Entity Purchase Agreement Definition
Entity Purchase Agreements, like Stock Purchase Agreements and Membership Interest Purchase Agreements, fall under the category of purchase agreements. There are many types of related agreements, but an entity purchase agreement is a buy-sell agreement that’s exclusively for buyers of business entities, such as corporations and LLCs.
The purpose of an entity purchase agreement is to outline the terms of an acquisition (buying) or disposition (selling) of an entity . It can be as simple as an all cash transaction or complex with multiple asset classes, earn-outs and other considerations as a major portion of the purchase price. An entity purchase agreement will also outline the terms for non-completion of the transaction and post-closing expectations. An entity purchase agreement is different from a stock purchase agreement or a membership interest agreement because it relates to the purchase of a business organized as a corporation or LLC.
If you’re buying or selling an entity, you will end up with an entity purchase agreement, and other related documents as well.
Key Features of an Entity Purchase Agreement
Attorneys describing the contents of an entity purchase agreement (sometimes known as a "stock purchase agreement," an "asset purchase agreement," or a "membership interest purchase agreement") will state that the document is really an agreement on the subject of what "goes with the sale." In enumerating the items referenced in our last sentence, the following are the principal components reflected in many entity purchase agreements.
The purchase price is typically a combination of cash at closing, assumption of any "assumed liabilities," and an "earn-out" of future payments over a certain number of years, usually tied to certain performance metrics. The purchase price is then allocated to specific assets being purchased. The purchase price can also take into account existing debt obligations and other financial adjustments. Although purchase price can be the subject of an earnest negotiation between the parties and their respective counsel, the items mentioned in the first paragraph above are not the only items subject to discussion.
Representations and warranties are obligations of the parties to the agreement as to the existence or non-existence of facts as of a particular point in time. Some representations and warranties are "fundamental," such as a disclosure that a party is a corporation or a limited liability company, while others are more substantive to the purchase (e.g. the business being sold is in good standing under applicable law). In addition, certain representations and warranties will survive the closing for a certain period of time (often survival periods are one, two, three, four or five years), while others will not survive the closing.
Covenants are contractual obligations on the part of the parties to do or refrain from doing something in the future. Examples include covenants by the seller not to compete with the company being sold, and to indemnify the purchaser from certain claims by third parties (which overlap with certain representations and warranties). Covenants can be part of the operative agreement or referenced under a separate "covenants" section.
Conditions to closing will usually require the satisfaction of material items prior to the closing, such as approval for the transaction by the applicable board of directors, shareholders and greater-than-10% shareholders of the company being sold (if applicable), applicable governmental approvals (such as a Hart-Scott-Rodino antitrust filing), and reviews by legal counsel.
Drafting an Entity Purchase Agreement: Essential Steps
Due Diligence – As the purchaser, it is not only important for you to fully understand what you are purchasing but it is also important for you the seller to disclose pertinent information so that all parties can make informed decisions. The process of due diligence involves obtaining the information about the entity and the terms of the transaction necessary to evaluate the acquisition. Negotiation – Generally a seller will prepare the first draft of the purchase agreement. It is then the job of the purchaser and counsel to review the terms and negotiate acceptable changes to the terms. Because changes will need to be made, it is not unusual for the parties to go through many drafts before the final agreement is reached. As the purchaser, you can expect the terms to be heavily weighted in favor of the seller because it is their business that is being sold. It may be necessary to change some of the terms from those provided by the seller in order to protect your interest. Review Terms – Typically purchase agreements are written in legal terms and rely on terms of art. Having counsel review the purchase agreement can provide comfort and understanding of terms used and obligations created.
Applicable Laws and Regulations
In addition to the practicalities of negotiating and vetting the agreement, the formation of an entity purchase agreement from a legal and regulatory standpoint is also paramount. Given that the formation of an entity purchase agreement can often involve the purchase or sale of a business (or ownership interest in a company), various potential compliance issues and necessary legal disclosures should be considered.
Generally, if the entity purchase agreement is formed between private entities only, then it does not need to be reported to any state or federal agency and is not subject to federal or state control. However, if one or both parties of the entity purchase agreement is a publicly-traded company, the parties must consider various disclosure requirements under certain state (such as in Delaware) and federal laws (such as the federal securities laws). If the seller company (i.e. the company selling the securities to the buyer company) is a publicly traded company , the seller company must file a registration statement with the SEC for the sale of its securities. In that case, the seller must file a Form S-3 or Form S-1 with the SEC (Forms S-4 and S-11 are used by companies engaging in mergers or similar corporate reorganizations). Before it can qualify for a short-form S-3 registration statement, the selling security must meet certain conditions. For example, the aggregate market value of the seller’s public float as measured by the market price of its common equity must be at least $75 million on or before November 15, 2018, and at least 90% of the seller’s outstanding voting and non-voting stock must be "held by non-affiliates" (meaning the shares have been held by holders other than directors, executive officers and greater than 10% stockholders for 90 days prior to the filing of the form).
Considerations when Structuring your Entity Purchase Agreement
Negotiating the purchase or sale of an entity brings a variety of unique challenges. One of the greatest challenges for both parties in these transactions is agreeing upon an acceptable purchase price given the absence of a robust marketplace in which to secure a fair market standard. Fair value in these types of sales is typically derived from the parties’ own calculations and approaches. One way to accurately determine fair value is through the use of a business valuation specialist. Such experts analyze information about the company and examine industry-specific economics, as well as the assets and liabilities that belong to the entity, to arrive at a number that they believe should reflect fair value.
Another area of contention in these agreements involves covenants not to compete. The concern is that after the transaction, the seller will create a new entity that appears to be a competitor, but in reality is just the seller’s new company operating under a different name. In order to avoid this risk, buyers should require a covenant signed by both parties stipulating that neither will commence a business in competition with the other for an agreed-upon period of time. The buyer should also have the option of discontinuing the acquisition if the seller refuses to sign the covenant.
Yet another issue to address in purchase agreements is the post-closing agreements that bind the parties. Many people believe that continuing obligations will disappear when the sale occurs. This is not true, and it could lead to trouble for both the buyer and seller. For instance, continued compensation agreements – the buyer should continue to compensate an owner for a specific period of time after the sale closes, based on the amount the owner produced before the transaction.
Sellers also should be prepared for the "bad boy" clause in most business purchase agreements. This clause typically states that if the seller engages in bad conduct, the buyer has the option to void the agreement. The disqualifying behavior might involve the seller failing to honor any of his or her post-closing obligations or affirmatively doing something to harm the buyer’s business.
One of the most common problems that sellers face when negotiating these purchase agreements is lack of financing to cover the sale price. The problem here is that someone interested in purchasing a business is unable to acquire the necessary financing because lenders are unwilling to engage in a deal that essentially involves purchasing a business that generates no profit. The solution includes offering assistance to help the buyer acquire financing, such as continued employment for a certain period of time and retention of some ownership interest in the new entity.
Examples of Entity Purchase Agreements
Successful entity purchase agreements often hinge on careful structuring and thorough due diligence. The following are examples of well-crafted buy-sell agreements that exemplify these principles:
Case Study 1: ABC Corporation
ABC Corporation is a successful manufacturer of specialty pharmaceutical products. The company has two equal owners, who each hold a 50% interest. The owners were juvenile friends who formed the company after gaining individual experience in the pharmaceutical industry. After 30 years of operation, both founders remain open to the possibility of selling their respective interests to the other, or to a third party. The founders engaged an attorney to draft the buy-sell agreement, which included three key provisions: These provisions worked well because they were carefully structured to provide a clear, enforceable process for business valuation. The appraisal process offered a fair solution for conflict resolution, and the buy-sell agreement handled every step in the transfer process .
Case Study 2: DEF Corp
DEF Corp is a construction services company with four equal owners, all of whom are shareholders and officers. The company is the largest of its kind in the region, and the founders are looking to increase its market clout by making a strategic acquisition. Unfortunately, the company’s bylaws did not contain a buy-sell agreement, and the founders had never discussed what should happen if one of them were to die. In the absence of this critical provision, each of the surviving owners would receive an equal share of ownership in the deceased shareowner’s estate – a scenario that would decrease the current shareowner’s voting power by 25%, and in turn, their control over the company. The DEF Corp founders spoke with an experienced business attorney, who helped them craft the required provisions for all key planning documents, including bylaws and corporate shareholder agreements. This case demonstrates the importance of fully discussing the outcomes of various planning scenarios, and ensuring that each owner’s interests are protected in the event of a worst-case scenario, including death or disability.