Why covenants form an important part of negotiations in M&A deals?


  1. In a M&A deal, once the due diligence is closed and the buyer decides to proceed with the deal, then Sale and Purchase agreement is drafted either by the buyer or the seller.
  2. The SPA agreement would include the purchase price, payment terms and conditions, earn out provisions along with reps and warranties declared by the seller on accuracy of the information shared with the buyer.SPA agreement also include Covenants which are basically the rules that govern the actions that buyer and seller should perform between signing and closing of the deal.

Why are Covenants important?

  1. In many deals, there is a time gap between the signing and closing of the deal.This is because the signing of the deal involves only the consent of the buyer and seller but for the deal to close, it requires the involvement of third parties.Hence the buyer and seller approaches these third parties to get their consent to close the deal.These third parties generally include the regulatory approvals, approvals from customers or suppliers for the change of control/ownership and settling any ongoing litigation disputes that the seller is involved with third parties.
  2. From the buyer side, if he is looking to fund the deal with external financing, then this time will be used by the buyer to get the necessary funding at best possible rates, after sharing the due diligence report of the seller business with the lender.
  3. The buyer should ensure that during this time gap between signing and closing, the target business valuation does not go down.Hence the buyer and seller include covenants in the SPA to ensure that the seller continues to manage the business at the same level till the closing.

Pre-Deal and Post Deal Covenants

Covenants are generally categorized as

  • Pre-deal covenants
  • Post deal Covenants
  1. The Pre deal covenants are generally focused on those activities that ensure the valuation of the seller business does not reduce.This includes actions that are needed to be discharged by the seller, which is called affirmative covenants and actions that seller should not discharge, which is called restrictive covenants.
  2. At the time of signing, the seller shares the budgeted business plan of the seller business for the coming financial year with the buyer.The buyer reviews the business plan and approves the same.So all the decisions that are aligned with the business plan can be taken by the seller.Some of these decisions would include payment of salaries to staff, rent payments, renewal of customer contracts and planned investments to be taken as per the approved budgeted plan.
  3. The seller on the other hand cannot take any decisions that may affect/lower the profitability and cashflow of the business.Some decisions like providing salary hike to staff, paying dividends to shareholders, pledging the business assets for borrowing loan and additional capital expenditure that are not budgeted.
  4. The buyer also finalizes the target Working capital that seller has to maintain at the time of closing along with key financials indicators like revenues and EBITDA.In some deals, the buyer also look at the Financial ratios and ensures that these values does not go below a certain threshold value.Some of the financial ratios that are considered are Current Ratio, Debt to Cash flow ratio and Debt to Equity ratio.
  5. In case of IP deals, where a considerable portion of the final purchase price is attributable to the Target IP, then IP specific covenants like Encumbrance on IP and restricting the seller to assign the IP to third party is included.
  6. If the covenants that are drafted in the SPA are violated by the seller, then appropriate remedy/penalty has to be provided by the seller.
  7. It is also to be noted that Covenants and Conditions to closing are different.
  8. Conditions to closing the deal includes critical conditions that needs to be fulfilled for the deal to take place.Some of these conditions are: key employee agreements that needs to be accepted by the target employees, getting regulatory approval and the consent of all the target customers subjected to the proposed acquisition. If the conditions for closing are not met, then the buyer can terminate the deal or discount the final purchase price accordingly.

Post Deal Covenants

  1. In addition to the pre-deal covenants, the buyer also includes post deal covenants in the SPA agreement. This is purely done to protect the buyer from any action that the seller performs post closing that may impact the buyer and the acquired business.
  2. Normally the buyer imposes restrictive covenants on the seller management and its employees to refrain from either getting involved in competing business or poaching key customers from the acquired business.These are termed as
  • Non Compete provisions
  • Non solicit provision
  1. Non compete provision is imposed on the founder and on the key employees of the seller.This provision basically restricts the founder to start a new business that competes against the acquired business.
  2. The non compete provisions generally includes the scope of the business activities that can be carried by the founder and the minimum duration/time frame that the founder should not start its own business.Generally the time duration is for 2 years, but the buyers demand 5-7 years.
  3. The success of the non-compete provisions is dependent on whether these can be enforced by the buyer on the breach by the seller.In order for these provisions to be enforceable, the scope of the provisions along with the duration should be narrowed and specific.The buyer should only focus on those provisions to be included in the scope that will affect its future business operations.It is also prudent for the buyer and seller to extensively negotiate on the restrictive covenants along with the remedy for the buyer in case of the breach by the seller.

Non-Solicit provisions

  1. These provisions are included to restrict the founders from doing business with its previous customers or suppliers for a minimum time period.The buyer would not want to lose any key customers relationships post the closing of the deal due to the founders.In addition, the seller is also refrained from poaching the target employees for it’s new business.
  2. The non compete provisions for employees is different ccompared to owners.In case of the employees refrained from joining the competitors till a certain time, then the employees need to be compensated for this lack of opportunity by the buyer in its compensation.


  1. Covenants form a very important part of the final SPA agreement.Hence extensive negotiations is needed to be done by both the parties and its advisors to decide what is to be included.
  2. Covenants also help in negotiating other important terms in SPA.For instance if the seller wishes to exit the business post the acquisition and wants to retire, then the seller would be fine with extending the non compete time frame to 5-7 years as required by the buyer but at the same time would bargain for lower level of Working capital required to be maintained at the time of closing.
  3. Covenants give a protection to the buyer for the value and assets it are buying from the seller so that it does not overpay for the deal.

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