Classification: Deal Driver
Section: Conditions to Closing
Negotiation Time: Moderate to Substantial
Transaction Costs: Insignificant to Expensive
Major Impact: Risk Management and Transaction Completion
Conditions to Obligations
What is This? This provision contains a comprehensive list of requirements that must be completed by the Seller or waived by the Buyer in order for the Buyer to be obligated to complete the purchase. If the Seller fails to fulfill any condition included in the list, the Buyer can walk away from the deal without penalty.
The Middle Ground: Typically, the list states that:
(1) the Seller’s representations and warranties are true in all material respects at the time of the signing of the Agreement and the Closing;
(2) the Seller has complied with the Agreement and any other Transaction Documents in all material respects;
(3) no legal action has been taken that would prevent the transaction;
(4) all third-party approvals, consents, and waivers listed in the Disclosure Schedules relating to the Seller’s representations and warranties have been obtained;
(5) nothing has occurred that would constitute or cause a Material Adverse Effect;
(6) all Closing Deliverables and Transaction Documents have been signed by the Seller (as applicable) and delivered to the Buyer;
(7) the Buyer has received all Permits necessary to conduct the Business as conducted by the Seller;
(8) the Seller has provided the Buyer with title insurance and a Land Title Survey (or other appropriate deliverables) for each piece of Owned Real Property;
(10) the Buyer has received a signed copy of the Seller Closing Certificate;
(11) the Buyer has received a signed copy of the Seller’s Secretary’s Certificate;
(12) the Buyer has received a FIRPTA Certificate relating to the Business; and
(13) the Seller has delivered any other documents or instruments reasonably requested by the Buyer that are reasonably necessary to consummate the transaction.
Purpose: This provision provides numerous “outs” for the Buyer that create a relatively painless path out of the deal if the Seller does not meet its obligations, including some obligations that are relatively minor. The fact that the Buyer can walk away without penalty if a condition is not met means the risk of the Seller’s failure to deliver is shifted entirely to the Seller, who is obviously in a much better position to control that risk.
Buyer Preference: In addition to the conditions listed above, any number of requirements can be added to this section through negotiation among the parties. Common additional conditions sought by the Buyer include: (a) a “due diligence out” that allows the Buyer to walk away if it cannot complete due diligence to its satisfaction; (b) a “financing out” that conditions the Buyer’s obligation to close on it being able to obtain financing to fund the deal; and (c) financial or operating targets, such as sales or working capital, that, if not met, provide the Buyer with a way out of the deal. If the Seller operates in a highly-regulated industry, the Buyer may also require a legal opinion from the Seller’s legal counsel regarding the Business’s compliance with applicable laws. In addition to these general additional conditions, the Buyer also has certain preferences regarding the listed conditions, such as:
(1) The Buyer will likely include a materiality qualifier but will not want that qualifier to apply to any representation or warranty that already contains a materiality qualifier (i.e. the Buyer does not want a “double materiality” standard). Some exceptions for which the Buyer will want no materiality qualifier whatsoever include the representation regarding the organization and authority of the Seller, any monetary obligations, and financial statements. The Buyer will typically want this condition to Closing to be satisfied both at the time of signing the Agreement and at the Closing so that it can walk away if it receives materially inaccurate information at either time.
(2) Here, the Buyer once again wants to avoid a double materiality standard.
(3) The Buyer does not want any materiality qualifiers whatsoever in this “litigation out.” The Buyer will want to include any actions brought against it in addition to those brought against the Seller.
(4) The Buyer wants all third-party consents to be obtained as a condition to Closing, not just specifically-identified material consents.
(5) The Buyer may want to eliminate the Material Adverse Event condition altogether and replace it with specific event-based conditions, such as operational or financial benchmarks. Or, it may want to keep the Material Adverse Event condition and merely supplement it with specific benchmarks. In either case, the Buyer should be aware when selecting such benchmarks that financials usually lag behind operations and it is easier to manipulate the financial measurements than to inaccurately represent that an operational benchmark was met.
(8) To determine which conditions relating to real property need to be included here, the Buyer should consult a real estate attorney. If the transaction involves Leased Real Property, the Buyer will seek estoppel certificates from the landlord of the property.
(9) If the Buyer knows which documents are necessary to release Encumbrances associated with the Seller’s property, it will want to specify the documents and include a general statement like the one seen above to cover any documents needed but not listed. If the only way the Seller can have the Encumbrances released is to pay the creditor using the Closing payment, the Buyer will want to have the release documents placed in escrow until the creditor is paid.
Seller Preference: In general, the Seller wants to avoid allowing any conditions in this section that are not within its control, such as a due diligence out and a financing out. More specifically, the Seller will generally have the following preferences regarding the listed conditions:
(1) The Seller wants to go beyond a general materiality standard and require that, in order for the Buyer to walk away, a false representation or warranty must have a Material Adverse Effect on the Business. The Seller also wants this condition to apply only at the Closing so that it can cure any inaccuracies that exist when the Agreement is signed.
(3) The Seller wants to limit this condition to legal actions that are reasonably likely to succeed on the merits as a way of excluding frivolous claims that do not have any practical chance of preventing the transaction. Regarding any legal actions taken by a Governmental Authority, the Seller will want only those that prevent a material transaction contemplated by the Agreement to qualify as a litigation out for the Buyer.
(4) The Seller wants to limit this condition to specifically-identified material third-party consents, especially if there are a significant number of third-party consents to be obtained.
(5) Because it is difficult to prove that an event had a Material Adverse Effect on the Business, and because the burden is on the Buyer to prove a Material Adverse Effect, the Seller wants that standard to be applied here, rather than using specific financial or operational benchmarks. If the Buyer insists on specific benchmarks, the Seller will likely favor financial metrics over operational ones.
(8) The party customarily held responsible for paying survey and title insurance costs varies by jurisdiction, but regardless of convention the Seller will want the parties to split any costs related to these items (unless, of course, local custom says the Buyer pays).
Differences in a Stock Sale Transaction Structure: In a stock sale, the Buyer wants any representations and warranties relating to the shares of the Seller to be true and correct in all respects or, in other words, not subject to any sort of materiality qualifier. If the Buyer in a stock purchase is going to replace the directors and/or officers of the Business, receipt of their resignations should be included as a condition to the Buyer’s obligation to close. The Buyer in a stock purchase will also need a certificate of good standing for the Business from the appropriate Governmental Authority in the company’s state of organization.
We want The Middle Ground to be an ongoing dialogue for and resource to the lower middle market M&A community. The outline above is generally applicable, but there is always specific case law and nuance around certain industries that can be useful in helping buyers and sellers come together. If you are a lawyer or deal professional, we encourage you to add your perspective below.