A Basic Primer on Selling a Business: What legal issues will buyers usually be concerned about when reviewing contracts?

Written by: Benedict O’Halloran

9 minute read

And what kinds of impacts can these issues have on a business sale project?

This article is part of our multi-part series - A Basic Primer on Selling a Business. See the other parts of this series here.

What are the most common types of contract terms reviewed in the sale of a business?

Are there any common things that buyers look for when reviewing business contracts? The answer is “yes”, and the types of legal issues buyers are on the lookout for can be broken down broadly into two categories. There are all kinds of contracts in a business (customer contracts, supplier contracts, real estate leases, technology license agreements, distribution agreements, employment agreements) but it is safe to say that across all of these categories of contracts, buyers will typically be on the lookout for each of the following:

  • Term and termination. As a starting point, a buyer always wants to know the duration of an existing contract and on what basis it can be terminated.
  • The scope and flexibility of assignment clauses. Contracts typically contain a clause stating if and how the contract can be transferred by one party or the other. If the mechanics of an acquisition transaction involve any such contract transfers, then the terms of these assignment clauses are of critical importance.
  • Change of control clauses. Some types of contracts sometimes confer special rights on the other party (eg. to terminate the agreement) if there is a change of control of the target business. These are not common, but their impact can be huge where they are present. A classic example of a business relationship where a change of control clause may be present in a contract is in an in-bound license of rights to strategically important technology or trademarks. The licensor may be very sensitive about who gets access to its technology and so may insist on this kind of protection.
  • Exclusivity clauses. Sometimes the commercial dynamics of a supplier or distribution relationship are such that the other party is able to negotiate exclusive rights under the contract. It’s not hard to see how such restrictions could pose serious obstacles to the future business integration plans of an acquirer.
  • Non-compete language. Any kind of legal commitment not to compete in a particular area of business activity can be tremendously dangerous for an acquirer, especially if the wording of the commitment is such that it would extend to the entirety of the acquirer’s business and the target after an acquisition is completed. Among other situations, these kind of non-compete restrictions can be found in the sale agreement for any past sales of business units by the target business or in inbound technology licenses that tie the license to the target business not using the relevant technology in certain geographies or business regions.
  • Most favoured nations clauses. These are a type of clause in which a supplier or partner receives a commitment that the terms of business extended to them will match (or even better) those of competing suppliers or partners. Influential suppliers or distributors are examples of the type of contract counter-party who might be able to negotiate for such commitments.
  • Indemnities. An indemnity in a contract is a specific commitment given by one party to reimburse the other party on demand for a defined category of costs and expenses (for example, a product-maker indemnifying a distributor against any product defect claims brought by end-user customers). In most legal systems, by virtue of being structured formally as an “indemnity” these clauses extend the scope and extent of reimbursement that the benefitting party is legally entitled to. They can be thought of as a blank-cheque made available to a third party…and sometimes the financial amount of that blank cheque may be uncapped.
  • Limitations of liability. It is generally not possible to sell a product or a service with no liability for it whatsoever. For products, the manufacturer generally has to be liable for product defects, for example. And for services, the provider is typically liable if the quality of service does not meet up to a pre-agreed standard. Obviously, business acquirers pay very close attention to the liability profile that a target business establishes for itself with its customers, and particularly any financial caps on those liabilities built into contracts. Similarly, on the supplier side, a buyer will be very focussed on how much liability suppliers take on for the quality of the input products and services they provide.

The eight potential contract issues above can come up in a lot of different kinds of business contracts. So we can label this first category of potential buyer concerns about business contracts as typically universal issues. But that does not represent the full list of potential contract issues that a business buyer will be on the lookout for.

What industry and contract-specific contract terms are typically reviewed in the sale of a business?

The second category of potential contract issues can be described as industry and contract-specific issues. For each type of business contract, whether it be employment contracts with senior management, borrowing agreements with banks, or customer, supplier and distributor contracts—or any other type of business contract—there will be particular contract terms that a buyer will have a view on and be wary of. In practice, when reviewing the various categories of contracts in a business, a buyer will develop a questionnaire specific to each of those categories, enquiring about the presence of the types of clauses that might concern them. For a particular type of contract, it is quite common for this so-called “due diligence template” on that type of contract to contain from 20 to 50 different potential contract issues that a buyer would want to understand. When it conducts its due diligence review, a buyer has its employees and advisers complete customised due diligence templates for the key types of contracts in the business.

All of this underlines the importance for a seller of taking time during the initial pre-sale preparation phase of a business sale process to not only a) think through what business contracts need to be assembled and shared with a bidder, but also equally or more importantly to b) carefully identify the potential bidder concerns that may arise from the terms of each contract, and if those concerns are important enough, plan out how to address and respond to each of them. In virtually every business there are important contracts which are incomplete, out of date, imperfect or which could generate undue concern in the mind of a bidder that lacks a full understanding of the business’ operations and history. (Consider the example of a key supplier relationship with a long history, for which the contract may not have been kept up to date with the evolution of product buying and warranty commitments over time or changes in types of products and services sourced. Or a key supplier contract with a very short-notice termination clause, when in practice the supplier is dependent on the business and couldn’t realistically walk away. Or thousands of customer contracts involving processing privacy-protected consumer data, where some sub-sets may not have been kept up to date with privacy law changes that could render key parts of them invalid.)

The options available to a seller to head off potential bidder concerns over specific contract terms range from things like providing additional documents, information and context all the way to potentially amending or renegotiating the contract (or category of contracts) in question before starting a sale process. And the appropriate time to identify contract issues like this (and how to address them) is of course at the outset, during initial pre-sale preparations, because regardless of the nature of the appropriate solution, it can very often be difficult and time-consuming to organise and implement. (Amending or renegotiating contracts obviously takes time (and the time involved can be unpredictable, depending on the negotiating dynamics and the situation (which can range from needing to fix one issue in a single specific contract to needing to fix multiple issues affecting a whole class of many similar contracts)), but so too can identifying and assembling the right documents or information to provide better context to assuage potential bidder concerns.)

Regardless of the choice of potential “solution” though, the goal for the seller is always the same: it has to be aware of and consider in advance any potentially concerning legal issues in all its important business contracts, because being surprised by a bidder’s discovery of a previously unknown key issue in an important contract (or across a class of contracts) can have very negative impacts on a sale process. There are few things more effective for undermining a bidder’s confidence in a sales process, the competence of a business management team and the projections in its own emergent business valuation than the discovery of a valid, fundamental issue in a key business contract (or class of business contracts) that the seller and its management team have never noticed before and therefore cannot effectively address and explain. At a minimum, such a situation will result in the bidder budgeting the costs to fix the problem into its projections, serving as an immediate deduction from its business valuation. And for certain types of issues, these kinds of surprise discoveries actually can be fatal to the whole business sale project.

Continue reading our multi-part series:
A Basic Primer on Selling A Business