Part V: Material Deal Terms to Negotiate in Private Equity Transactions
This is the fifth article in our series on “Closing a Private Equity Transaction.” In Part I, the benefits of preparing for a transaction were explained, along with how best to prepare. In Part II, the letter of intent was discussed, and key terms were identified. In Part III, we walked through what to expect during the due diligence process. In Part IV, we outlined the various healthcare regulatory issues that arise in private equity transactions. Here, we highlight some of the more material terms typically negotiated in the definitive transaction documents.
The primary definitive document will be the purchase agreement (which will either be an asset purchase agreement or a stock purchase agreement, depending on the structure of the transaction). The first step will be to confirm the agreement contains the various terms negotiated in the letter of intent. (See Part II for a discussion of the terms that should be negotiated.) While the LOI will cover the major deal terms, the purchase agreement will expand upon those terms in more detail, and include other provisions necessary to effectuate the transaction.
The purchase agreement will have a section that addresses the purchase price. If a portion of the purchase price includes equity, the agreement will at least need to name the entity in which the equity will be issued (e.g., the buyer or the parent company of the buyer), specify the amount of equity (e.g., the number of shares or units) to be issued, name the class of equity being issued, and provide the valuation used for calculating the amount of equity being issued. In addition, a specific agreement (e.g., subscription agreement or exchange agreement) that sets forth the specific rights and obligations related to such equity will be included with the definitive documents.
The purchase price will often be subject to pre-closing and post-closing adjustments to address required working capital (discussed further below), unexpected changes in the business, and any unforeseen (or unanticipated) liabilities not taken into account in the calculation of the purchase price. With respect to working capital, the agreement should state the amount required, as well as the date upon which it will be calculated. If working capital is insufficient as of such date, the buyer typically obtains a dollar for dollar reduction to the purchase price. The next adjustment arises if there is an unexpected material change to the business, or issues are uncovered during due diligence (e.g., a refund to a payor or the settlement of a dispute).
If the purchase agreement is structured so that the parties sign on one date, and then close (i.e., fund) on or before a specified date in the future, then the agreement should include the specific conditions that must be met between the date the parties sign the purchase agreement and the date of the closing. Closing conditions may include regulatory approvals (e.g., a regulatory agency’s issuance of a new license or permit, or approval of change of ownership); and written consents from landlords, vendors, third party payors, and creditors. To avoid an indefinite amount of time to close, termination provisions can be included to allow both the buyer and seller to terminate the transaction if such conditions do not occur within a certain period of time.
If concerns were identified during due diligence, they may have an impact on the purchase price, or cause the buyer to require some amount of money to be escrowed to cover an associated potential future claim. Should escrowing be required, it will be important to specify the escrow agent (e.g., a bank, accounting firm, or law firm), the duration of the escrow period, the frequency of when funds will be released from escrow, and the types of claims that will be funded from the escrow account (which will be covered under indemnification discussed below).
Incorporated through the purchase agreement will be requirements that the seller disclose certain information related to the business. This will include listing assets, liabilities, pending disputes, employees, licenses, and material contracts. The disclosures will be made on schedules that are then attached to the purchase agreement. The seller is responsible for the process of creating the schedules (which is only slightly less tedious than the due diligence process) based on the requirements of the purchase agreement. If any material information is not included in the disclosures of the seller, technically, it will not be considered disclosed to the buyer. Careful attention should be given to the items required to be disclosed, and reasonable limits on disclosures should be negotiated.
Overlapping with the seller’s disclosures will be the seller’s representations and warranties that the disclosure scheduled are complete and certain conditions designated in the purchase agreement are (or continue to be) true at the time of closing. These representations and warranties will also be the basis of any indemnification claim one party may have against the other (as discussed below). It is standard and reasonable for the seller to try and limit the scope of the disclosures and representations that the seller makes to the buyer in a number of ways. The primary areas to negotiate include: (i) who will make the representations on behalf of the seller and the business, (ii) the time period covered by the representations (i.e., when the representations of the seller to the buyer expire, if ever), and (iii) which representations of the seller may be qualified by using “materiality” and “knowledge” terminology. For example, in a transaction that includes more than one seller, buyers may first try and require all sellers to make the representations on behalf of themselves and the business, but it is customary to narrow those individuals to senior management and the controlling owners. Most sellers are willing to negotiate these points, but often carve out the fundamental representations (often called “fundamental reps”) from being subject to these changes. Fundamental reps usually include those related to the entity’s existence and good standing, the entity’s or seller’s authority to enter into the transaction, title to assets, taxes paid, whether there are any brokers involved in the transaction, and compliance with healthcare laws and regulations.
To protect a party from false or incomplete disclosures and representations, an indemnification obligation will be included. The buyer will try to protect itself against future liabilities resulting from a seller’s pre-closing actions or failures to act by contractually requiring the seller to compensate the buyer for damages. The seller will negotiate to limit the duration and amount of its indemnification obligation. The total indemnification obligation is usually capped at the amount of the purchase price and limited in duration (e.g., not more than 36 months from closing). Indemnification obligations are also negotiated so as not to be triggered until a certain dollar value has been met. These “baskets” or “deductibles” are similar to how a health insurance deductible works. They range in amounts depending on the size of the transaction (generally from $25,000 to $250,000). It should be noted that indemnification obligations related to fundamental reps are not usually subject to a cap or limitation on time.
The above is just a sampling of the important terms included in a purchase agreement and how they are often negotiated. Each of the terms above has complexity and dimension that impact other parts of the negotiation process and the ultimate financial benefits of the transaction from both the seller and buyer perspectives. Success will be dependent upon relying on experienced legal, tax, and investment banker advisors.
In the final instalment in the series, we will review the private equity activity for the year and share our thoughts on the year to come.
For more information on preparing for a transaction, contact a member of the Husch Blackwell Healthcare Law team.