The purchase price structure
Preliminary negotiations will have allowed you to come to a tentative agreement on a price for the business. This price will have been reflected in the letter of intent for the business acquisition.
However, you may need to negotiate a different price structure based on your due diligence on the business. That’s why your due diligence should encompass all aspects of the company, including legal, tax, financial, operational, environmental, intellectual property and technology.
“Due diligence is not a place to cut corners,” says Noce, a Blakes Partner who practises in the firm’s M&A Group in Montreal. “When you’ve done proper due diligence, you have the tools available to make decisions when it comes to negotiating the purchase agreement.”
In those negotiations, you will also typically decide how much of the purchase price will be paid immediately upon closing the sale and how much will be held back in escrow or made subject to conditions.
As a buyer, you will typically want to hold back some part of the purchase price, often 5% to 15%, as security to make sure that if you do have a claim against the vendor you can have funds available to make you whole.
“As a buyer, you will typically want to hold back some part of the purchase price, often 5% to 15%, as security to make sure that if you do have a claim against the vendor you can have funds available to make you whole,” Noce says.
There will also usually be purchase price adjustments for the condition of the business on the day you take it over. One particularly important adjustment is for the amount of working capital in the business at closing. There needs to be a reasonable target amount identified in the financial diligence in order for the buyer to be able to operate on day one and not have to immediately inject additional funds into the business.
Representations and warranties
This is the core of the purchase agreement and is all about risk allocation. It’s where the vendor formally describes the condition of the business and makes disclosures about any issues or problems of which it is aware.
“This is the vendor telling you things like there is no litigation, no environmental issues, no labour issues. It’s hard for any company in any industry to give clean representations that say those kinds of things. So, typically, they will say there’s no litigation other than the litigation that I’ve disclosed to you in such and such a schedule.”
At this point, you will also negotiate who will assume various risks for issues disclosed. For example, the parties will agree who is responsible for paying damages if a lawsuit goes against the company or if an existing environmental issue flares up after closing.
These are the actions the buyer and vendor agree to take, both before and after closing.
For example, the vendor will agree to operate the business as usual until the sale closes, avoiding any radical decisions like making new capital expenditures or major personnel changes.
Another covenant might be a non-compete agreement, where the vendor promises not to participate in a competing business for a certain number of years after the closing.
In most acquisitions, there’s a period of time between signing the purchase agreement and the closing of the transaction—the date you actually take possession of the business.
The closing conditions are undertakings the vendor agrees to complete during this period in order for the deal to close.
For example, there may be leases or contracts where the vendor needs to get the consent of third parties to transfer them to a new owner. There may also be regulatory approvals, such as Competition Law approvals, to get, or remedial actions to take, such as cleaning up corporate or environmental issues flagged during the due diligence.
This is an important and “hotly negotiated” section where parties agree on the ground rules governing the compensation the vendor will have to pay if disclosures about the business turn out to be inaccurate or if covenants are not respected.
For example, if the vendor discloses that there are two outstanding lawsuits and it turns out there are five—what compensation or indemnity does the vendor have to pay to the buyer?
Importantly, the seller of a business is not liable for misrepresentations forever and their liability is typically capped at a certain percentage of the purchase price. The market norms on indemnity have changed substantially in Canada over the past few years, so it is doubly important for both buyers and sellers to be guided by advisors who are up to date on these norms.
It’s important for an entrepreneur not to think this is a few hours a week kind of exercise. It can become almost a full-time job when it’s crunch time with the purchase agreement, so you need to put substantial time and resource into the acquisition process, while continuing to operate your business.
Noce says the acquisition market currently favours vendors. This means they can drive a hard bargain not only on purchase price, but also on capping their liability and limiting how long they’re on the hook to compensate the new owner.
“We used to see liability caps in Canada that were 50% to 100% of the purchase price. Typically, a cap now is 10% or 15% of the purchase price,” he says. “And we see 12 to 18 months for the period of survival for those types of claims.”
There are often ancillary agreements that accompany the main purchase agreement. These might cover such things as non-compete, employment for key employees and a transitional services agreement, where the vendor agrees to provide services after closing.
Some final advice
Noce cautions entrepreneurs not to underestimate how time-consuming and disruptive it can be to make an acquisition, in general, and negotiate a purchase agreement, in particular. It’s often a good idea to free up one or more senior managers or executives to focus on the acquisition, he says.
“It’s important for an entrepreneur not to think this is a few hours a week kind of exercise. It can become almost a full-time job when it’s crunch time with the purchase agreement, so you need to put substantial time and resource into the acquisition process, while continuing to operate your business.”