Nondisclosure and Confidentiality Agreement

Typically, a nondisclosure or confidentiality agreement is the first document executed by the parties in a transaction. In the early stages of a deal, the buyer seeks information regarding the target company to determine whether to move forward with the acquisition, and the target company seeks to protect the confidentiality of the trade secrets and other confidential information concerning its business that it discloses to the buyer. A confidentiality agreement is often mutual in that it protects both parties in a deal (i.e., buyer and seller), since each may be disclosing information to the other. Confidentiality agreements are often mischaracterized as boilerplate documents; however, they do typically contain standard provisions requiring the recipient to keep the information confidential and not to disclose the information or use it for any purpose other than in connection with the proposed transaction. A confidentiality agreement also contains certain standard exceptions from the definition of confidential information, such as information that is or becomes part of the public domain; information the recipient can prove it already knew before disclosure; or information the recipient subsequently acquires from a third party or develops themselves independently and without reference to the disclosing party's confidential information. There are also typically provisions that permit the recipient to disclose confidential information in response to subpoenas, court orders, or other legal process, often accompanied by a requirement to give the disclosing party notice so that they may seek a protective order or other relief at their own expense.

Although most confidentiality agreements contain somewhat standard provisions, some agreements may contain unexpected, restrictive covenants, such as noncircumvention provisions, nonsolicitation provisions, and noncompetition provisions. These provisions must be carefully negotiated and potentially deleted from the agreement.

Through the nonsolicitation provision, potential buyers who become familiar with the seller's employees as part of the due diligence process are precluded from soliciting those employees for employment if the deal does not close. Through the noncompetition provision, a buyer is prohibited from competing against the target company for a specified period of time if the deal does not close. These are critical provisions for a buyer to understand if included in the agreement.

Another provision in a confidentiality agreement that is often subject to negotiation is the termination provision. The agreement should include a clause providing that after a specified period of time, the confidentiality obligations no longer apply. Such survival periods will often range from two to five years, with an exception that information qualifying as a trade secret under state law will continue to be protected so long as it so qualifies.

It is prudent, for these reasons, to pay particular attention to the confidentiality agreement. It is also important to use the negotiations of the confidentiality agreement to set the tone for the negotiations that will ensue throughout the transaction. Especially for sellers in an auction mode, the tone established early on will set the stage and expectations going forward.

Letter of Intent

A buyer and seller involved in a transaction generally enter into a letter of intent or term sheet when they have reached an agreement in principle. The letter of intent sets forth the critical terms of the deal after those terms have been discussed by the buyer and the seller, either directly or through intermediaries. Except for certain specific binding provisions, the letter of intent is generally nonbinding. Nonetheless, it is extremely important, as it provides the framework of the deal and a road map for closing the transaction and serves to give the buyer and seller some sense of confidence that sufficient agreement in principle exists to justify the devotion of further time and expense in exploring a potential transaction.

Generally, the letter of intent includes the following transaction terms:

• Purchase price and basis of valuation
• Working capital expectations, if applicable
• Payment terms
• Structure of the deal (asset or stock/merger)
• Assets being purchased and liabilities being assumed (in an asset purchase transaction)
• Expectations regarding indemnification provisions and/or whether representation and warranty insurance will be obtained
• Indemnification and/or working capital holdbacks or third‐party escrows, including amounts and terms
• Other agreements relevant to the deal such as employment agreements, consulting agreements, covenants not to compete and other restrictive covenants, financing agreements, and leases/licenses

A letter of intent may also detail specific conditions that must be satisfied prior to closing the deal, including satisfaction of due diligence, third‐party consent to the assignment of critical contracts, governmental and regulatory approvals, third‐party financing, agreements with key employees, and lack of a material adverse change in the business or prospects of the target company between signing and closing.

In addition to the nonbinding transaction terms, the letter of intent will include certain binding provisions for the benefit of the buyer, the most important of which is an exclusivity or “no‐shop” provision. An exclusivity provision precludes a seller from negotiating, discussing, soliciting, or accepting other offers to purchase the target company for an agreed‐on period of time—typically 60 to 90 days—and in some cases will require the seller to report any unsolicited offers it receives to the buyer. It is important to a buyer to include an exclusivity provision because the buyer is concerned that they will expend a significant amount of time and money to commence due diligence, retain professionals, negotiate transaction documents, and prepare for the transaction only to have the seller accept an offer from another party or attempt to renegotiate deal terms with the leverage of a new buyer. Thus, a buyer requires that an exclusivity provision be included in the letter of intent. To maintain this exclusive right, the seller may insist that the buyer adhere to a certain timeline during the due diligence process. This gives the seller assurance that the buyer is continuing to pursue the transaction as intended, and not merely taking the company off the market. This is a standard term for a letter of intent and typically is not dependent on any earnest money deposit, which although common in real estate transactional settings, is an uncommon component of traditional M&A.

The other binding provisions of a letter of intent generally include a right of the buyer to conduct due diligence, inspect the seller's books and records, and meet with key employees; a limitation of the target company's conduct of the business prior to closing to ordinary course of business; the payment by each party of its transaction expenses; the restriction of public announcements regarding the deal; and, if applicable, the payment of breakup fees.

Table 18.2 contains examples of legally binding provisions in a letter of intent.

Stock Sale/Merger

In a stock or merger transaction, the buyer acquires the equity interests of the target company, such as the capital stock in a corporation and the membership interests in a limited liability company, from the equity owners of the target company. Through this structure, the buyer obtains all the assets of the target company and, most concerning to the buyer, all the liabilities (known, unknown, and contingent) of the target company. The inability of the buyer to separate themselves from the liabilities of the target company, namely unknown and contingent liabilities, generally makes a stock purchase or merger structure a less favorable structure to the buyer, although these risks can often be effectively mitigated through a combination of effective due diligence and a well‐crafted indemnification package. Since this structure in essence includes all the assets and all the liabilities of the target company, it would not be the proper structure in a deal in which only certain assets of the target company are to be sold or in which the buyer is not willing to take on the risk of unknown or contingent liabilities of the target company. In a stock purchase structure, the transaction involves the equity owners of the target company and not the target company itself, although the target company will typically provide representations and warranties to the buyer in the purchase agreement, for the breach of which the equity owners will be liable.

Typically, a stock sale requires the approval of all shareholders. From a practical perspective, a merger enables the sale of the entire company with the consent of a lesser number, often as low as a simple majority, depending on applicable state law and any approval provisions that are built into the target's governing documents. Chapter 17 covers the details of the various types of mergers and their tax implications.

Asset Purchase

In an asset purchase transaction, the buyer purchases some, substantially all, or all the assets (tangible and intangible, real or personal property) of the target entity and assumes certain identified liabilities of the target entity. In such a transaction, title to the assets is sold, transferred, and conveyed to the buyer. After the transaction has been completed, the target company may remain in existence and potentially may remain in business indefinitely, although it is most often left as a nonoperating shell with only cash and rights to future consideration (e.g., third‐party escrow or holdback releases, earnout consideration, principal and interest due under a promissory note from the buyer) and will eventually be wound down and dissolved.

An asset sale does not require the target company to sell all its assets and, most importantly to the buyer, does not require the buyer to assume all the liabilities of the target company. Rather, the target company may sell less than all its assets and the buyer may limit the assumed liabilities to certain identified liabilities of the target entity. The asset purchase structure will ordinarily require different closing documents than a stock purchase transaction in that documents of assignment and transfer must be prepared with respect to each type or class of asset that is being sold, and an assignment and assumption agreement must be prepared with respect to the contracts the buyer has agreed to take on and/or liabilities the buyer has agreed to assume. It is important to note that an asset purchase structure does not ensure that the buyer has isolated themselves from all liabilities of the target company other than those expressly assumed by the buyer, as certain liabilities of the target company may as a matter of law follow the assets being sold under successor liability legal theories, such as product liabilities, ERISA liabilities, tax liabilities, and environmental liabilities.

An asset purchase transaction raises certain issues that do not arise in a stock purchase transaction. One important issue in an asset purchase transaction is determining whether the target company has entered into critical contracts that require third‐party consent (or has critical licenses or permits that require regulatory or governmental approvals) before an assignment of the contracts is effective. These contracts will generally contain clauses that prohibit their assignment to the buyer without the consent of the other party to the contract, and likewise for related regulations, licenses, and permits. This is particularly important to discern in an acquisition of a regulated company (e.g., banking, energy, healthcare, telecommunications, etc.) or a target company with government contracts. Review and discovery of contracts that require consent for assignment becomes a significant part of the legal due diligence, as discussed in Chapter 16.

Qualifications to Representations and Warranties

It would be highly unusual for a seller to be able to make all the representations and warranties that the buyer requests without any qualifications. A seller will generally prepare and deliver to the buyer a disclosure schedule that discloses exceptions to the representations and warranties requested by the buyer. The disclosure schedule in essence qualifies those representations and warranties and, to the extent of the disclosures made, shifts risk as to those disclosures to the buyer. In addition to qualifying representations and warranties through the delivery of the disclosure schedule, the seller will attempt to qualify representations and warranties by making them subject to the seller's “knowledge” (either actual or constructive) or to a materiality standard. Without a knowledge qualifier, the seller is responsible for the representation and warranty regardless of whether the seller knew the representation and warranty was not true and correct at the time made. To the extent a buyer agrees to a knowledge qualifier, the buyer will combat the seller's attempt to limit its liability by defining knowledge as not only actual knowledge but also constructive knowledge. Constructive knowledge incorporates into knowledge not just that which the seller actually knew but also that which the seller should have known after reasonable investigation.

Indemnification

A breach of a representation, warranty, or covenant will trigger indemnification by the breaching party in favor of the party for whose benefit the representation and warranty was made. An indemnification obligation requires the breaching party to indemnify the other party for all damages, losses, costs, and expenses, including attorney's fees, incurred by the other party due to such breach. Since indemnity requires the payment of funds by the indemnifying party to the indemnified party, the financial strength of the indemnifying party is critical. Strong representations and warranties without strong financial support of the associated indemnification obligations make those representations and warranties a “toothless tiger.” The financial strength of the parties making or guaranteeing the indemnification obligations in a transaction is crucial to the party relying on the representations and warranties. To ensure indemnification in the event there is a breach of a representation and warranty, the buyer often seeks to hold back a portion of the purchase price or create an escrow account, which (in either case) will segregate funds from the purchase price and provide the buyer with a source of recovery if an indemnification obligation arises. With a holdback, the funds are typically retained by the buyer until the conditions for release to the seller under the purchase agreement are satisfied, whereas with an escrow an account is established with a third party such as a bank or other financial institution. In the event an indemnification claim subsequently arises, the buyer will settle the claim from funds they retained in the holdback, or submit a notice of claim to an escrow agent. Sellers typically prefer a third‐party escrow to a holdback because it avoids the credit risk that comes with the seller being an unsecured creditor of the buyer while the holdback is in place.

Sellers generally negotiate limitations to their indemnification obligations, including finite survival periods of representations and warranties, baskets and deductibles that must be satisfied before indemnification obligations are triggered, and caps on indemnification obligations. Survival periods for representations and warranties are generally included so that a seller knows that, after a certain period of time, its obligations for breaches of the representations and warranties will be extinguished. The survival periods of representations and warranties are generally not uniform across all representations and warranties. General representations and warranties typically have survival periods of 12–24 months, while certain fundamental representations and warranties (such as those relating to authority and enforceability, taxes, ERISA, broker fees, and related‐party transactions) will have a longer survival period that could be tied to the statute of limitations or other practical expiration date. Sellers often also include a basket or a deductible concept to limit indemnification, which provides that the seller is not responsible for indemnification obligations until a certain dollar threshold of claims are incurred by the buyer. Basket provisions are distinct from deductibles. When a basket is used, damages are reimbursed to the buyer back to the first dollar once the threshold is met; when a deductible is used, damages are reimbursed only above the threshold.

Caps on the amount of the indemnification obligations are also typical in a deal. The caps are a product of negotiation and, like representations and warranties, are not uniform for all breaches and may differ depending on the specific representation and warranty breached.

Baskets, deductibles, and caps are typically only applicable to indemnification claims based upon breaches of representations and warranties (as opposed to other basis of indemnification, for example, breaches of covenants and agreements), and breaches of fundamental representations and warranties are typically excluded.

The use of representation and warranty insurance has become more commonplace in middle market transactions. The buyer typically acquires the policy, as they are the insured party, but the cost of the premium is often shared by the buyer and the seller. Using representation and warranty insurance can avoid the need for the buyer to hold funds in escrow to protect from indemnification risk beyond the policy deductible or to protect against risks that are excluded from the policy. This type of insurance is particularly common where the transaction is structured to include a rollover, as it gives the buyer a recourse for indemnification claims without having to directly pursue the seller (who is their minority partner postclosing and is often involved in the day‐to‐day operation of the business).

Transaction Statistics

While many of the legal terms in a transaction are subject to negotiation and customized to address the specific risks of the parties, often the letter of intent or terms sheet is signed under the assumption that the parties will agree later to legal provisions that are “typical and customary.” This sometimes leads to differences of opinion and negotiations become contentious when each party has a different interpretation of “market” terms.

To resolve these disputes, a few different organizations collect and report on commonly negotiated provisions in private transactions. Armed with data from these studies, M&A advisors can help buyers and sellers settle on terms that are in line with the rest of the market.

Here are a few organizations that offer these studies:

• American Bar Association's M&A Market Trends Committee
• SRS Acquiom
• GF Data
• Houlihan Lokey and other investment banks

The following are some common terms, provisions, and points of negotiation in an M&A deal where data can often be obtained in these types of studies, usually by transaction size:

• Cap amount
• Deductible or basket size
• Indemnification survival period
• Mix of deal consideration
• Size of escrow or holdback
• Earnout metrics