The purchase agreement: the main parts in plain English

The purchase agreement is the contract that actually transfers a business. Your offer or letter of intent set out the deal in a page or two. The purchase agreement spells it out in many more, and much of it answers one question: what happens if something turns out to be different from what you were told?

An attorney who handles business purchases should draft it or review it for you. Don't rely on a template from the internet, and don't let the seller's attorney be the only lawyer involved. This post is a map, so you can read the draft alongside your attorney and ask good questions.

Two kinds of agreement

Small business purchases usually take one of two forms:

• An asset purchase: your new company buys the business's assets (equipment, customer lists, phone numbers, the name) and takes on only the debts and obligations the agreement lists.
• A stock or ownership purchase: you buy the seller's ownership of the existing company, which comes with everything it has ever done.

Many small deals are asset purchases, partly because the buyer leaves the old company's history behind. Which one fits your deal, and the tax effects for each side, are questions for your attorney and accountant. The rest of this post follows an asset purchase.

What you're buying, and what you're not

The agreement lists the purchased assets, usually in schedules attached at the end. Expect equipment and vehicles, inventory, contracts, customer lists, phone numbers, the website, the trade name, and goodwill (the value of the company's reputation and relationships).

It also lists the excluded assets the seller keeps. Cash in the bank is often one. Personal items and sometimes a vehicle or two are others.

Then come the debts and obligations. In an asset purchase, you typically take on only the assumed liabilities named in the agreement, such as finishing work customers have already paid for. Everything else, like the seller's old debts, taxes and claims from before closing, stays with the seller.

Some contracts, leases and licenses can't simply be handed to you without someone's consent. See contracts that may not transfer for how to spot them.

Price and how it's paid

This section sets the price and how it gets paid. The usual pieces are cash at closing (from your down payment and loan), a note the seller lets you pay over time, and sometimes an earnout (a later payment tied to results), though SBA 7(a) loans don't allow one. The structure can matter as much as the number; see price versus terms.

Look for three other things here:

• A working capital adjustment, if the deal includes receivables, inventory or bills owed to suppliers. The price moves up or down depending on what's actually in the business at closing. See working capital at closing.
• Prorations: rent, utilities, prepaid contracts and similar items split as of the closing date.
• How the price is divided. The price gets split among the assets: equipment, inventory, goodwill and so on. Both the buyer and the seller of a business's assets generally report that split to the IRS on Form 8594, and it affects each side's taxes. The agreement often sets the split, so you both report the same numbers. Have your accountant review it.

Representations and warranties

These are statements of fact the seller makes about the business, for example:

• the financial statements and tax returns you were given are accurate;
• the company has paid its taxes and its employees;
• the seller owns the assets, free of liens;
• there are no lawsuits or claims except those disclosed;
• the company holds the licenses it needs and follows the law;
• the listed contracts are in effect, with no one in default.

The exceptions go in disclosure schedules. Read them closely: they're where the real information lives. A promise that "there are no lawsuits except as listed in Schedule 4" is only as comforting as Schedule 4.

Watch for softening words. "To the seller's knowledge" means the seller is only promising what they actually know. "Material" means small problems don't count. Both can be reasonable, but you should know where they appear.

What you learned in your review belongs here. If you found that a key customer has no written contract, or that a license is up for renewal, ask your attorney how the agreement deals with it.

Indemnification: who pays if something is wrong

Indemnification is the seller's promise to pay you back if a representation turns out to be false, or if an old liability lands on you after closing. It usually comes with limits:

• A time limit for making claims.
• A cap on the total the seller can owe.
• A threshold that losses must pass before you can make a claim.

Some items, such as fraud, unpaid taxes or who owns the assets, are often treated differently from the rest. What's usual depends on the deal, the industry and the risks you found, and your attorney will know what's reasonable.

Escrow, holdbacks and offsets

A promise to pay you back is only as good as the seller's ability to pay. So agreements often keep some money within reach:

• Escrow: part of the price held by a neutral third party for a set time, then released to the seller if no claims come up.
• Holdback: part of the price you keep and pay later, on the same idea.
• Offset: the right to reduce payments on a seller note by the amount of a valid claim.

If you're using an SBA loan, ask your lender early how it treats escrows, holdbacks and seller notes, because the loan's rules can affect what the agreement may say.

Promises about what happens next

Covenants are promises about behavior. Before closing, the seller agrees to run the business normally, not to sell off assets, and to keep giving you access. After closing, the seller usually agrees to help with the handover for a period, to keep the company's information confidential, and not to compete or take customers or staff for a time.

Conditions to closing

These are things that must happen before either side has to close, such as:

• your loan is approved and ready to fund;
• the landlord consents to the lease being transferred, or signs a new lease with you;
• key contracts and licenses are transferred, or new ones are in place;
• nothing seriously harmful has happened to the business since signing;
• the seller delivers signed documents, like a bill of sale and releases of any liens.

If a condition isn't met, the agreement says who can walk away and what happens to any deposit. Signing and closing can happen on the same day or weeks apart. When they're apart, these conditions protect you in between.

Working with your attorney on it

• Give your attorney the letter of intent and a list of everything your review turned up, good and bad.
• Read every schedule yourself. You know the business better than your attorney does.
• For each section, ask: "What happens if this turns out to be wrong?"
• Check the final draft against the letter of intent. Late changes are easy to miss.
• Have your accountant review the split of the price and any working capital terms, and share the draft with your lender if the loan depends on it.
• Leave enough time. The last week before closing is a poor time to read the whole agreement for the first time.