Best Practices: The Importance of Reviewing Key Deal Terms in Purchase Agreements

Loan proceeds under the Small Business Administration’s (“SBA”) 7(a) loan program are often used to finance a complete change of ownership transaction, which can be in the form of a stock purchase or an asset purchase. Typically, lenders review the purchase agreement to confirm (i) the buyer is the same entity or individual as the loan applicant, (ii) the purchase price matches underwriting and is supported by the business valuation, and (iii) the description of the assets being transferred is properly documented. While these items are critical, lenders should review the entire purchase agreement and exhibits to ensure that all terms and conditions comply with SBA regulations and prudent lending standards. This article will briefly discuss other key deal terms to review in purchase agreements.

For example, many times an acquisition is structured with a portion of the purchase price paid out to the seller over a period of time post closing. These payments are usually based on the future earnings of the business. This type of pay out is often referred to as an earn-out. Earn-out provisions can take a number of forms, including cash payments to the seller or a reduction in a seller’s note post closing. Regardless of how structured, when using SBA financing, an earn-out cannot be paid to the seller of the business. As such, a purchase agreement should be closely analyzed to ensure no provisions contain an impermissible earn-out.

Further, the SBA only allows 7(a) loan proceeds to be used to finance a complete change of ownership. This means the seller cannot remain as an officer, director, shareholder or key employee of the selling business. Therefore, offering an employment agreement to the seller is restricted and lenders should carefully review any transition provisions for SBA compliance.  If needed, the buyer can offer the seller a consulting agreement, but the term cannot exceed twelve months (including extensions). Lenders should also be careful that any such arrangement does not result in the seller retaining control over the borrower or providing any earn-out based compensation.

In addition, it may be prudent for a lender to require a non-compete covenant and an indemnification clause. A non-compete agreement is an agreement between two parties whereby one party agrees not to work for or own any private interest in a competing business for a certain length of time and within a certain geographical area. The laws regarding non-compete agreements vary greatly from state to state, but courts oftentimes focus on the terms for reasonableness, good faith, and consideration to determine if a non-compete agreement is enforceable. Lenders should analyze non-compete provisions in the purchase agreement to determine whether the terms are sufficient for the type of business, the parties, and/or the market.

Similarly, lenders may consider requiring an indemnification provision benefitting the buyer, which is intended to make the buyer whole for certain losses incurred by the buyer in connection with the business due to an action (or inaction) of the seller. For example, the seller may indemnify the buyer for losses arising from the seller’s inaccurate, or breach of, representations and warranties.

Indemnification provisions can vary widely and provide different levels of protection to a buyer. As such, lenders should read these provisions to determine if there are any limitations (e.g., threshold or maximum amount) and to confirm how long the provision will remain in effect after closing. While an indemnification clause is not a substitute for conducting thorough due diligence of the seller and the business, it can provide significant protection for the buyer.

Lenders should review and analyze purchase agreements to determine whether the terms of the purchase agreement meet both SBA requirements and prudent lending standards prior to closing.

For more information regarding business acquisition purchase agreements, please contact Katherine Tohanczyn at 267.470.1187 or  ktohanczyn@starfieldsmith.com.