AFTER analysing all the pertinent issues and gaining a better insight into your company, the private equity (PE) investor informs you that the due diligence exercise performed on your company has come to an end and the results therefrom are satisfactory for the investor to proceed to other action items in accordance with the term sheet that you had earlier executed with the investor.
Against this background, we make effort in this eighth part of our ten-part article series to provide practical insights into the process of drafting and negotiating the definitive agreement with the PE investor.
What is a definitive agreement? It’s, in the context of a sale of your company to a PE investor, “an asset purchase agreement” or “stock purchase agreement”; however, in the case of a pure merger, the definitive agreement is called the “merger agreement”.
For ease of understanding, the asset purchase agreement is the definitive agreement that finalizes the terms and conditions related to the purchase of your company’s assets (not the shares). It’s distinguishable from the stock purchase agreement where the shares of your company are bought by the PE investor.
The definitive agreement reflects the final terms and conditions of a deal transaction.
As a company owner, reaching this stage of drafting and negotiating the definitive agreement may well mean that you are on your way to successful closing. But, prior to finalizing the definitive agreement, both you and the PE investor need to deal with a number of habitually challenging issues, some of which are discussed herein. In particular, we focus on the purchase consideration (which was probably rundown in a high-level description, but not in the required profundity, in the term sheet), and the representations and warranties that are to be made by your company.
In respect of the purchase consideration, matters that will find comprehensive expression in the definitive agreement include: description of the assets or shares of your company that the PE investor is going to buy; liabilities to be assumed by the investor; aggregate consideration to be paid by the investor and the nature of that consideration; timeline of payments after the closing date; structure of earn-outs (will the investor pay you a part of the purchase price only if predetermined levels of business performance e.g. specific revenue figures are attained following the acquisition?); and required working capital at the time of closing. With these matters, it is difficult to state a precise “price” for the transaction.
Turning to representations (“reps”) and warranties; in this part of the definitive agreement, certain statements are made—and you and the PE investor warrant that each one is true. When selling your company’s assets or shares, the reps/warranties are very extensive. So, you need to be in compliance with the tax laws and other laws and regulations, not forgetting internal controls for accounting. The PE investor states something about the commitment letters it has received from lenders if debt financing is involved in the deal.
The challenge is that while your aim as a company owner is to make as few reps/warranties as possible and limit their scope, the investor wants to make them as far reaching as possible!
And because reps/warranties compliment the due diligence process by compelling you to make binding statements concerning the information you supplied about your company in due diligence, the reps/warranties would be the basis for whether the investor is in future vindicated to pull out of the deal or open a lawsuit against you after the deal is closed.
A key component of the reps/warranties, the “disclosure schedule”, stipulates the supporting documentation for your reps and any exceptions thereto. Technically, this documentation transfers the risk of disclosed matters to the PE investor.
Arguably, it’s interesting to note that complete financial models or projections for your company will not form part of the definitive agreement. This is so because the agreement is focused on “facts”, rather than speculations on future performance of your company.
Although it’s not unusual to be focused on the price of the deal transaction, as a company owner you need to understand the definitive agreement as it impacts the price you get.