Preliminary Investigations

The purchaser will usually seek representations and warranties on matters such as the financial strength of the business, the accuracy of financial statements, the major contracts pertaining to the business, and the ability to assign major assets, such as leases of land or licenses. Even in a share sale, leases and licenses are often not assumable without the landlord or licensee approving the new shareholders.

However, representations and warranties, no matter how extensive, do not take the place of careful due diligence and a purchaser (together with its lawyer and accountant) should always conduct independent searches and investigations of the target company or business and its assets in order to make an independent assessment of the financial strength of the business being purchased. Ideally your client will consult you prior to a binding agreement being entered into, so that you have an opportunity to discuss the overall approach to the transaction with him or her. The sale of a business may also involve third party interests, and if possible, those should be identified with the client at the outset. For example, the purchaser may have to deal with third party agencies or be in the position of settling claims on the assets with a former creditor or even the separated spouse of an individual vendor who claims the business is a “family asset”.

The following is a list of some of the business and legal issues that should be considered at the preliminary stage:

  1. The purchaser and his/her accountant should review the vendor’s current financial statements (no older than 120 days).
  2. Assess whether a significant portion of the sales are with a small group of customers or suppliers. Ensure that these contracts will be continued after sale (which may require meeting with those customers in advance of closing to advise them of the impending change of ownership and to address any questions they may have).
  3. Document the vendor's promises, preferably as representations in the Agreement of Purchase and Sale, regarding future sales, profitability, gross margins, cash flow, capital expenditures and warranties regarding management commitments, contractual arrangements and legal actions. Be particularly cautious of businesses that are being sold at an unfairly high price for immigration purposes. If the final agreement of purchase and sale contains an “entire agreement” clause, it may preclude the purchasers from enforcing pre-contractual or oral promises and representations against the vendor after the transaction has closed, so include language to extend the life of those promises and representations past closing.
  4. Consider whether part of the transaction purchase price should be paid over time, conditional on the business achieving certain sales or profit forecasts and being free from unexpected liabilities.
  5. Clarify profit and sales definitions and similar financial terms at an early stage in the negotiations.
  6. Familiarize yourself with the physical plant of the subject business and with the accountants, lenders, and other advisors of the vendor's business.
  7. Consider the consents that must be obtained from governmental authorities or others whose consent to the transaction is required. These parties should be contacted early in the negotiations so that their response will not delay the closing. Make key consents a condition precedent to the transaction closing.
  8. Carefully review important employment contracts, including collective bargaining agreements. For example, if there are collective agreements, successorship rules may apply such that the agreement will follow the deal and bind the new purchaser, even if the transaction is an asset sale.

On a rush basis you may be asked to put together a letter of intent or memorandum of understanding. This type of document usually sets out the general parameters of the proposed transaction, but indicates that further work is required before a deal can be finalized such as, for example, settlement of definitive documents, completion of due diligence, obtaining financing or a determination as to whether the purchaser will be able to merge its technology with that of the seller.

Have your client decide beforehand whether this document is intended to create a binding contract or whether it is simply meant to be an indication of the parties’ desire to continue bargaining in good faith. If the document is intended to be a binding agreement, be careful not to make it non-binding by contemplating that it be followed by a more formal agreement. Alternatively, if it is intended that the document not be binding as an agreement to purchase, there may be aspects of the document that your client does wish to be binding, such as confidentiality obligations, “stand still” agreements and the like (particularly where the purchaser and vendor are existing competitors and the due diligence process will of necessity involve access to information about each other that is competitively valuable) so careful drafting is key in those situations. Appendix C is a sample letter of intent.

Ideally, the parties will seek legal advice about the structure of the transaction early in their negotiations. However, even if the parties have a signed contract without conditions precedent (“subject tos”), you should ensure that your client understands the rights and obligations under the contract, discuss any areas which are unclear or potentially unfavorable and assess the prospects for renegotiation of those areas. Typical examples would include the client’s failure to allocate the purchase price in a way that is advantageous from a tax point of view and the failure to consider whether employees are to be terminated by the previous employer prior to the completion date (thereby reducing the amount of severance that your client would have to pay in the event that the employees’ work did not meet your client’s expectations).

Keep in mind as you advise your client and negotiate the purchase agreement with the other parties that purchase and sale transactions involve a balancing of interests and risks. Both sides have interests to protect which may inevitably conflict and there are inherent risks involved in any business venture which cannot be completely eliminated. It is as unreasonable for a purchaser to expect that the vendor will assume all risks associated with the purchaser’s operation of the business post-closing, as it is for a vendor to expect to be able to obtain full value for his or her business without any responsibility for the representations regarding the business that the price was based upon. Your role as counsel will be to ensure, first, that to the extent possible, the final transaction represents a fair balance of the rights and interests of your client versus those of the other parties (i.e., it is not to ensure that your client bears no risk and the other parties bear all of the risk). Second, ensure that your client understands the balance of rights and benefits that has been struck. Remember that unlike litigation, the successful closing of a purchase and sale transaction should be a “win-win” situation for all parties, not a “winner takes all” scenario.

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The model letter of intent should not refer to an earn-out "to be agreed" but should even at this stage of negotiations establish the basic principles on which it will be constructed. Agreements to agree are anathema at every stage.