Why It’s Important to Understand the Asset Purchase Agreement When Buying or Selling a Practice

by Richard Chen, 9/17/24

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When buying or selling an RIA practice, one of the most important documents you'll encounter is the Asset Purchase Agreement (APA). This agreement is like the foundation of the deal, spelling out exactly what is being bought or sold, how much will be paid, and the responsibilities of both parties. It's the blueprint for the transaction, and understanding its key provisions is crucial for ensuring the deal goes smoothly.

Let’s take a closer look at the major sections of a typical APA, especially those that RIAs need to focus on when going through a transaction. For a more detailed description of the steps involved in buying or selling an RIA practice, click here.

Defining the scope of assets and liabilities

At the heart of any APA is a clear understanding of what’s being sold and what isn’t. In an RIA transaction, this is particularly important because you’re not just talking about office space or furniture – you’re talking about things like client relationships, goodwill, and intellectual property. The assets typically include both tangible and intangible things. Tangible assets might involve office equipment, computers, or even leasehold improvements, while the intangible assets are where much of the real value lies. This includes client lists, advisory contracts, goodwill, and the brand recognition the RIA has built over time.

But it’s equally important to understand which liabilities are being transferred to the buyer as part of the deal. This could include outstanding contracts, lease obligations, or pending legal disputes. Clearly specifying which liabilities are part of the deal, and which stay with the seller, can help avoid confusion and ensure both parties are fully aware of what they’re getting into.

It’s worth spending extra time on this part of the agreement to avoid any misunderstandings. Both the buyer and seller should have a crystal-clear view of exactly what’s being transferred – because any ambiguity here could lead to disputes later on. This is especially true when you’re dealing with things like advisory contracts, where client consent might be needed to transfer the relationship.

Base purchase price and purchase price adjustments

When it comes to the purchase price, it's rarely as simple as a single number. The APA will define a base purchase price – essentially, the agreed-upon amount for the sale – but that’s often just the beginning.

The parties may negotiate with respect to the timing of payouts, including determining how much of the purchase price is paid upfront at the closing. The parties may also negotiate what portion of the purchase price will be paid for in cash and what portion will be paid for with the equity of the buyer, if applicable.

The deal may include a purchase price adjustment based on what amount of the client assets or revenue is retained at appropriate measurement points. The parties may also want to determine whether any such adjustments will be market neutral – meaning that any amounts do not factor in how movements in asset values impacted the amount on which the adjustment is based.

The deal may include an earnout, where the seller gets additional payments based on how well the firm or the seller performs post-sale. Earnouts can be a great way to align the interests of the seller and buyer, especially in a business where client retention and revenue stability are key. However, structuring an earnout can get tricky. You’ll need to be very specific about the metrics that will determine whether the seller gets those extra payments. Are the earnouts tied to client retention, revenue growth, or another factor? It’s important to define these terms clearly, so there’s no confusion later on.

Another common adjustment mechanism is a working capital adjustment, which accounts for the firm’s operational needs at the time of closing. If the firm has too little working capital, the price might be adjusted downward. These price adjustments protect the buyer from overpaying if the business’s financial situation changes before the sale is complete. It’s all about making sure the final purchase price reflects the actual value of the assets and operations being transferred. For an article discussing how to maximize the purchase price when selling an RIA, click here.

Representations and warranties

In any APA, both the buyer and the seller make a series of representations and warranties. These are essentially promises about the state of the business and the parties involved in the deal. The seller will typically warrant that the assets being sold are in good condition, that there are no hidden legal issues, and that they have the legal authority to sell the business. The buyer, on the other hand, will often make representations about their ability to make the purchase and fulfill their financial obligations.

These representations and warranties serve as a way to build trust between the parties, but they also serve as legal protections. If it turns out that one party misrepresented something – say, the seller claimed the business had no pending lawsuits, but it turns out there’s a major legal issue brewing—then the other party may have grounds for legal action.

The key here is to make sure these representations and warranties are accurate. If you’re the seller, you don’t want to accidentally make a false claim that could come back to haunt you. And if you’re the buyer, you want to be sure you’re getting what you expect. This is where thorough due diligence comes into play, ensuring that both parties are being honest and transparent about the business.

Indemnification provisions

Indemnification is one of those legal terms that might sound intimidating, but it’s really just about protecting both sides from potential problems that arise after the sale. In simple terms, indemnification provisions say that if something goes wrong after the sale – like a lawsuit related to actions taken by the seller before the sale – the responsible party will compensate the other.

In RIA transactions, indemnification is a crucial part of the deal because of the ongoing nature of advisory services. Imagine the seller didn’t disclose a significant regulatory issue that surfaces after the sale. The buyer would want to be compensated for the costs they incur because of that issue.

Often, the APA will set limits on indemnification through baskets (the minimum amount of damages that must be incurred before indemnification kicks in) and caps (the maximum amount one party can be held responsible for). These provisions are carefully negotiated, as they define the extent to which each party is financially responsible for post-sale issues. A buyer will often push for lower baskets and higher caps to maximize their protection, while the seller will want the opposite.

Conditions to closing

Finally, the APA will spell out the conditions to closing – the things that need to happen before the sale can be finalized. This section ensures that both parties meet their obligations before the keys are handed over. Common conditions include regulatory approvals, the preparation of bills of sale, and the transfer of client contracts.

One key aspect of this for RIAs is making sure that the investment advisory contracts are properly assigned in accordance with the contract terms and in compliance with applicable regulations, if needed. For SEC-registered advisory firms, advisory contracts require client consent to be transferred to a new advisory firm, and ensuring that this process is handled correctly is critical. Failing to do so could result in clients walking away from the firm, which would seriously impact the value of the business.

Other closing conditions might involve the employment agreements for key employees. In many cases, the buyer will want to retain certain employees, such as advisors with strong client relationships. Ensuring that these agreements are in place before closing is essential for a smooth transition.

Conclusion

Buying or selling an RIA practice is a complex process, and the Asset Purchase Agreement is the backbone of that transaction. By understanding the key provisions – such as the scope of assets and liabilities, the purchase price adjustments, representations and warranties, indemnification provisions, and conditions to closing – you can help ensure the deal goes as smoothly as possible.

These agreements are packed with legal terms, but at the end of the day, it’s about making sure both parties get what they expect. Having a solid understanding of the APA and working with experienced attorneys will give you the confidence to navigate the transaction successfully.

Richard Chen is a managing partner with Brightstar Law Group, a law firm that serves investment advisory firms by providing proactive business-minded solutions pertaining to corporate and securities-law-related matters. Among other things, our firm provides counsel with respect to securities and compliance matters (including representation in SEC examinations), private fund formation, corporate formation and structuring, business transactions (including M&A and joint ventures), contract drafting and negotiation, employment law matters, operational due diligence, and succession planning. For more information, please visit our website at www.brightstarlawgroup.com or call us at 917-838-7398.

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