Stock Purchase Agreements Defined
A stock purchase agreement is a contract that explains the circumstances under which the stock of a corporation either privately or publicly held , will be bought or sold. It typically provides for the purchase of shares for a stated price and within a set period of time or as determined by some other provision. A stock purchase agreement is essentially the framework for a deal between the buyer and seller of corporate securities. It will contain information about how the sale is to be accomplished and sometimes lays out the terms of compensation. It is particularly important in real estate transactions that the deal include language covering the rights of the buyer and seller if the ownership of the business is disputed.
Key Elements of Stock Purchase Agreements
Like all contracts, stock purchase agreements contain essential components. While the particulars of each negotiated stock purchase agreement will vary, most possess several key components in common, such as purchase price (and any associated payment terms), representations and warranties, and closing conditions.
Purchase Price and Payment Terms
The purchase price for stock is usually stated as a fixed amount, divided by the number of shares to be purchased, or as a formula based on a business valuation formula or method. It may also include an earn-out in cases where the selling shareholder may receive additional compensation at a later date based on either the company’s performance or the achievement of certain milestones by the buyer. If so, earn-out language will need to be carefully drafted due to the potential future disputes that can arise over their performance.
Representations and Warranties
Representations and warranties in a stock purchase agreement are generally limited to those made by the selling shareholders and/or the company. These may include:
Representations about the buyer are less common but may be "limited to the buyer or seller" in character, such as existence of capacity of an entity, good standing, qualification and authority to execute and deliver the agreement, and absence of conflicts and violations.
Conditions Precedent to Closing
There are a variety of conditions that may precede closing of the transaction. Some of these conditions include (but are not limited to):
Other conditions common to closing may involve intermediaries and/or third parties, particularly private equity and investment firms.
How Stock Purchase Agreements Differ from Asset Purchase Agreements
The key difference between a stock purchase agreement and an asset purchase agreement is in what is being transferred and in the extent of liability that a buyer is willing to take on with a sale. With a stock purchase agreement the seller first forms a corporation, and then sells the ownership interest held in that corporation (which includes the assets held in that corporation) to the buyer. The corporation maintains the same name, and all of the obligations of the corporation remain the same, but now the corporation has a different owner.
With an asset purchase agreement, instead of the seller selling the ownership interest in the company that is sold to the buyer, the seller sells only the assets owned by the corporation. With this agreement, the corporation is still formed, but only the assets are being sold—and not the ownership interest held in that corporation. A buyer often prefers an asset purchase agreement because that buyer takes on the corporation’s assets, but does not take on the corporation’s liabilities, because all of the corporations liabilities are left with the seller after the sale.
Buyers on the other hand will sometimes prefer a stock purchase agreement because they are willing to take on a seller’s liabilities as long as they can continue to operate the business in a similar fashion because the seller’s obligations are left with the corporation.
Legal and Financial Aspects to Keep in Mind
Legal & Financial Considerations
For a seller, one of the immediate advantages of entering into a stock purchase agreement is the receipt of liquid assets. That cash becomes available to the seller to use however he or she wishes without concern about such funds being subject to any future claims by creditors.
For the buyer, the ability to acquire a business in a relatively uncomplicated manner is the primary advantage. The assets to be transferred as a result of a stock purchase agreement may include rights, permits and licenses previously granted to the corporation that would be difficult to transfer in any other manner.
However, there are also substantial considerations to be made when entering into a stock purchase agreement, including an analysis of the company’s financials and due diligence into liabilities that may not be readily apparent. From the seller’s perspective, the consideration of including representations from the buyer about its ability to assert certain defenses is important, especially if it agrees to provide a covenant not-to-compete and if it has not fully divested itself of obligations on behalf of the corporation.
Many times, the seller will want to avoid a buyer who will use any disclosures made on other matters to tempt an owner or manager into setting aside agreements reached on the sale of stock, or even to set them aside entirely by impugning the seller’s good faith in the negotiations. The seller may also wish to avoid a buyer who will at some later stage try to enforce taxation terms against the seller that were not in the original agreement. Due diligence will also reveal areas where a seller can structure the stock purchase agreement to better protect themselves in the future by enumerating what it is that they wish to limit their liability for in the agreement itself.
Advantages of Implementing Stock Purchase Agreements
One of the fundamental benefits of a Stock Purchase Agreement is that it serves all those who have invested time and money into the security of the company (shareholders, officers, directors and potential third-party investors) to make sure that the merits of a business are bought and sold as expected.
Risk is reduced when a transfer is consummated because once a Stock Purchase Agreement is executed, the transaction terms are known to both the buyer and the seller. Knowing exactly what a company owns, or the company’s liabilities up front helps lower risk by eliminating surprises, both for the buyer and the company being sold; and the company has the assurances and guarantees expected of the deal agreed upon. It also reduces risk for the parties because the legal protections in the stock purchase agreement are strengthened with the presence of the representations and warranties.
Additionally, because the parties know that a "meeting of the minds" has taken place, the shareholders know that they may leave or enter negotiations for the sale of their stock without the concern of someone else making a better deal. The absence of risk allows the parties to emphasize their relationship, rather than the deal, during contract negotiations.
It is an opportunity for the buyer to review the historical financial status of the company. This is particularly important because a company’s records may not note the illusory nature of certain financial information. For example, a seller may have an accountant classify a bad debt as an AR of a customer who attends church with him . It is good practice for buyers to obtain a purchaser’s letter of understanding to verify the accuracy of the disclosure regarding the assets of the seller and the seller’s right to transfer them.
A Stock Purchase Agreement can also be written so that stock cannot be transferred until conditions are met, i.e., a certain level of revenue must be generated before the stock can change hands.
Because a Stock Purchase Agreement creates a sale involving a particular set of items, it must be clear about which items are to be included and which items are to be left out. This means that it is critically important to include a complete list of any specific tangible or intangible assets that are to be transferred as part of the sale. A list should include specific names of employees, specific products, even specific supplies, if those are to be included in the sale. Be very explicit because if a seller omits things from the list that he intends to be included in the sale, although he may be able to amend the Stock Purchase Agreement to add them after the fact, this could lead to bad blood between the buyer and seller and should be avoided.
It is a good idea to put a binding date in the agreement to make sure that the final sale happens as soon as possible. If the parties to the agreement do not finish the transaction by a specified date, the seller or buyer may be free to sell the stock to someone else.
It is important to identify any proscribed activity that will be prohibited to the buyer once the transaction has been finalized.
Pitfalls to Avoid
When entering into a stock purchase agreement, it can be easy to overlook key elements that could leave you unprotected and vulnerable. Here are a few of the most common pitfalls and how to avoid them:
Issuing Stock Without an Agreement A stock issuance without a stock purchase agreement is a big mistake. In many cases, the company assumes the stock issuance is a gift given at the discretion of the board, but this is not the case. A gift is a conveyance of property or funds without consideration with the intent of benefiting the recipient without any anticipated return. By contrast, a stock purchase involves consideration, and there is an expectation that something of value will be returned to the company in exchange for the stock.
Failing to Specify Stock Purchase Terms If the purchase terms of the stock are not outlined in the agreement, you could be exposing yourself, both personally and as a company. In order to ensure proper protection, it is vital to make sure that the agreement includes the necessary terms for a sale, even if it is a gift between family members or friends—this also applies to board election of shares.
Omitting Key Factors, Like Vesting Considerations When dealing with stock options, it is crucial to ensure employees vest before they can fully exercise their option. If a purchase agreement doesn’t include vesting terms, the company could be in danger of giving stock to employees who leave early in the process. In order to prevent this, establish a vesting period—often four years—with a "cliff"—often one year—to ensure the employee shows commitment to the project before becoming a full partner.
Without legal counsel, it is easy to overlook these—and other—valuable terms of a stock purchase agreement. By familiarizing yourself with some of the most common pitfalls, you can ensure a smooth stock issuance process while protecting yourself and your business at the same time.
Closing and Signing the Stock Purchase Agreement
Once negotiations over the terms of the deal have concluded, the parties will then turn their attention to preparing the final stock purchase agreement. The process of finalizing the agreement typically involves the following steps: The Closing Process The execution of a stock purchase agreement is often referred to as the "closing," which signifies the end of the negotiation process and the parties’ mutual commitment to the agreed terms. It is common for the closing to take place soon after the stock purchase agreement has been signed by the parties. However, the closing may occur at a later date if additional time is required to complete the transaction. In such cases, the agreement will provide that the closing will occur within a defined period of time after the execution of the stock purchase agreement. In either case, the closing involves three primary matters: In addition to drawing up the stock certificate, the seller and purchaser must typically satisfy a series of closing conditions, such as the payment of all purchase price due, the receipt of governmental and third-party consents, or the satisfaction of all representations and warranties made by the parties. The parties may also be required to execute additional documents and instruments in connection with the closing. After the closing, the purchaser must promptly report the transaction to applicable securities regulators or agencies and perform other administrative tasks, such as filing the appropriate federal and state forms with the Securities and Exchange Commission (SECI) and paying any required state filing fees.
Clarifying With Examples or Case Studies
To illustrate the benefits that can be derived by sellers from forcing prospective buyers to "put their money where their mouth is", below are some real-life examples demonstrating how sophisticated sellers of companies and outstanding deal architects have dealt with the common problem of "tire kickers" and "low ballers" on the buy-side.
Example #1: In one transaction where my firm represented the seller, the real estate associated with the target business was owned by a separate entity. The buyer team had proposed an all cash offer to purchase the business for approximately $4 million. It was not until after the transaction documents had been drafted that the buyer’s environmental consultants uncovered a major environmental contamination in the real property that was associated with the target business. The proposed purchase price was reduced to $3.5 million. The seller’s management team recommended accepting the offer as they believed that this was the best offer available and the funds could be used very quickly to purchase an unrelated company. The seller’s board of directors decided to accept that offer but required the buyer to deposit the $3.5 million purchase price in an escrow account to be held for the benefit of the seller until closing. The buyer attempted to use the environmental contamination as an excuse to renegotiate the terms of the transaction but the seller had the buyer "over a barrel" as there were no other offers for the business at the time. The buyer backed down and closing occurred shortly thereafter.
Example #2: In another transaction where my firm represented the seller, the target business was owned by three individuals who had been in business for approximately ten years. One of the owner’s sons was the company’s president and chief executive officer. The business had recently lost several large contracts as the 58-year-old son became ill and was unable to fulfill commitments to the existing customers but the entity had substantial current cash flow. The father wanted to sell the business quickly and had the other owners (who were also the father’s brother-in-law and sister-in-law) but the son was adamant against a sale of the business to a third party. The seller’s board of directors decided to sell the business at the best price available. The son was aghast when advised of the decision and told his father that he would maintain control of the business until someone removed him from that role. However , the father reminded his son that he was still the owner of the business and was depending on the proceeds from the sale, and that the closing would occur if he was removed from the family. The son complied with his father’s request and accepted a minority position as the head of operations of the target company even though he did not trust the buyer to run the business. Satisfied by both parties, the transaction closed within 30 days of the board’s decision.
While some may suggest that the son was unreasonable and, therefore, my client’s action was completely unacceptable, a few other observations support the conclusion that the seller was justified in his action. First, the son, who had not been involved in the day-to-day operations for the past several years, was making unilateral decisions. Second, he had no involvement in the operations or finances of the business but had obtained the power to effectively force the transfer of his father’s interest to himself. Third, while the son’s actions may seem commendable, the fact remains that the father was the owner and if he no longer wants the son to have an ownership interest, then it must be respected; and, only the father can determine if the buyer is acceptable in his opinion. Bottom line: The father was not "abusive"; he qualified as a "good guy" because he had given his son every opportunity to run the business. But, when the son sought to destroy the family business, the good guy had the right to defend it at all costs.
It is also critical to consider that this example demonstrates why buyers must take extreme steps to build seller confidence. This is a classic case of "Everything looks OK on the outside, but after you get below the surface, you realize that what is underneath is a real mess."