What is a Definitive Agreement?

What is a definitive agreement? A legally binding contract, a definitive agreement (DA), lists the terms and conditions of a business transaction or M&A deal. Legal teams typically draw up this document just as negotiations conclude and the deal closes.

Although most DAs have standard boilerplate terminology and clauses, you should study the contents carefully. The agreement is unique to the transaction with regard to payment terms, representations, warranties, covenants, and annexures.

A definitive agreement is also called a stock purchase agreement or definitive merger agreement and differs from the LOI. The LOI or Letter of Intent is a preliminary document the buyer sends over expressing their intention to purchase. It may or may not be legally binding.

But the DA is the final document outlining the details and rounds off the transaction. The DA is also featured in joint ventures, divestiture, strategic alliances, and any other business transactions. It is also distinct from a Memorandum of Understanding or MOU.

Unlike the LOI and MOU, the definitive agreement is always legally binding and executed on stamp paper. It essentially transfers ownership of the asset from the seller to the buyer and concludes the deal on signing. A standard agreement lists details like inventory, core team, tangible assets, and IP.

Once the parties sign this document, it supersedes all previous agreements and understandings, oral or written. That includes the Letter of Intent (LOI).

Types of Definitive Agreements

Definitive agreements can be of two kinds, depending on the terms of the deal. If the transaction involves only transferring some assets, the parties enter into a share purchase agreement. However, if the deal involves selling the entire company, they’ll have a share purchase agreement.

Deals between public companies are more streamlined since they divulge detailed information about their operations. However, deals between private companies are more complex, and every clause is defined in detail. Here’s how:

Share Purchase Agreement

In a share purchase agreement, the seller transfers the company’s shares and stock in the buyer’s name. As a result, the buyer owns not only the assets but also the liabilities the seller previously owned. This is why such transactions are also called stock sales.

Regardless of whether the company is a public or private entity, the share purchase agreement is a complex document. It lists in detail all the assets the buyer acquires and all the liabilities they must assume. For instance, working capital considerations.

Asset Sale Agreement

Dealmakers sometimes enter into an acquisition structured as an asset sale instead of an actual divestiture for taxation purposes. The seller transfers individual assets to the buyer instead of selling the entire company. Such transactions are typically made with a distressed company.

The seller retains ownership of the company but the buyer integrates the purchased assets with its organization. Alternatively, the buyer may create an independent company with the assets. In that case, the definitive agreement will outline more terms and is called an asset sale agreement.

This document will define the transition plan to the purchasing entity, including details like retaining employees and valuations. The value of each asset and liability will be mentioned separately.

Clauses Included in a Definitive Agreement

Key Terms and Their Meanings

The initial section outlines the key terms mentioned in the agreement and their meanings pertaining to the entire document. For instance, the names of the buyer and seller, the meaning of the closing date, the sale price, and other considerations.

It may also define the meaning of working capital, earn-outs, and escrow to lend complete clarity to the document.

Purchase Considerations

This section details the aggregate consideration the buyer must pay the seller, including adjustments. It also describes the payment terms, including the timelines after the closing date and earnest money placed in escrow. Other terms include earn-outs with detailed information to eliminate disputes.

The buyer may also require that the company have a fixed amount of working capital at the time of transfer. This information will feature in the definitive agreement. In case the buyer is raising funding from third parties to finance the deal, they must specify whether it’s in the form of cash or stock.

In the case of stock sales in public companies, purchase prices are expressed in terms of per-share rates. The agreement specifies the exact number of shares and the treatment of dilutive securities later.

Dealmakers may use two methods to calculate the number of shares payable to the seller for the assets.

• Fixed or floating exchange ratios where the seller receives an equal number of shares in the buyer’s company. The ratio is 1:1 against the number of shares the seller delivers.
• Collars is a technique that allows dealmakers to hedge against falling or rising share prices. They change the exchange ratios according to the purchase price.

Earn-outs are another payment option buyers increasingly prefer. According to this condition, the buyer pays a portion of the purchase price only if the company achieves certain milestones. The company should meet these targets within a pre-determined time interval.

Targets can include EBITDA metrics, revenues earned, IP developed, or number of team members hired. This method allows the buyer to hedge against some of the risks.

Representations and Warranties

This section is the most crucial section of the definitive agreement, and dealmakers typically engage in extensive negotiations when finalizing it. The representations and warranties section of the definitive agreement states that the facts or representations are warranted or true.

From the buyer’s perspective, representations and warranties should be as comprehensive as possible since they deliver valuable information. The buyer gets an understanding of the assets they are purchasing and paying for.

The seller’s goal is to limit the reps and warranties. At the same time, the warranty ensures that the seller has complied with the applicable government regulations. Other warrants include compliance with intellectual property, anti-trust, accounting, and Worker’s Compensation laws.

Most importantly, the seller warrants that they have the legal authority to sign the definite agreement and sell the asset. On their part, buyers financing the deal from third-party lenders must specify they have confirmation of loan commitments.

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Limitations of the Representations and Warranties

The seller can add limitations or conditions to the representations and warranties. Accordingly, the reps and warranties will not be applicable under certain situations. For instance:

• The reps and warranties are valid only up to a specific deadline. The seller will not take any responsibility after that date.
• The definitive agreement will also include disclosure schedules that qualify, disclose, or supplement exceptions to the reps and warranties.
• The rep or warranty is subject to materiality, and the agreement defines what is material. Or what could cause an adverse material impact.
• The seller can limit the scope of the information provided in the data room during the negotiation and transaction process.

No-Shop Clause

The buyer may request that the “no-shop” clause be added to the DA. This clause prevents the seller from contacting other buyers in the market during the negotiation process. In this way, they have an assurance of not being outbid by other potential buyers.

Go-Shop Clause

If the seller is not happy with the purchase price, they may request the inclusion of the “go-shop” clause. This condition allows them to actively scout the market for better offers before the deal closes. Clearly, the buyer is at a disadvantage with this limitation.

Interestingly, sellers of a public company have a fiduciary obligation to consider “unsolicited” offers. However, it can also apply to private companies. This clause protects them from potential lawsuits, citing that the sellers did not conduct a thorough market price check before entering into the deal.

The “go-shop” clause typically has a 30 to 60-day deadline beyond which sellers cannot accept alternative bids.

Covenants

Covenants in the definitive agreement prevent the seller from certain actions and activities before they formally transfer ownership. These covenants protect the buyers’ interests by outlining what the seller “Cannot Do.”

For instance, they prevent the seller from selling off assets (physical and IP), taking on debt, or issuing stock. The basic premise is to prevent any actions that can potentially diminish the asset’s value in any way. Or impact the buyer’s value.

Indemnification Clauses

Indemnification clauses in the definitive agreement compensate the buyer if the seller does not disclose a liability. This clause protects the buyer from incurring losses if they uncover liabilities the seller failed to divulge during the negotiations.

At the same time, indemnification clauses come with a fixed timeline ranging from 12 to 24 months. The buyer cannot claim damages once this deadline has passed. This section also goes through extensive negotiations with dealmakers on both sides of the table, safeguarding their interests.

The buyer will want to cover a broad range of potential punitive damages that they can recover later. The seller will also want to limit their liability by excluding punitive, consequential, and other similar damages. Excluding damages that arise from diminishing value is also an objective.

The buyer may want to include the sandbagging clause. This clause allows them to claim damages for breaches that they were aware of before the deal closed. Sellers will also anticipate this clause and limit the damages buyers can claim even though they were aware of the liabilities.

Such indemnification clauses in the definitive agreement also extend to breaches or inaccuracies in divulging information prior to the sale. They may also include a pre-determined monetary value of the damages.

For instance, baskets that limit the damages to at or below a fixed amount. Or deductibles, which the seller must pay over and above a fixed limit. Indemnification clauses also come with a cap expressed in terms of a percentage of the transaction value. Or a pre-determined dollar amount.

Both sides negotiate extensively to limit the damages they may have to carry.

Closing Conditions

M&A transactions typically have a time lag between the formal signing of the definitive agreement and the deal’s closing. The deal needs to go through regulatory scrutiny and get authorization before the deal culminates. Accordingly, the DA includes certain conditions both parties must meet.

If the dealmakers fail to meet these conditions, the opposite party can terminate the deal. For instance, buyers should request that the reps and warranties are accurate on the signing and closing dates. However, since reps cannot have standard clauses, they are open to negotiations.

Buyers can also include Material Adverse Change (MAC) and Material Adverse Effect (MAE) clauses in the definitive agreement. This clause enables the buyer to back out of the deal in case of major occurrences during the time lag.

These major catastrophic changes can include an unexpected economic downturn, macroeconomic changes, banks failing, or climatic disasters. Of course, sellers will include exclusions to prevent the buyer from canceling the deal.

Termination Fee

The seller typically pays the termination fee if the deal falls through. This fee is equivalent to 2% to 3% of the equity purchase price or a fixed sum as outlined in the definitive agreement. When sellers cancel the deal in favor of a competing and better offer, they are liable to pay damages.

Annexures

The definitive agreement also has the annexures section, which includes additional clauses like:

• IP Agreement 
• Fixed Assets
• Net Working Capital Determination Methodology
• Escrow Agreement
• Key Employee Agreement
• Detailed description of the inventory in the company and conditions for valuing it in case of changes. Dealmakers assume the company will continue operating as usual during the ownership transfer.
• Conditions for resolving disputes should they arise during the closing period.
• Terms for covering the finder’s fee payable to the agent or entity facilitating the deal.

Before We Sign Off!

The definitive agreement describes all the relevant information about the purchase transaction and how it will proceed. However, it is crucial to note that the agreement talks about the company and its status at the time of negotiating the deal. It does not include future projections and estimations.

The agreement specifies facts and expects both sides to be upfront about the information they divulge.

Disclaimer: This article is intended to provide a quick overview of a definitive agreement and is by no means exhaustive. Readers should retain the services of qualified professionals to assist them with drawing up legal documents.

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