Transferring Intangible Assets: Playbook for Selling the Knowledge-Based Enterprise - Purchase Agreement
[This article is part 7 of an 8-part series covering the key elements involved in the sale of IP-based and professional services businesses. The next, and final, article in the series will be “Consents & Closing.”]
Once a Knowledge-Based Enterprise (“KBE”) seller and a prospective buyer have agreed on the key elements of a transaction, and after (or more often, during) the due diligence process, legal counsel for the buyer and seller will begin drafting the Purchase Agreement, a definitive agreement governing all aspects of the transaction.
The main focus of drafting definitive deal agreements for the transaction will be on the Purchase Agreement, but it could also include a number of additional documents related to the transaction. However, the type of ancillary agreements needed vary greatly from deal to deal, so this article concentrates on the primary focus agreement, except for a couple of the most common additional agreements involved in a KBE transaction.
Asset vs Equity Sale
There are two main ways to affect a KBE sale: an equity sale, and an asset sale. As you might expect, much of the language in the Purchase Agreement will be driven by which type of transaction is involved.
Equity Sale. In an equity sale, the deal involves the ownership of the KBE entity, itself. So, even though the purpose of the transaction is to acquire the entity, the deal is actually between the purchase and the KBE’s owners, rather than the KBE entity, itself. An equity purchase involves the payment of money (or perhaps a note or stock in the purchaser entity) in exchange for the units of equity owned by the KBE owners.
Although such deals typically involve the acquisition of all the KBE’s equity, whether stock (in a corporation), membership interests (in an LLC), or partnership units (in a general partnership, LLP or an LP), in some instances the purchaser is merely acquiring enough of the equity to control the KBE – typically a minimum of 51%. Thus, any KBE equity sale involving control of the entity would be considered an equity sale – even if the KBE sellers retain a minority interest after the sale.
By acquiring the equity of the KBE, the purchaser is acquiring all the assets of the KBE, as well as the liabilities - known and unknown. As such, the purchaser will need to be extra thorough during the due diligence process to fully ascertain all current liabilities, as well as any risks for potential liabilities.
In addition to discovering and evaluating all the general risks associated with the liabilities of the entity, purchasers in an equity sale will need assurances that they are acquiring the amount of equity they desire, and they will want to be certain there are no liens or options outstanding on the equity.
Asset Sale. By contrast in an asset sale, the KBE is selling all, or substantially all, of the assets of the KBE, rather than the equity interests. As such, the transaction will be between the purchaser and the KBE entity, itself.
By purchasing the KBE’s assets, the purchaser will not be acquiring any of the liabilities of the KBE. However, in some instances, the assets themselves will have mortgages, liens, licenses, or other liabilities attached to them, and the purchaser will either demand those be eliminated prior to closing or will assume the liability for those specific obligations.
In an asset sale, most of the key concerns or considerations relate to the proper valuation and ownership of the assets and assurance that the assets will be free from any undesired ongoing debts, liens, encumbrances or other obligations. For a KBE sale, special attention must be paid to all intellectual property assets, which may be subject to co-ownership, licenses, and escrow agreements.
Key Elements of KBE Purchase Agreements
In addition to the deal-specific elements related to the equity or assets sale, most Purchase Agreements will contain a number of common provisions, such as:
Language Incorporating Schedules. Most KBE sales, especially asset sales, involve a number of details such as lists of assets, loans, key contracts, insurance policies, accounts, etc. Because these lists and charts are often critical to the deal, they must be included in the Purchase Agreement. However, adding them into the Purchase Agreement would create a convoluted mess. As such, for drafting purposes, these lists and charts are best incorporated as schedules and exhibits to the Purchase Agreement, with language in the Purchase Agreement specifically incorporating them by reference as if they were stated in full in the document.
Language Incorporating Key Ancillary Agreements. Because a KBE sale may involve a number of elements that are not easily integrated into the Purchase Agreement, it can also serve as an “umbrella” agreement that will incorporate by reference certain important agreements, such as IP transfer agreements, key employee employment agreements, promissory notes, etc. Similar to the way in which lists and charts are incorporated into the Purchase Agreement, language in the Purchase Agreement specifically incorporating key contracts in the document will ensure that those agreements are treated as part of the Purchase Agreement, itself.
Consents Required. As part of their corporate governance obligations, the boards and shareholders of the KBE and purchaser will need to consent to the transaction. In addition, several third parties may be impacted by the transaction, such as creditors, vendors, and customers of the KBE. Their consent to the transaction may also be required. As such, the Purchase Agreement should reference these consents and require they be obtained as a condition of closing the deal.
Payment Terms. Likely the most obvious and well-discussed provisions of the Purchase Agreement will relate to the payment of the purchase price. That said, payment terms can be quote complicated in a KBE sale transaction.
The purchase price is sometimes a fixed number, and at other times can be tied to certain future events, such as KBE revenue, continued employment, etc. Moreover, even where the purchase price is a single fixed amount payable in cash, the payment terms may involve a portion paid upfront, with the remainder to be paid in the future.
In addition to an upfront cash payment in full, the purchase price can also involve other valuable payment options, such as: payment of the seller’s debts, payment via a promissory note bearing interest, issuance of stock in the purchaser, or an “earn out” that connects the amount of future payments to the Seller to certain revenue, profit, or other benchmarks.
Typically, the total purchase price can be significantly increased if the KBE seller is willing to accept less than the full amount at closing, with the remainder payable in the future, whether as a promissory note or as an “earn out”. But KBE sellers must beware: any cash not paid to the KBE seller at closing might prove expensive, if not impossible, to collect from the purchaser in the future.
One option to guarantee the payment of future payments to the KBE seller involves the use of an escrow agent. In such instances, the purchaser will pay that portion of the purchase price to the escrow agent, who will hold it for a certain amount of time or pending the occurrence of certain events. If the KBE seller satisfies its obligations, the escrow agent will pay the escrow funds to the KBE seller. If not, the escrow funds will be returned to the purchaser.
Tax Implications. The KBE transaction will likely have all sorts of tax implications. Although both the KBE seller and purchaser will need to work with their respective tax advisors to discuss those implications, language should be included in the Purchase Agreement allocating responsibility for tax obligations to each party as appropriate.
Non-Compete. To ensure they receive their expected benefits of the KBE purchase, purchasers will want to ensure that the KBE sellers will not compete with the KBE’s business after closing. As such, a key provision of the Purchase Agreement will be a non-compete, typically for three to five years. This non-compete would be separate and in addition to any non-competition obligations any key employees may have in their employment agreements. Although non-compete provisions restricting employees are often viewed very narrowly by courts, those entered into as part of a business sale are typically enforced.
Representations and Warranties. The representations and warranties sections of the Purchase Agreement contain language whereby the parties – most importantly the KBE seller – make specific legal guarantees about the truth of certain facts, the delivery of certain promises, and other critical elements of the transaction. Because of the high standards of liability these promises can create for the parties, these provisions are carefully written and negotiated. In addition, the purchaser will typically want to ensure that the KBE seller’s promises as provided in the representations and warranties sections of the Purchase Agreement will continue for several years after the closing.
Clawback Provisions. In the event new liabilities are discovered after closing, or the value of assets turns out to be inflated, or for any number of other reasons, circumstances could result in the purchaser getting less of a deal than they bargained for. To address those situations, the purchaser will often include provisions in the Purchase Agreement to modify the purchase price to account for those surprise circumstances. These provisions, referred to as “clawback” provisions allow a mechanism for the purchase price to be modified after closing.
Of course, each deal is unique, and the foregoing provisions represent only a portion of the overall Purchase Agreement and the KBE sale.
Conclusion
The Purchase Agreement for a KBE sale is often not the only document executed between the KBE seller and buyer. However, it serves as the master agreement that integrates all the other terms, schedules, and agreements related to the KBE sale. As such, KBE sellers should work closely with their legal counsel to draft and negotiate the Purchase Agreement.
About the Author:
Jim Chester is a 20+ year business and technology attorney, professor, and entrepreneur. He is a recognized authority in buying and selling technology businesses, global technology transactions, and providing strategic legal counsel for innovators and industry disruptors. For more on Jim, visit here. He may be reached at jim.chester@klemchuk.com.
To view the previous articles in this 7-part series:
1 - Transferring Intangible Assets: Playbook for Buying & Selling Knowledge-Based Enterprises
2 - Transferring Intangible Assets: Playbook for Selling a Knowledge-Based Business - Overview of the Process
3 - Transferring Intangible Assets: Playbook for Selling a Knowledge-Based Business - Preparing for the Sale
4 - Transferring Intangible Assets: Playbook for Selling the Knowledge-Based Enterprise - Finding Buyers
5 - Transferring Intangible Assets: Playbook for Selling the Knowledge-Based Enterprise- Negotiating the Deal
6 - Transferring Intangible Assets: Playbook for Selling the Knowledge-Based Enterprise - Due Diligence
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