The life cycle of a deal | Part 3: Drafting the purchase agreement

Parts 1 and 2 of the Life Cycle of a Deal series examined the preparatory steps of a transaction, ‎including the preparation of the business for sale, drafting of a non-disclosure agreement and letter of intent, and then some key aspects of the due diligence process. Once the non-disclosure agreement and letter of intent have been entered into, and often while the diligence is being completed, the next step is the drafting (and negotiating) of the definitive purchase agreement that outlines the terms and conditions of the transaction. Part 3 of the life cycle of a deal series ‎examines the logistics of drafting a purchase agreement for an acquisition, its key provisions and objectives.

Logistics

In both share purchase transactions (involving the acquisition of all of the issued and outstanding shares of the target) and asset purchase ‎transactions (involving the acquisition of specific assets and liabilities of the target listed in the asset purchase agreement), the purchaser generally completes the first draft ‎of the purchase agreement. The main exception to this general rule is in respect of “auction” transactions, where the sellers circulate the first “auction” draft of the purchase agreement for prospective purchasers to review and revise.

The structure of share and asset purchase agreements differs depending on whether the parties will seek to close the transaction upon signing (i.e. a “simultaneous sign-and-close”), or whether an interim period may be required between the signing of the purchase agreement and the closing of the transaction. If the purchase agreement contemplates an interim ‎period gap, the purchase agreement will contain several conditions to closing that are required to be satisfied after the date of signing of the purchase agreement to complete the underlying transaction. Parties will structure the purchase agreement with an interim period for various reasons such as: (a) a number of third-party consents are required in order to consummate the transaction; or (b) certain regulatory filings

are required to be made prior to closing the transaction.

‎Key provisions

Agreement to sell / consideration:

Among the most important provisions of the purchase agreement is the “agreement to sell”, wherein the ‎sellers agree to sell the shares/assets to the purchaser in exchange for consideration. The

consideration ‎to be provided to the sellers can be structured in various forms, but generally consists of:‎

• cash;‎
• debt instruments (e.g. promissory notes for a portion of the purchase price); ‎
• securities of the purchaser; or
• a combination of cash, debt and/or securities. ‎

It is our observation that the vast majority of current private deals contain all of the above elements, as ‎well as an earn-out (discussed more fully below).‎

Adjustments: ‎

Purchase agreements will generally contain purchase price adjustments which are calculated and settled ‎within a pre-determined period of time following closing of the transaction. The ‎most common ‎type of ‎purchase price adjustment is based on the target's working capital. A ‎purchaser acquiring ‎a target ‎corporation typically wants to ensure that the target has enough working capital ‎to operate after ‎closing. ‎In this scenario, if the working capital is deficient, the purchaser must infuse more cash ‎into the target, ‎‎increasing the purchase price.‎

Earn-outs: ‎

Often, purchase agreements will contain an earn-out provision. An earn-out provision is a negotiated ‎arrangement where at least part of the ‎purchase price of the business is calculated based on its future ‎performance. It is usually based on the revenue or EBITDA ‎achieved by the purchaser from the acquired ‎business in a certain period after the purchase. The ‎earn-out provision is typically a compromise to allow ‎for the purchaser to pay a higher ‎amount for the business than the purchaser thinks it may be worth. In ‎structuring the earn-out, the vendor and purchaser should ensure that (1) ‎the provision is compatible with ‎the accounting procedure to be used in the future; and (2) ‎ the income attributable to the particular assets ‎purchased ‎sold is identifiable, particularly in an asset transaction.‎

Conditions precedent: ‎

If the purchase agreement includes a time gap between signing and closing, the purchase agreement will ‎almost always list out certain conditions that must be met or actions that must be taken before the ‎transactions contemplated in the purchase agreement can be consummated. Common conditions ‎present include obtaining certain regulatory approvals and consents prior to closing the transaction ‎‎(noting that it may in the seller’s interest to ensure that there is a firm deal in place before approaching ‎third parties to obtain consent for the transaction).‎

For example, depending on the context of the underlying transaction, the purchase agreement may ‎require that regulatory approvals relating to the Investment Canada Act, R.S.C., ‎‎1985, C.28 (the ‎‎“Investment Canada Act”) or the ‎Competition Act, R.S.C., 1985 c. C-34 (the ‎‎“Competition Act”) are ‎obtained. The Investment Canada Act requires that any non-Canadian corporation proposing to ‎‎acquire ‎direct control of a Canadian business (exceeding the applicable threshold) satisfy the ‎‎relevant Minister ‎that the investment is likely to be a net benefit to Canada. Under the Competition ‎Act, the ‎Competition ‎Bureau examines whether a proposed transaction prevents or lessens, or is ‎likely to prevent or reduce, ‎competition substantially within a ‎relevant sector. The Competition Act also ‎regulates notifiable ‎transactions when mergers ‎between large commercial entities occur.‎ In both cases, parties should ensure ‎appropriate filings ‎have been made.‎

The purchase agreement should also address any third-party or other consents that may have been ‎identified in the diligence process that are required to be obtained prior to the consummation of the ‎transaction including third-party consents under material contracts, landlord consents and ‎regulatory/other governmental consents.‎

Closing deliverables:‎

A purchase agreement will include certain closing deliverables that should be produced by both parties. ‎These usually include officer's certificates, incumbency certificates, board and/or shareholder ‎resolutions, ‎‎releases, resignations, employment and restrictive covenant agreements. ‎

Representation and warranties:‎

In standard purchase agreements, the parties give representations and warranties about the state of the ‎business. Typically, the seller's representations and warranties are much more extensive as they ‎‎include ‎information about the business of the target company and the assets being transferred. Common ‎representations and ‎warranties of the target and the seller often include:‎

• ‎The target corporation has been incorporated and exists under the laws of the jurisdiction in ‎which ‎it ‎was incorporated;‎
• The condition of the assets of the target business;‎
• The latest financial statements and other financial statements have been adequately prepared;‎
• All employee benefit plans, pension commitments etc. are fully funded;‎
• The valuation of accounts receivable is accurate;‎
• All taxes are paid, and the target business is in compliance with tax matters and tax statutes; and ‎
• ‎The corporation is not in default under key contracts or licences.‎

The representations and warranties in a purchase agreement should be tailored to address the specific ‎nuances of the target business. For example, if the target business develops and utilizes essential ‎intellectual property, the intellectual property representations and warranties should be more robust. A ‎purchase agreement should also specify how long the representations and warranties will survive post-‎closing. ‎

Representations and warranties are an integral part of a purchase agreement, and often a larger portion ‎of the time spent negotiating is allocated to settling the representations and warranties. If a ‎representation and warranty is not accurate and there is consequently a breach of the contract, the ‎aggrieved party will often seek recourse under the indemnification provisions in the purchase agreement. ‎ ‎

The survival period of representations and warranties can be modified to meet the ‎party's ‎needs and ‎typically ranges from six months to 24 months. Sellers will attempt to shorten ‎this ‎period, while a ‎purchaser will usually want to ensure that the survival of the representations and warranties lasts through ‎the completion ‎of ‎one financial statement audit after closing.‎

Indemnification:‎

Indemnification provisions are included in a purchase agreement to protect the parties ‎from losses ‎‎arising from ‎breaches of representations, warranties or covenants. The indemnification ‎provision is often ‎highly ‎negotiated. How the indemnification provision is structured ‎‎depends on the number of ‎indemnifying parties. It may be structured as joint and several ‎liability, ‎several liability or joint liability.‎

A seller may try to limit their potential exposure under a indemnity provision by including certain ‎limitations on it’s indemnification obligations. For example, many purchase agreements include a ‎‎“deductible” (meaning the indemnified party’s losses must exceed a certain threshold before the ‎indemnifier is obligated to indemnify) and a “cap” (the indemnifier is only responsible for losses up to a ‎certain amount). ‎

As with the representations and warranties, the indemnification provisions should be drafted bearing in ‎mind the specifics of the target business and the deal terms. For instance, if during due diligence certain ‎litigation matters are exposed, a purchaser may seek comfort in having a specific indemnity obliging the ‎vendor to indemnify for these specific litigation matters.   ‎

Negotiating a purchase agreement

Certain provisions of a purchase agreement may be highly negotiated, to the point where they become ‎‎“battlegrounds”. ‎These include:‎

• Purchase price adjustments;‎
• Representation and warranties: Retain a specialist's opinions and cross-reference with all the ‎‎disclosure schedules;‎
• Survival of representations: Verify if their survival is general or fundamental; and
• Indemnity: Confirm which indemnities are provided, for how long and who is responsible.‎

While drafting a purchase agreement will vary with every transaction, the foregoing provides a summary ‎of some of the key terms of a purchase agreement. ‎