Key Elements of a Stock Purchase Agreement Letter

During the first article we mentioned the initial steps to take into account when you want to carry out a stock purchase agreement. This abbreviated version allows buyers and sellers, especially beginners, to feel more confident and evaluate key aspects that allow the reduction of risks.

Given the reception and the emergence of new doubts, Lumina Legal brings you specified some of the key elements, emphasizing the importance of establishing clauses with validity after the closing of the negotiations.

H2. Purchase Price and Payment Terms 

Two key questions that may be on your mind when you want to develop an agreement letter: How do I know if a share is profitable? and How is the purchase price determined? This is where the valuation step comes in, using quantitative techniques to determine the current value of a company while analyzing whether a stock is overvalued or undervalued.

In the financial world, we have an important tool that helps us to measure a company. There are the Key Performance Indicators, and in this case it is used as a method to evaluate the shares of companies.

H3. Methods

• Dividend discount model: Shareholders determine whether the target company pays dividends. If they’re stable and predictable, financial analysts can determine the true value of the company.
• Price to earnings (P/E) ratio: It is commonly used when comparing companies in the same industry. Then the investor makes a relationship between the amount he is willing to pay for every dollar of earnings. A greater P/E ratio, greater valuation have the shares.
• EV (Enterprise value)/EBITDA: With this KPI, a potential buyer considering the debt and profits of the company. First you calculate the market capitalization and then divide the result into the company’s profit given by the sale of goods and services.

H3. Payment Structure

Once the value to be paid by the buyer has been determined, it is important for the seller to establish the payment structure. This refers to the way in which the transaction will be made and includes deadlines. Here are a few key components of a payment structure:

• Lump sum payments: When buyers have the financial resources readily available, they use this process in which they pay the entire purchase price in one go. 
• Earn-outs: An earn-out involves a portion of the purchase price being contingent on the future performance of the acquired business. This could be tied to revenue, profit, or other predetermined targets. It is important that both parties have clarity on performance parameters to avoid disputes due to factors external to the company.
• Escrow Arrangements: In some cases, buyers and sellers agree to an escrow (portion of the purchase price) to protect themselves from possible risks. Such as undisclosed liabilities to the buyer, or representations and warranties made by the seller. In this way, if there are any issues, the escrow is used to cover costs.

As we have mentioned in previous articles, the specifications depend on the industry to which the parties involved belong. Therefore, it is important to have legal and financial counsels to help you establish the most appropriate terms for your situation.

H2. Representations and Warranties 

We know that representations and warranties are conditions of the business and can vary depending on the interests of the buyer and seller. But here is an example to give you a better idea of the reality.

Let’s suppose you are the buyer into the stock purchase agreement, you must carry out a study where you take into account variables such as financial statements, compliance with laws, intellectual property, taxes, liabilities, environmental compliance, insurance, among others. 

Then, at the moment of writing the letter of intent, in the representations section buyers and sellers stipulate things like “To the best knowledge of the seller, the company owns or has valid licenses for all intellectual property necessary for the conduct of its business”. Or, “The company is in compliance with all applicable laws, regulations, and permits, and there are no legal actions or investigations pending or threatened against the company”.

The above examples give you a more specific view, but at Lumina Legal you can find the necessary advice applied to the nature of the business and industry you are in, whether you are a buyer or a seller.

And why is this part so important in a stock purchase agreement? Well, quite simply, there is risk in all types of negotiations, but good management allows you to mitigate it as much as possible. 

H3. Significance in mitigating risks

• Risk allocation: If a representation or warranty is false, the party that made it, is responsible for any resulting losses.
• Due diligence: (click, previous article)
• Disclosure Schedules: It is a mechanism in which sellers establish exceptions to certain statements in the purchase contract. In this way, they avoid being at fault if there is a breach in the actual information.
• Time Limitations: After the closing of the agreement, the buyer has a specific period to identify and make claims for any breaches.

H2. Covenants and Post-Closing Obligations 

The execution of a stock purchase agreement requires a certain period of time, during which external and internal factors may cause the financial statement of the company being sold to change. That is why it is important to have clear clauses in the agreement letter that will operate before, during and after the contract, prevailing the good faith of buyers and sellers.

Therefore, we will present some covenants and post-closing obligations that establish an adequate transition framework.

H3.Covenants

1. Non-compete clauses: It is an agreement in which sellers are restricted to perform a similar activity for a certain period of time and in a specified geographic area. The scope of this is based on local laws.
2. Confidentiality agreements: It is a covenant acquired during the due diligence process, where both parties choose to keep certain information confidential. Only legal and financial counsels are allowed access to this information.

H3. Post-closing obligations

A successful negotiation also focuses on the after the deal, the practical implementation of what has been agreed is reflected in the post-closing obligations that exist between buyers and sellers. Here are some of the most common ones:

1. Transition service: The seller helps the buyer adapt to the company with IT support, employee training or customer transition.
2. Indemnification: These are the compensations agreed in the representations and warranties in case of possible breaches.
3. Employee Matters: Generally, when a stock purchase process of this magnitude occurs, most or all of the workforce is kept on by the buyers. Therefore, it is important to create a smooth relationship between the existing employees and the new ones coming from the buying company.

H2. Review: What about The Role of Legal Counsel in a Stock Purchase Agreement Letter?

Throughout the article, we saw new elements that are crucial for drafting a stock purchase agreement letter. Many of which depend on local laws and financial aspects.

For this reason, the role of a legal counsel is essential, as he or she is in charge of maintaining the interests of the party that represents, ensuring legality and transparency, as well as the fulfillment of the proposed objectives.

I’m Rocky, and I hope you will stay tuned for further updates on this very interesting topic. In future articles we will focus our attention on dispute resolution in SPA´s, common pitfalls and mistakes to avoid, alternatives to SPA´s, and many other items.