What is a Sales and Purchase Agreement (SPA)?
A Sale and Purchase Agreement (SPA) is a crucial legal document in any business transaction. It outlines the terms and conditions under which a seller agrees to sell, and a buyer agrees to purchase a particular asset, such as real estate or shares in a company. Once the buyer has completed the due diligence to determine the true state of the company for sale, the final phase of the transaction is to craft the SPA and determine the sale price of the company.
In this document, we will explore the main elements of an SPA and identify the most commonly negotiable areas to help you navigate this complex process.
Key Learning Points
- The SPA is the principal document that lays out the terms of a transaction and is negotiated by the buyer and seller
- Clear and solid financial terms in the SPA are essential to closing a successful transaction
- Prior to drafting the SPA, the parties usually negotiate and execute a term sheet, which addresses all the principal terms of the transaction, which can then be incorporated into the SPA
- An M&A transaction is typically accompanied by extensive due diligence before the SPA is finalized
- SPAs may also be affected by existing shareholders’ agreements between the shareholders of a target company
Main Elements of a Sale and Purchase Agreement
1. Parties Involved
The SPA must clearly identify the buyer and the seller, including their names, addresses, and any other necessary contact information.
The agreement should provide a detailed description of the assets being sold and purchased, including any tangible and intangible assets, such as property, equipment, intellectual property rights, and contracts. SPAs are not used for the sale of services.
3. Purchase Price
The SPA must specify the total purchase price, the currency in which it will be paid, and any adjustments to the price based on factors like the value of inventory or the occurrence of specific events. These purchase price adjustments generally shield a purchaser from changes in the value of the target between the date the target was valued and the transaction closing.
4. Payment Terms
The agreement should outline the method and schedule of payment, including any deposits, escrow arrangements, or financing conditions.
5. Representations and Warranties
Both parties must provide representations and warranties in an SPA, assuring the accuracy of the information, the legality of the transaction, and the absence of undisclosed liabilities or encumbrances.
Covenants are promises made by the parties to perform or refrain from certain actions during the transaction, such as maintaining the business operations or obtaining necessary approvals.
7. Conditions Precedent
These are stipulations that must be satisfied (or waived) before the transaction can proceed. This can include regulatory approvals, satisfactory due diligence, or third-party consents.
8. Closing and Possession
The SPA should detail the closing date and the process for transferring possession of the assets, including any required documents and procedures.
The agreement should include provisions to permit a party to terminate in case certain conditions are not met or if either party breaches the agreement.
10. Governing Law and Dispute Resolution
Both parties should specify the jurisdiction whose laws will govern the SPA, along with the method for resolving any disputes that arise, such as arbitration or litigation.
SPA typically contains language specifying that the terms are deemed confidential information and are not to be disclosed to any third party. This also usually includes reference to any previous non-disclosure agreements (“NDA”) that were entered into during a prior phase of the transaction.
Commonly Negotiable Areas in a Sale and Purchase Agreement
Purchase Price and Adjustments
The purchase price and any price adjustments are often subject to negotiation, depending on factors like market conditions, the financial health of the asset, and the valuation methods used.
In a sale and purchase agreement, purchase price adjustments are mechanisms to ensure that the final price paid for the assets or business accurately reflects their value at the closing date. These adjustments are documented in the Sale and Purchase Agreement if you are using a completion accounts mechanism. If you are using a locked box method, then these adjustments are made, but they are done outside the sale and purchase agreement as you are using a historical set of accounts.
These adjustments can help protect both the buyer and the seller from potential discrepancies between the agreed-upon price and the actual value of the assets on the final balance sheet. Common purchase price adjustments include:
Working Capital Adjustment
A working capital adjustment ensures that the business being acquired has an adequate level of working capital (current assets minus current liabilities) at closing. The parties usually agree on a target working capital amount, and the purchase price is adjusted up or down based on the difference between the target and the actual working capital at closing. A key issue can be the seasonality of working capital – or more specifically ‘operating working capital’. Lawyers typically only focus on accounts receivable, inventory and accounts payable. Below is the operating working capital for Mattel Inc.:
If you value Mattel on an EV/EBITDA multiple, and you complete in September the company is full of inventory – and you capture all that value. If you complete the deal in December, a significant portion of the inventory is liquidated and the accounts receivable paid – so potentially the value has left the business. The accountants will prepare a ‘permanent level’ of working capital (averaged over the year if it’s seasonal) and make an adjustment based on the permanent level versus the actual level at completion.
A good analogy to think of is buying a second-hand car. If the gas tank is full then you have to pay more, if the gas tank is empty then you will demand to pay less.
Net Debt Adjustment
A net debt adjustment accounts for the difference between the debt and cash levels of the target company at closing compared to the levels agreed upon during negotiations. The purchase price is typically adjusted to reflect any changes in the net debt position, with an increase in net debt leading to a decrease in the purchase price, and vice versa. Practically, this becomes an issue if you are using the completion accounts method. Under completion accounts, you must ‘estimate’ the net debt at completion as it takes a month or so to prepare the final accounts.
An earn-out is a contingent purchase price adjustment based on the future performance of the acquired business. The parties agree on specific financial or operational targets (e.g. revenue, EBITDA, or customer growth) to be achieved within a certain time frame. If the targets are met or exceeded, the seller receives additional payments, effectively increasing the purchase price.
Escrow or Holdback Arrangements
An escrow or holdback arrangement involves setting aside a portion of the purchase price, typically to cover potential indemnification claims, breaches of warranties, or other contingent liabilities. The funds are held in escrow or withheld from the seller for a specified period or until certain conditions are met. Any unused funds are eventually released to the seller, effectively adjusting the final purchase price.
Milestone payments are similar to earn-outs but are tied to specific events or achievements rather than financial or operational performance. These payments are contingent on the occurrence of agreed-upon milestones, such as regulatory approvals, product launches, or the completion of a project.
Understanding and negotiating appropriate purchase price adjustments can help protect both buyers and sellers from unexpected changes in asset value, financial position, or business performance between signing and closing a transaction. These adjustments can also facilitate the alignment of interests between the parties and contribute to a smoother transaction process.
Buyers and sellers may negotiate the timing and structure of payments, including the use of escrow, deferred payments, or earn-outs.
Representations and Warranties
Representations and warranties are given by both parties to disclose material information to each other. The scope and extent can be subject to negotiation, with buyers seeking broader coverage and sellers aiming to limit their exposure to potential claims. Representations and warranties allocate risk between the parties and form the basis for a legal claim in case of misrepresentation or breach.
Indemnification provisions, which allocate the responsibility for any losses or liabilities arising from the transaction, are often negotiated to balance the risk between the parties.
What is the difference between an indemnity and a warranty?
In the context of a sale and purchase agreement or other commercial contracts, indemnities and warranties are both used to allocate risks and potential liabilities between parties. However, they serve different purposes and operate in distinct ways:
An indemnity is a contractual promise by one party (the indemnifying party) to compensate the other party (the indemnified party) for specific losses or damages that may arise in connection with the transaction. Indemnities are often used to cover particular risks or liabilities that have been identified during negotiations or due diligence, such as third-party claims, tax liabilities, or breaches of environmental regulations.
The key features of indemnities include:
- They provide direct compensation for actual losses or damages incurred by the indemnified party.
- They are usually triggered by a specific event or circumstance outlined in the contract.
- The indemnified party does not need to prove that the indemnifying party was at fault or negligent to claim under an indemnity.
- Indemnities may not be subject to the same limitation periods or caps on liability that apply to warranties.
A warranty is a contractual statement or representation made by one party (the warrantor) to the other party (the warrantee) regarding the existence of certain facts, conditions, or circumstances. In a sale and purchase agreement, warranties typically relate to the accuracy of the information, the quality or condition of assets, or the legal and financial status of the parties.
The key features of warranties include:
- They provide a basis for the warrantee to claim damages for breach of warranty if the warranted facts or conditions turn out to be inaccurate or untrue.
- Damages for breach of warranty are generally calculated based on the difference between the value of the asset or transaction as warranted and its actual value.
- The warrantee must prove that the warrantor breached the warranty and that the breach caused a loss to claim damages.
- Warranties are often subject to specific limitations on liability, such as caps on the amount of damages, time limits for bringing claims, or requirements for notice and mitigation of losses.
In summary, indemnities provide direct compensation for specific losses or damages, while warranties provide assurances regarding the accuracy of information or the existence of certain facts or conditions. Indemnities are generally broader in scope and may not be subject to the same limitations as warranties. Understanding the differences between these two risk allocation mechanisms can help you negotiate more effectively and protect your interests in a commercial transaction.
Covenants and Conditions Precedent
Covenants and conditions precedent are essential components of Sale and Purchase Agreements (SPAs). The parties may negotiate the specific covenants and conditions precedent to tailor the SPA to their unique circumstances and to allocate risk and responsibility more equitably.
Covenants are binding promises made by the parties to perform or refrain from certain actions during the transaction, while conditions precedent are specific conditions that must be satisfied before the transaction can proceed.
Here are some examples of covenants and conditions precedent commonly found in SPAs:
- Conduct of Business: The seller agrees to continue operating the target business in the ordinary course and maintain its financial condition, assets, and relationships with customers, suppliers, and employees until the closing of the transaction.
- Access to Information: The seller agrees to provide the buyer with reasonable access to the target company’s books, records, and personnel for the purpose of conducting due diligence or preparing for the closing
- Regulatory Compliance: Both parties agree to comply with all applicable laws, regulations, and licensing requirements related to the transaction.
- Non-Competition: The seller agrees not to engage in any business activities that directly compete with the target business for a specified period following the closing.
- Non-Solicitation: The seller agrees not to solicit or hire any employees, customers, or suppliers of the target business for a specified period after the closing.
- Cooperation in Obtaining Approvals: Both parties agree to cooperate in obtaining any required third-party consents, regulatory approvals, or other authorizations necessary for the transaction to proceed.
Conditions Precedents (CPs)
The buyer’s satisfactory completion of due diligence on the target company’s financial condition, assets, liabilities, operations, and legal compliance.
Due diligence is a critical process undertaken by buyers during a business transaction, such as a merger, acquisition, or investment, to assess the risks, potential rewards, and overall viability of the target company. The process involves a thorough examination of various aspects of the target company to ensure that the buyer makes an informed decision. Here are the key components of a due diligence process:
Financial Due Diligence: The primary objective of financial due diligence is to assess the target company’s financial health and performance. This involves examining:
- Historical financial statements, including balance sheets, income statements, and cash flow statements
- Quality of earnings and revenue recognition practices
- Key financial ratios and performance indicators
- Budgets, forecasts, and financial projections
- Capital structure, debt, and financing arrangements
- Contingent liabilities and off-balance-sheet obligations
Legal Due Diligence: Legal due diligence focuses on identifying potential legal risks and liabilities associated with the target company, such as:
- Corporate structure and ownership
- Compliance with applicable laws and regulations
- Material contracts and agreements, including customer, supplier, and employment contracts
- Intellectual property rights, including patents, trademarks, and copyrights
- Litigation history and ongoing disputes
- Employment matters, including employee benefits and labor relations
Operational Due Diligence: Operational due diligence aims to evaluate the target company’s business operations and efficiency, including:
- Business model and strategy
- Market position and competitive landscape
- Key customers, suppliers, and partners
- Supply chain and distribution channels
- Manufacturing processes, capacity, and facilities
- Quality control and management systems
Technological Due Diligence: Technological due diligence focuses on assessing the target company’s technological assets, capabilities, and risks, such as:
- Information technology infrastructure and systems
- Software applications and licenses
- Cybersecurity and data protection measures
- Research and development activities and innovation pipeline
- Technological Dependencies and potential obsolescence
Environmental, Social, and Governance (ESG) Due Diligence: ESG due diligence involves evaluating the target company’s performance and risks in terms of environmental, social, and governance factors, including:
- Environmental compliance and potential liabilities (e.g., waste disposal, emissions, and hazardous materials)
- Social factors, such as labor practices, health and safety, and community relations
- Corporate governance, including board composition, executive compensation, and internal controls
Human Resources Due Diligence: Human resources due diligence aims to assess the target company’s workforce, organizational culture, and talent management practices, including:
- Employee demographics, skills, and experience
- Compensation and benefits programs
- Retention and turnover rates
- Training and development initiatives
- Succession planning and leadership development
Tax Due Diligence: Tax due diligence involves reviewing the target company’s tax compliance and potential liabilities, such as:
- Federal, state, and local tax filings and payments
- Transfer pricing policies and documentation
- Tax credits, incentives, and exemptions
- Contingent tax liabilities and exposures
By conducting a comprehensive due diligence process across these key components, buyers can gain a deeper understanding of the target company’s risks, opportunities, and value drivers, ultimately enabling them to make more informed decisions during the transaction process.
Other Conditions Precedent
- Regulatory Approvals: The receipt of necessary regulatory approvals, such as antitrust clearance, foreign investment approvals, or industry-specific licenses.
- Third-Party Consents: The obtaining of consents from key stakeholders, such as lenders, landlords, or major customers, whose approval may be required for the transaction to proceed.
- Financing: The buyer’s successful arrangement of financing to fund the purchase price, if applicable.
- No Material Adverse Change: The absence of any material adverse change or effect on the target company’s business, financial condition, or prospects between signing and closing. See below for more detail.
- Representations and Warranties: The accuracy of each party’s representations and warranties in the SPA as of the closing date.
- Fulfillment of Covenants: The performance by both parties of all covenants and agreements required to be performed before the closing.
By including appropriate covenants and conditions precedent in an SPA, both buyers and sellers can better manage the risks and uncertainties associated with a transaction, ensure a smoother process, and protect their respective interests.
Material Adverse Change (MAC)
A Material Adverse Change (MAC) or Material Adverse Effect (MAE) clause is a provision often included in a Sale and Purchase Agreement (SPA) that allows a party, typically the buyer, to walk away from the transaction or renegotiate the terms under certain circumstances. The clause is triggered when a significant negative event or change occurs that materially impacts the target company’s financial condition, business operations, assets, or prospects.
The purpose of a MAC or MAE clause is to protect the buyer from unforeseen risks and uncertainties that arise between signing and closing, which could significantly affect the value of the target company or the buyer’s willingness to proceed with the transaction.
Examples of events that could constitute a material adverse change or effect include:
A significant decline in the target company’s revenues, profits, or other key financial metrics, which could indicate a worsening financial condition or a reduced valuation.
Legal or Regulatory Issues
The target company becomes subject to a lawsuit, regulatory investigation, or changes in applicable laws or regulations that could materially impact its operations, financial condition, or ability to conduct business.
Loss of Key Customers or Contracts
The target company loses major customers or contracts, which results in a substantial reduction in its revenue, profitability, or future growth prospects.
Natural Disasters or Force Majeure Events
Events such as earthquakes, floods, or pandemics that cause significant damage to the target company’s assets, disrupt its operations or adversely affect its financial condition or prospects.
The sudden departure of key executives or management personnel, could negatively impact the target company’s leadership, strategy, or operations.
It is important to note that MAC or MAE clauses are often heavily negotiated, and their scope and definition can vary depending on the specific transaction and the parties involved. Buyers typically seek a broad definition to maximize their protection, while sellers aim to narrow the scope and include specific exceptions to avoid the risk of the clause being triggered by minor or temporary issues.
In summary, a Material Adverse Change or Material Adverse Effect clause in an SPA provides a mechanism for the buyer to protect itself from significant negative events or changes affecting the target company between signing and closing. By understanding and negotiating the scope and definition of this clause, both buyers and sellers can better manage the risks and uncertainties inherent in the transaction process.
Renova Investment Holding Limited (the Buyer) entered into an SPA with 3DOM Inc (the Seller), in relation to the acquisition of the entire issued and paid-up share capital of 3DOM (Singapore) Pte. Ltd (the Target). Under the SPA, the Buyer will acquire the entire issued and paid-up capital of the Target from the Seller.
Key terms of the SPA:
Valuation: The Buyer appointed an independent qualified appraiser to complete a valuation report on the Target. The independent valuation expert, the Buyer, and the Seller concluded the Target should be valued at S$1,700,000,000.
Consideration: The Consideration was agreed on a willing-buyer and willing-seller basis, after substantive negotiations with the Seller, and is based on an agreed 20% discount to the Actual Valuation of the Target conducted by an independent qualified valuation expert.
Payment method: The parties agreed that the consideration is paid in shares. The Buyer shall allot and issue 1,813,333,333 new fully paid-up common shares (the Shares) in its capital (the Consideration Shares” at a pre-consolidation issue price of S$0.75 each to the Seller
Structure: Following the acquisition, the Target will become a subsidiary of the Buyer.
Transaction fees: the Parties agreed that the Transaction cost shall be paid by the Buyer.
Conditions Precedent: The Proposed Acquisition is conditional upon the fulfillment or waiver of customary conditions precedent for a transaction of this nature, including but not limited to the following:
- The consideration derived from the Actual Valuation being not less than S$1.36 billion
- The completion of financial, legal, operational, and any other due diligence exercise on the Target by the Buyer, and the results of such due diligence being reasonably satisfactory to the Buyer
- The findings and methodology presented in the valuation report to be issued by the independent qualified valuer being satisfactory to the Buyer
- The entry into service agreements by the key management of the Target, on terms mutually agreeable to the parties
- The Seller procuring the Target shall obtain such approval(s) required from the respective Target‘s board of directors and its shareholder(s) in connection with the SPA
- The Buyer obtaining such approval(s) as may be required from its directors and shareholders
- The Proposed Share Issuance
- The allotment and issuance of the Consideration Shares at Completion
- The appointment of individuals nominated by the Seller to serve as directors of the Buyer post-completion
- In respect of the Buyer, all consents and approvals are required under any and all applicable laws and regulations.
A Sales and Purchase Agreement serves to provide a mutual written agreement on the terms and conditions of an asset sale. It considers the valuation of the asset and pricing complexities as well as the rights and obligations of the buyer and seller. In M&A, using an SPA service expert to provide advice can lead to a significant advantage in the deal process.