition. This preserves your ability to end the agreement or seek indemnification, regardless of notice delivery.
Tool No. 4: Certifications
When finalizing your transaction, in addition to transferring payments, stocks, and necessary documents, both you and the seller typically swap certificates issued by specific officers. There are typically two common kinds: certificates from officers and certificates from secretaries.
A seller’s officer’s certificate is usually a one-page document in which a senior officer of the seller certifies to the buyer that:
the seller’s representations and warranties were true when the transaction agreement was signed and remain true at closing and
the seller and the target have complied with pre-closing covenants.
A seller's secretary's certificate is a concise document, usually a single page, where the seller's secretary or equivalent officer confirms to the buyer that the individuals signing the transaction agreements and officer's certificates possess the authority to legally commit the company. These certificates commonly include verified copies of the target company's organizational papers and any necessary board and shareholder resolutions.
These closing certificates provide added assurance by validating the seller's promises and commitments, providing an extra means for recourse if you uncover any breaches by the seller later on.
Tool No. 5: Legal Opinions
As highlighted earlier, you might choose to ask the seller's attorney for a written legal opinion to be handed over to you during the closing process. These opinions aim to offer you confidence that specific legal aspects align with how the seller has portrayed them in their representations and warranties. A standard opinion might address the following points:
the target was duly formed,
the target is in good standing in relevant states,
the target’s capital structure (i.e., shares outstanding),
the transaction and transaction agreements will not violate the target’s charter and other organizational documents or material contracts,
there is no litigation pending or threatened against the target and
any issuance of stock or other securities in the transaction complies with federal and state securities laws.
Although seller legal opinions were once widespread, they're now infrequently sought by buyers due to the associated legal costs and the buyer's capacity to autonomously verify numerous or all aspects covered in such opinions. Yet, in transactions where specific concerns arise about the matters typically covered by seller legal opinions, requesting one might be considered.
Tool No. 6: Conditions to Closing and Termination Rights
Once again assuming a gap period between signing and closing, the main agreement governing the transaction will outline conditions that must be met or waived before either party is obligated to finalize the deal. Typically, these conditions involve ensuring that the representations and warranties made by the other party remain accurate from when they were stated to the closing, and that the other party has adhered to its pre-closing commitments. Often, buyers will also seek conditions that prevent any significant adverse changes in the target business, which could affect its long-term earnings. Sometimes, buyers may negotiate to ensure their due diligence examination of the target has been satisfactorily completed as a condition precedent.
If these conditions aren’t satisfied by an agreed-upon deadline or if an irremediable breach of representations, warranties or covenants shall have occurred prior to closing, the non-breaching party will usually have the right to terminate the transaction agreements and walk from the deal.
Altogether, these conditions and termination rights, when considered in light of well-crafted seller representations and warranties and pre-closing covenants, reduce the risk that you’ll be buying a lemon.
Tool No. 7: Indemnification Rights / Breach of Contract Claims
M&A indemnification rights grant you compensation from the seller for losses resulting from any breach of their promises in the main transaction agreement. Essentially, if you discover the purchased business isn't as promised, these rights allow you to seek damages.
You might question why I'd mention indemnification in tools aimed at securing what you expect in an M&A deal. After all, don't these rights apply only after identifying issues post-acquisition—meaning you've already received more or less than anticipated?
No, that's not entirely accurate. You could seek indemnification even before closing if you uncover a breach in the seller's commitments. More significantly, indemnification gives the seller a reason to honor their promises. Without this recourse, even strong seller commitments wouldn't matter—falsehoods and non-compliance wouldn't carry consequences.
But, even without indemnity, you could pursue damages for contract breaches. This, too, discourages the seller from breaking the agreement and boosts your trust in the seller's statements about the acquired business.
Tool No. 8: Post-Closing Covenants
One way to enhance your assurance in acquiring the intended assets and liabilities is to introduce protective post-closing covenants into the transaction agreements. These covenants serve as safeguards, beyond indemnification clauses, and typically fall into three categories.
Firstly, in cases where you're purchasing a segment or division of a larger entity, there might be assets crucial to the business that weren't formally transferred to you at closing. These agreements often demand that the seller transfer these assets to you post-closing or compensate you for the benefits you would have gained if those assets had been conveyed during the closing process.
Another approach involves the use of transition services agreements, as mentioned earlier, to alleviate the difficulties associated with transitioning the acquired business to new ownership. These agreements entail sellers committing to providing essential support to both the target company and the buyer for an agreed-upon duration following the closing.
Finally, M&A transaction agreements usually contain some form of “Further Action” covenant through which the parties agree to exercise efforts to effect the intentions of the parties. An example may provide:
Each party involved will make reasonable efforts to perform all necessary actions, comply with relevant laws, and execute required documents to fulfill the provisions outlined in this Agreement and associated Ancillary Agreements, ensuring the successful completion of the Transactions.
These comprehensive provisions act as a safety net, ensuring that if all previous tools and measures fail to secure the complete assets and liabilities as expected in the deal, the Further Action clause empowers you to prompt the seller to take additional necessary steps to fulfill the terms of the agreement and obtain the intended benefits of the deal.