Purchase Agreement Mechanics
SPA structure, reps and warranties, indemnification, and closing mechanics
~20 min read
The Stock Purchase Agreement (SPA) or Asset Purchase Agreement (APA) is the definitive legal document that governs the acquisition of a company. While the LPA defines the fund's operating rules, the SPA defines the deal's terms. Every PE acquisition results in a purchase agreement that runs 50-150+ pages and covers the purchase price, what the buyer is getting, what the seller is promising, and what happens if those promises turn out to be wrong.
Understanding purchase agreement mechanics is essential for PE professionals because these terms directly affect deal risk and economics. A poorly negotiated indemnification cap can leave the buyer exposed to millions in losses. A narrow set of reps and warranties can hide material problems that only surface after closing. In this lesson, we will break down the anatomy of a purchase agreement: reps and warranties, indemnification mechanics, closing conditions, and working capital adjustments.
Anatomy of a Stock Purchase Agreement
A typical SPA contains five major sections: (1) the purchase price and payment terms, (2) representations and warranties from both buyer and seller, (3) covenants governing pre-closing conduct, (4) closing conditions that must be satisfied, and (5) indemnification provisions that allocate post-closing risk. The purchase price section defines the headline number, but the real economic terms live in the indemnification and working capital provisions. Two deals with the same $500 million purchase price can have very different effective prices depending on how indemnification baskets, caps, and escrows are structured.
Representations and Warranties
Representations and warranties ('reps') are factual statements that the seller makes about the business being sold. They serve two purposes: (1) they force the seller to disclose information about the business (a discovery function), and (2) they provide the basis for indemnification claims if those statements turn out to be false (a risk allocation function).
Reps fall into two categories:
- Fundamental reps cover core matters: the seller's legal authority to sell, ownership of the equity, proper corporate organization, and capitalization. These are considered so important that they typically survive indefinitely (or for a very long period, such as 6 years) after closing and are not subject to the standard indemnification cap.
- General reps cover operational matters: accuracy of financial statements, absence of undisclosed liabilities, compliance with laws, status of material contracts, condition of assets, employment matters, tax compliance, environmental compliance, and intellectual property ownership. These typically survive for 12-24 months after closing and are subject to indemnification caps and baskets.
The negotiation of reps is intensive. Sellers want to limit the scope and add qualifiers ('to the seller's knowledge,' 'in all material respects'). Buyers want reps to be broad, unqualified, and backed by strong indemnification. Every qualifier inserted by the seller's lawyers represents a potential gap in the buyer's protection.
| Term | Definition | Typical Range | |
|---|---|---|---|
| Indemnification basket (deductible) | The threshold of losses the buyer must absorb before the seller is obligated to pay. Works like an insurance deductible. | 0.5-1.5% of enterprise value. A $500M deal might have a $3.75M basket (0.75%). | |
| Indemnification basket (tipping) | Once losses exceed the threshold, the seller is liable for all losses from dollar one (not just the excess). More buyer-friendly than a deductible basket. | Same range as deductible basket; the key difference is first-dollar recovery once the threshold is crossed. | |
| Indemnification cap | The maximum amount the seller can be required to pay under general indemnification. Limits the seller's total exposure. | 10-20% of enterprise value for general reps. Fundamental reps are often uncapped or capped at the full purchase price. | |
| Escrow | A portion of the purchase price held by a third-party escrow agent after closing to fund potential indemnification claims. | 5-15% of enterprise value, held for 12-24 months. Released to the seller if no valid claims are made. | |
| R&W Insurance | A third-party insurance policy that covers losses from breaches of reps and warranties, allowing the seller to limit or eliminate its indemnification exposure. | Premium of 2-4% of the coverage amount. Increasingly standard in PE deals since the mid-2010s. |
Closing Conditions
A purchase agreement is signed at one point and closed at a later date (typically 30-90 days later). Between signing and closing, certain conditions must be satisfied. The most common closing conditions include:
- Regulatory approvals such as HSR (Hart-Scott-Rodino) antitrust clearance, CFIUS review for deals involving foreign buyers, and industry-specific approvals (banking, insurance, healthcare).
- No material adverse change (MAC) in the target's business between signing and closing. MAC clauses are heavily negotiated and rarely triggered, but they provide the buyer with an exit if something catastrophic happens between signing and closing.
- Third-party consents required under the target's material contracts (change-of-control provisions in customer contracts, leases, or licenses).
- Financing condition (in some deals) requiring the buyer to have obtained its committed debt financing. In PE, many deals are structured as 'certain funds' transactions where the buyer cannot walk away due to financing failure, because lenders have provided committed financing.
The period between signing and closing is a risk window. The buyer has agreed to a price but does not yet own the business. If the company's performance deteriorates or a regulatory issue surfaces, the buyer may try to invoke a MAC clause or renegotiate. Sellers protect themselves by insisting on 'hell or high water' provisions that require the buyer to take all steps necessary to obtain regulatory approval.
Working Capital Adjustment in Practice
Consider a PE fund acquiring a distribution company for $300 million. During due diligence, the parties agree that the target's 'normal' level of net working capital (current assets minus current liabilities, excluding cash and debt) is $25 million. This becomes the working capital target (or 'peg') in the purchase agreement.
At closing, the company's actual net working capital is estimated at $28 million, meaning there is $3 million more working capital than the target. The purchase price is increased by $3 million at closing to compensate the seller for leaving extra working capital in the business.
After closing (typically 60-90 days), the buyer performs a detailed calculation of actual closing-date working capital. If the final number comes in at $26.5 million (only $1.5 million above the peg), the buyer receives a $1.5 million refund of the $3 million overpayment. These adjustments often lead to disputes, and many SPAs include an arbitration mechanism (typically a mutually agreed-upon accounting firm) to resolve disagreements over the final working capital calculation.
Composite example based on typical middle-market PE transactions
The Rise of Representations & Warranties Insurance
Since approximately 2015, representations and warranties (R&W) insurance has transformed PE deal-making. Rather than the seller providing indemnification directly, the buyer purchases a third-party insurance policy that covers losses from breaches of the seller's reps. The premium is typically 2-4% of coverage, and policies can cover 10-30% of enterprise value.
R&W insurance benefits both parties. Sellers can negotiate for reduced or eliminated indemnification obligations and a smaller escrow, meaning more of the purchase price flows to them at closing. Buyers get a creditworthy insurer backing the reps rather than relying on a selling shareholder who may be difficult to collect from. By 2023, R&W insurance was used in an estimated 75-90% of PE transactions in North America, making it a near-default feature of the market. The availability and pricing of R&W insurance can influence deal structuring, as buyers factor the premium into their total transaction cost.
Quiz: Purchase Agreement Mechanics
5 questions · ~3 min