Legal issues in structuring a company acquisition – Part 4

An acquisition agreement must do more than state the price and transfer the business. It must allocate risks, define the conditions for completion and address liabilities arising before the transfer.

The earlier parts of this series addressed transaction preparation, due diligence, legal due diligence and the basic choice between an asset deal and a share deal. Part 4 focuses on the further contractual framework.

The central topics are:

• purchase price,
• purchase-price security,
• statutory and contractual warranties,
• indemnities,
• signing and closing,
• closing conditions and actions,
• covenants between signing and closing,
• legacy liabilities.

1. Purchase price

The purchase price is the consideration for the value of the target. In both asset deals and share deals, it reflects the parties’ negotiations and differing views of the target’s value, prospects, risks, synergies and financing.

The price may be a single amount or a formula that balances multiple valuations, services and counter-services.

The M&A lawyer generally does not perform the commercial valuation but must incorporate the agreed formula into the acquisition agreement. The agreement may need to define cash, debt, working capital, reference accounts, accounting principles, closing accounts, review rights and dispute resolution.

2. Fixed and variable purchase price

A fixed purchase price is agreed finally and generally remains unchanged, subject to agreed or statutory claims relating to defects, warranties or other breaches.

A variable purchase price is initially set provisionally and adjusted later by reference to the target’s economic development or defined financial parameters. The agreement should address the calculation methodology, valuation date, reference accounts, accounting rules, information rights, objections, independent experts and binding dispute resolution.

Purchase-price adjustments can also allocate the risk of changes between signing and closing. The agreement should distinguish ordinary-course performance from extraordinary measures and material adverse developments.

3. Payment and purchase-price security

The seller may require security for the purchase price, particularly where title or shares transfer before the entire price is paid. Possible protections include a bank guarantee, a condition precedent to the transfer, instalment arrangements or other security.

The buyer may seek protection for warranty and indemnity claims through:

• instalments,
• a hold-back,
• an escrow account,
• set-off rights,
• rights to withhold payment,
• other security arrangements or insurance.

The allocation of payment and security risks is usually a central negotiation issue.

4. Statutory warranties

Statutory remedies for defects may include cure, withdrawal, price reduction, damages and reimbursement. These rules are primarily designed for individual assets and rights rather than for an entire business consisting of assets, contracts, employees, permits and commercial relationships.

M&A agreements therefore commonly replace or supplement the statutory framework with individually negotiated warranties, liability rules and remedies.

5. Contractual warranties and representations

In an asset deal, the warranty catalogue may focus on the transferred assets, liabilities, contracts, employees, permits, receivables and intellectual property.

In a share deal, warranties generally focus on the target as a legal entity, including its existence, ownership, capital contributions, constitutional documents, management, solvency and the seller’s title to the shares.

Depending on the target and transaction, warranties may also address:

• financial statements,
• taxes,
• real estate,
• intellectual property and know-how,
• IT,
• material contracts,
• permits,
• compliance with law,
• employees,
• insurance,
• litigation,
• environmental matters,
• ordinary-course operations,
• material adverse changes,
• completeness of information.

Warranties may be hard, requiring objective accuracy, or soft, with liability linked more closely to the seller’s knowledge. The agreement should also define caps, de-minimis thresholds, baskets, time limits, knowledge qualifiers and the exclusion or limitation of withdrawal rights.

6. Indemnities for identified risks

If the seller does not agree to give a broad warranty for a particular issue, the buyer may request an indemnity for a specifically identified risk discovered during due diligence.

Examples include pending litigation, environmental risks, contamination, tax liabilities or known regulatory claims.

A warranty generally addresses the accuracy of a specified state of affairs. An indemnity is intended to ensure that the buyer is not economically burdened by the identified risk. The indemnity should define the risk, covered losses, time period, notice, defence of third-party claims, settlement decisions, exclusions, caps and limitation periods.

As a general distinction, abstract risks may be addressed through independent warranties, while specific and identified risks may be dealt with through indemnities.

7. Signing

Signing is the execution of the acquisition agreement and generally creates a binding contractual relationship. In larger or international transactions, the actual transfer and performance of the transfer obligations may be postponed until closing.

Signing and closing may take place on the same day or at different times. A gap between them is common where regulatory clearances, third-party consents, corporate approvals or preparatory steps are still required.

8. Closing conditions and closing actions

Closing is the central completion point at which the transfer is implemented and the buyer generally obtains control and entrepreneurial responsibility for the target.

Closing conditions may include:

• merger-control clearance,
• waivers or non-exercise of pre-emption rights,
• third-party consents,
• corporate approvals,
• audit reports or certificates,
• execution of ancillary agreements,
• regulatory requirements,
• completion of restructuring steps,
• remediation of material due-diligence risks.

Closing actions may include payment of the purchase price, delivery of possession and documents, transfer of assets or shares, notices, delivery of clearances, interim accounts, declarations, guarantees, changes in management and transfer of powers or access credentials.

The closing agenda should identify every action, responsible party, document and dependency.

9. Covenants between signing and closing

Between signing and closing, the buyer generally wants the target to remain in the agreed condition. Covenants may therefore require the seller to operate the target in the ordinary course and restrict extraordinary actions without the buyer’s consent.

Typical restrictions may cover liquidation, a further sale of shares, amendments to the articles, distributions, disposal of material assets, extraordinary liabilities, termination of material contracts and unusual investments.

The covenants should protect the buyer without unduly interfering with the target’s ordinary management.

10. Legacy liabilities

The allocation of liabilities arising before the transfer depends on the transaction structure, statutory provisions, continuation of the business name, transfer of business, the legal position acquired, unpaid contributions and the contractual allocation of risk.

10.1 Asset deal

In an asset deal, the buyer may be liable for liabilities that were not expressly assumed. These include in particular:

• liability of a purchaser of a commercial business where the business name is continued under Section 25(1) sentence 1 HGB,
• entry into employment relationships in a transfer of business under Section 613a(1) sentence 1 BGB,
• liability for business taxes under Section 75(1) sentence 1 AO.

The specific statutory requirements must be assessed. An agreement may allocate the risk internally between buyer and seller, but may not always exclude liability to third parties.

10.2 Share deal

In a share deal, the target remains the same legal entity and its liabilities generally remain with it. The buyer nevertheless bears the economic consequences through the value and performance of the acquired company.

Covenants protect the buyer between signing and closing. After closing, legacy liabilities may be addressed through warranties, indemnities, price adjustments, hold-backs, escrow or other contractual mechanisms.

10.3 Special share-deal situations

Legacy-liability issues may also arise in connection with the acquisition of interests in partnerships, the admission of new partners, unpaid capital contributions in GmbH interests and outstanding payments on shares. The relevant rules depend on the legal form and the precise transaction.

10.4 Contractual allocation

The acquisition agreement should clearly allocate the internal economic burden of legacy liabilities through warranties, indemnities, disclosure schedules, liability caps, reserves, price adjustments, escrow arrangements and claims-handling provisions.

Contractual allocation does not replace an analysis of statutory liability towards third parties, but it clarifies the economic relationship between buyer and seller.

11. Practical checklist

Purchase price

• Is the price fixed or variable?
• Are all calculation parameters defined?
• What is the valuation or transfer date?
• How are cash, debt and working capital treated?
• Who prepares and reviews closing accounts?
• Is there an expert determination process?

Payment and security

• When is the price due?
• Is payment deferred or made in instalments?
• Does the seller require a bank guarantee?
• Is transfer conditional on payment?
• Is a hold-back or escrow required?
• Are set-off and withholding rights addressed?

Warranties and indemnities

• Which warranties are material?
• Are they hard or knowledge-qualified?
• Which due-diligence risks require an indemnity?
• Are de-minimis, basket and cap provisions included?
• What limitation periods apply?
• How are third-party claims handled?

Signing and closing

• What becomes binding at signing?
• Which closing conditions must be met?
• Which closing actions must occur?
• Which consents and clearances are required?
• Are signing and closing simultaneous?
• Who bears the risk between them?

Covenants

• Must the target operate in the ordinary course?
• Which actions require consent?
• Are distributions, disposals or constitutional amendments restricted?
• What information rights apply before closing?

Legacy liabilities

• Are statutory asset-deal liabilities triggered?
• Which liabilities remain with the target?
• Is the business name continued?
• Is there a transfer of business?
• Are capital contributions outstanding?
• Which warranties or indemnities cover legacy liabilities?
• Can the internal allocation be enforced against third parties?

Legal notice

This article provides general information based on the law and M&A practice as at 27 February 2019. It is not a substitute for reviewing the specific acquisition agreement, purchase-price formula, warranties, indemnities, closing conditions or statutory liability provisions.