Structuring the Deal
Agreeing to structure the deal as an asset purchase is like laying the foundation for a house. It’s an essential early step but there’s still much of the structure to assemble. Many of the other essential deal terms can be teased out with targeted questions, including the ones that follow.
Is the buyer purchasing all the assets of the company or just certain specific assets? If a buyer is picking and choosing which assets to purchase and which liabilities to assume, the diligence and drafting process will require even higher levels of thoroughness and precision.
How will the purchase price be paid? For instance, the buyer could pay in cash at closing, could require third-party financing, could request seller-financing, or another method. The purchase price structure can have a ripple effect on the overall structure of the deal.
Is the goal for the deal to be structured as taxable or tax-free? Typically, an asset purchase will be structured as a taxable transaction. However, if the buyer is a public company, the seller may accept buyer stock as considerations, which could qualify the transaction as tax-free.
Are third-party consents needed, and can they be obtained? An asset purchase often triggers consent requirements from third parties. For example, the seller may have a commercial lease, in which case the landlord will almost certainly have to consent to the acquisition. Or a startup may need to obtain approval from its investors to consummate the acquisition.
Are there timing considerations for the deal closing? Parties usually want to close acquisitions quickly, but sometimes there may be deal-specific deadlines that need to be met. It’s important to identify these early on and ensure they can be met.
Will any seller personnel be offered employment or asked to assist with transitioning? It’s not uncommon for the buyer to want help with the transition from key seller personnel, or even to offer them employment following the acquisition, particularly if the buyer is purchasing substantially all of the assets of the seller.
Drafting Preliminary Agreements
Once a rough deal structure has come together, it’s time to start drafting. Rarely do potential parties to an asset purchase proceed directly to preparing the definitive agreements. Instead, they start with preliminary agreements, with the goal of ensuring alignment on key deal terms, preserving confidentiality during the diligence process, and protecting against the seller shopping the deal to other buyers.
The term sheet (this is also often called a letter of intent) is like a very firm handshake. It lays out the critical deal terms, like purchase price, but doesn’t bind the parties to finalize the deal. Instead, its function is to ensure the parties are sufficiently aligned on the critical terms to justify moving to the next steps of conducting due diligence and preparing the definitive agreements. If there isn’t sufficient alignment, the risk is too great that the parties will spend lots of time and money only to end up without a deal. While the deal terms in term sheets are non-binding, there are often binding provisions included, e.g., relating to confidentiality or exclusivity.
Typically, before confidential information is shared between parties, they engage in an agreement to ensure the protection of that information. This could be in a separate confidentiality agreement or it could be a provision included in the term sheet.
The buyer usually wants to prevent the seller from shopping the deal to other interested buyers. And so often the buyer will require the seller to agree to an exclusivity period, either in an exclusivity agreement or in the term sheet, during which the seller can’t shop the deal to other buyers and must negotiate exclusively with the buyer. These are also known as no-shop clauses. Exclusivity periods are usually in the 45-60 day range, though they can vary.
Conducting Due Diligence
Due diligence is the buyer’s opportunity to investigate the seller’s assets and liabilities. It’s the buyer’s chance to get a look under the hood and make sure everything is running smoothly, or at least smoothly enough to justify the purchase. If the buyer discovers problems, it may back out of the deal, or it may try to leverage these problems to improve deal terms in its favor (e.g., reducing the purchase price).
The key to a smooth and efficient due diligence process is for the seller to have a thorough and well-organized data room in place. To learn more about this, take a look at our post on data room and preparing for diligence: Startup Superpower: Getting Organized.
The seller may be tempted to conceal or minimize potential problems during diligence. But this is a mistake. The definitive agreements, including the asset purchase agreement and disclosure schedules (more to come on these), will be structured such that deceit by the seller will lead to exposure to liability, indemnification obligations, and the like.
Negotiating and Preparing the Asset Purchase Agreement
The asset purchase agreement is typically drafted by the buyer’s attorney. It should reflect the terms agreed to in the term sheet, though there will almost certainly be additional terms not covered in the term sheet which will be subject to negotiation by the parties.
The Purchase and Sale
Here, the parties will return to the earlier question of which assets are being purchased and which liabilities are being assumed. This will need to be spelled out with some precision in the asset purchase agreement and attached exhibits.
The parties will also need to finalize the form of consideration and how it will be paid. For instance, in cash at closing, promissory note, seller equity, or some combination. The parties may also decide to build in earn-out payments, meaning that some portion of the consideration will only be paid if certain performance targets are met post-closing.
Related Post: Earn-Outs
Additionally, the purchase price may need to be subject to adjustments at closing. For example, to adjust for variations in inventory being purchased. This may prompt the parties to hold some amount of the purchase price in escrow to ensure purchase price adjustment (or indemnification obligations) can be satisfied.
Reps and Warranties
The representations and warranties section of the asset purchase agreement is where the parties provide assurances about the state of affairs relevant to the deal, and they can serve as a basis for legal remedies if they turn out not to be true. During an acquisition, the buyer will want the seller to make detailed reps and warranties about the assets, liabilities, and business in general; if any of these are false, the buyer may then have recourse against the seller for breach of contract.
This is mainly an area where the lawyers fight things out. There is significant technical maneuvering that can be done to try and limit exposure to liability. However, lawyers can get carried away here, and it’s important for the client to stay involved to ensure their legal team isn’t fighting battles that the client would just as soon concede. It’s true that concepts like “materiality” can be very important in this setting, but it’s also true that lawyers can work themselves into a lather over items that don’t matter to the client.
Indemnification refers to the obligation to compensate another party for harm and loss. It also typically includes an obligation to defend the harmed party against lawsuits from a third-party.
In an asset purchase deal, it’s used to remedy losses incurred (usually by the buyer) after the deal has closed. It often covers losses from breaches of reps, warranties, or covenants made in the asset purchase agreement. In this way, indemnification clauses are simply contractual tools to allocate risk between the parties. As you might expect, these tend to be negotiated heavily.
It’s key to remember that the indemnification provision works hand-in-hand with the reps, warranties, and covenants (as well as the disclosure schedules, which we’ll come to shortly), as the reps, warranties, and covenants provide the basis for indemnity claims.
Relative leverage between the buyer and the seller, as well as somewhat vague notions of what the lawyers believe is “market,” tends to drive the negotiation on indemnity structure. The buyer will often insist on funds being held back in escrow to ensure that indemnity obligations can be satisfied. The seller may try to insert “caps” and/or “baskets” to set ceilings and floors, respectively, on claims for indemnity. There are many more tools that can be deployed, including insurance.
As with reps and warranties, the parties should be sure to take an active role in the negotiation, rather than simply letting the lawyers fight it out. Indemnification language tends to be dense and tedious to read, which can tempt the parties to retreat to the sidelines. But they should instead enlist the help of their legal team to translate the language into real-world risk to help them make wise decisions about risk.
Conditions to Closing
If the deal is a sign-and-then-close structure, meaning the parties sign the asset purchase agreement and then have a subsequent closing date, there will be conditions the parties need to satisfy in order to close, which will be set out in the asset purchase agreement. Examples of this include:
The buyer obtaining financing, e.g., from a bank.
The seller obtaining third-party consents, e.g., a landlord consenting to assignment of a lease.
Both parties obtaining organizational consent to consummate the deal.
Execution of transfer documents.
The asset purchase agreement will also include certain covenants the parties make to each other. These could cover the period prior to closing and/or after closing.
For example, during the period prior to closing, the seller may be required to covenant that it will continue to operate the business and maintain the assets in the same manner as it’s done historically to ensure it doesn’t take action that would unreasonably diminish the value of the assets or the business.
An example during the period post-closing is a non-compete covenant, where the seller and its representatives covenant to not compete against the buyer for a period of time following the closing.
The asset purchase agreement should also spell out what rights of termination the parties have. For example, is there a drop dead date at which point one or either party can terminate if the closing conditions haven’t been met? And if a party has the right to and in fact does terminate, will there be any consequences for the other party, e.g., if their failure to meet their closing conditions has effectively prevented the deal from closing?
There will be a long list of what’s often referred to as “boilerplate” provisions in the asset purchase agreement. Some of these terms may be important to negotiate, while others may be sufficiently “standardized” that they can be included without the need to do battle over. This is yet another area where the parties will benefit from engaging with their legal team to help understand what’s at issue and help educate their legal team over what the parties really care about.
Drafting Disclosure Schedules, Transfer Documents, and Exhibits
Disclosure schedules will be drafted by the seller’s counsel and attached to the asset purchase agreement. Their purpose is to provide information to the buyer about the assets and liabilities and to make excepts to the reps and warranties. For example, if seller had to rep and warrant that there were no threatened lawsuits that seller was aware of, but seller had received a demand letter from a customer threatening legal action, then the seller would need to include this in the disclosure schedule as an exception to the rep and warranty.
In an asset purchase deal, the transfer documents, including bills of sale (for tangible assets), assignment and assumption agreements (for contracts), and deeds (for real property), are needed to “perfect” the transfer of assets and assumption of liabilities. In essence, the form of these documents is needed to ensure the transfer is legally binding. These are usually not subject to meaningful negotiation.
Depending on the deal, there may be other exhibits to the asset purchase agreement. A few illustrative examples are listed below:
Transition Services Agreement: This kind of agreement is used to ensure a smooth transition, often by having certain key seller personnel agree to provide specific services for a period of time following the closing.
Escrow Agreement: If part of the purchase price is held back in escrow, then an escrow agreement will need to be used.
Preparing for Closing
Assuming, again, that the deal is a sign-and-then-close structure, there will be a period of time between when the asset purchase agreement is signed and when the deal closes. This could be 1-2 weeks or it could be 1-2 months–-the time period should reflect the time needed for the parties to fulfill closing conditions and any other timing-related objectives.
One of the most helpful things the parties can do to prepare for and manage this process is to agree to a closing checklist, which divides labor between the parties so it’s clear who needs to do what and when.
Closing the Deal
Closing the deal is the easy part. On the closing date, the parties will deliver all the final documents and the buyer will pay the purchase price, usually by wire transfer. While closings may take place in person, they’re often done remotely. After all the hard work that’s gone into making the deal happen, the main emotion from closing is often relief.
Handling Post-Closing Tasks
There are usually a handful of post-closing items to take care of, some of which–like the post-closing adjustment to the purchase price–can be contentious. But most of these things are fairly straightforward tasks, like a joint press release, routine filings, and the like.
If you’re a first-time startup founder, you should now have a better grasp on what to expect heading into an asset acquisition. There will be new challenges you’ll encounter that weren’t covered here but that’s inevitable. The key is not to know everything ahead of time, but rather to understand the process well enough to keep from being overwhelmed and to know when to seek help from experts.
Once you’ve gotten through your first acquisition, you’ll have an exit under your belt and very likely a newfound sense of confidence–and hopefully a big payday for you, your team, and your investors.