Pre-Closing Covenants in M&A

In practice, these parameters are most often fine-tuned already when preparing the transaction documentation as part of contracts and negotiations.

The importance of covenants between signing and closing

The time lag between signing the agreement and the actual settlement of the transaction (closing) is, in modern practice, more the rule than the exception. This interim state creates natural tension between the interests of both parties.

During this period, the seller tends to make rather short-term decisions, while the buyer is already focused on the long-term stability of the business. These covenants clearly define which steps require the buyer’s consent and what standards of care the seller must maintain. It is important to distinguish them from conditions precedent and from representations and warranties.

While conditions precedent condition the closing itself, pre-closing covenants are active rules of conduct for the interim period. In practice, these covenants serve a protective role by preventing the loss of key customers, the departure of management, or undesirable indebtedness. At the same time, they have a cooperative function, as they facilitate the handover of data and preparation for the takeover. Without precisely drafted rules, even a promising transaction can end in a protracted dispute because the agreement does not address the boundaries of ordinary operations.

The risk of subsequent disputes in transactions is also linked to the topic of insurance, which is discussed in the update Transaction risk insurance (W&I): How to close a deal without the risk of litigation.

Pre-closing covenants must always be tailored to the specific business and industry. A generic template cannot simply be adopted, because each business model requires a different level of protection. That is why the attorneys of ARROWS, a Prague-based law firm, always base contract drafting on how the business actually operates and on the risks that may arise during the interim period.

Situations leading to an interim period

An interim period arises wherever ownership rights cannot be transferred immediately upon signing the agreement. It is often necessary first to obtain approvals from regulators, financing banks, or to complete internal restructuring.

In mid-sized transactions without the need for regulatory approval, the buyer needs time to secure financing or vacate premises. The preparation of the closing itself is administratively demanding. It is necessary to arrange a notary, a bank escrow, and to provide updated extracts from public registers or confirmations of no outstanding debts.

The attorneys of ARROWS, a Prague-based law firm, have extensive experience with international deals, where the interim period tends to be longer and requires coordination of different legal systems If the transaction involves multiple jurisdictions (e.g., signing in one country and closing in another), it is advisable to involve the team for international law..

Basic types of pre-closing covenants

The first pillar of pre-closing arrangements is the general covenant to operate the business in the ordinary course of business. This ensures that the buyer receives the company in an operating setup corresponding to the due diligence performed.

The second pillar consists of specific prohibitions on certain actions, such as selling assets or incurring debt, without the buyer’s consent. The third pillar is made up of cooperation covenants, which impose on both parties the obligation to cooperate in preparing the closing, handing over data, and communicating with authorities.

The agreement must clearly define financial thresholds and the consequences of breaching these rules to prevent speculative withdrawal from the transaction.

The article Covenants under the microscope: In other words, what to watch out for in Pre-closing Covenants and how not to tie your own hands also returns in more detail to the practical setup of covenants during the interim period (including pre-closing covenants).

2. Is it possible to have a transaction without covenants if signing and closing take place on the same day?
Yes—if the transaction is signed and settled at the same moment, pre-closing covenants do not make sense because there is no interim period. In practice, however, obligations effective after closing may still apply, such as a non-compete. ARROWS, a Prague-based law firm, can help you assess whether such an approach is realistically feasible for your transaction.

3. When is it better to address risks through representations and warranties instead?
Some risks are better covered retrospectively—for example, by a representation that no liabilities exist as of the closing date—rather than trying to regulate the company’s day-to-day operations in detail during the interim period. The attorneys at ARROWS, a Prague-based law firm, will assess whether, for a specific risk, a preventive covenant or a subsequent warranty with compensation is more effective.

Key types of covenants to protect transaction value

Protecting transaction value requires a combination of several types of contractual arrangements that cover different aspects of how the business operates during the interim period.

Operating in the ordinary course of business

A covenant to operate the company in the ordinary course of business is the most important protective element. It ensures that the buyer acquires the business in an operating condition consistent with the state identified during due diligence.

However, a strict interpretation of this concept can be risky if market conditions change and the company needs to respond. The attorneys at ARROWS, a Prague-based law firm, work closely with financial advisers to ensure the wording accurately reflects real operational needs.

Restrictions on material transactions and disposals

This set of covenants restricts significant legal actions by the seller that could harm the value of the business. This includes prohibitions on incurring new debt, selling assets, or entering into disadvantageous contracts.

These restrictions are typically tied to specific financial thresholds to avoid unnecessary approvals for minor operational actions. The attorneys at ARROWS, a Prague-based law firm, help align the contract wording with financial plans and internal processes in such cases.

No-shop / no-talk

Exclusivity arrangements (no-shop and no-talk) prohibit the seller from seeking other interested parties or negotiating with them. These clauses protect the buyer’s investment in preparing the transaction and conducting due diligence.

In corporations with a larger number of shareholders, exclusivity must be aligned with the statutory bodies’ duties to act with due managerial care. ARROWS, a Prague-based law firm, helps set exclusivity so that it protects the buyer without unreasonably blocking the seller for too long.

Difference between warranties and pre-closing covenants

It is important to distinguish between warranties, which describe the state at a specific point in time, and behavioural covenants aimed at the future. A breach of covenants gives the buyer stronger leverage, including the option to postpone closing.

The choice between these tools is a strategic decision. The attorneys at ARROWS, a Prague-based law firm, analyse with clients which risks are more effectively addressed preventively and which should be handled through subsequent compensation.

Relationship between material adverse change and pre-closing covenants

Material adverse change clauses and pre-closing covenants are two key, but distinct, pillars of investor protection during the interim period of a transaction.

How material adverse change clauses work

Material adverse change clauses allow the buyer to withdraw from the agreement if, during the interim period, an event occurs that fundamentally devalues the target business.

In legal practice, the threshold for invoking this clause is set very high and requires a long-term and material impact on financial performance. In addition, the clause applies exclusively to new events occurring during the interim period. It cannot be invoked for earlier hidden defects that were only subsequently discovered during this period.

Aligning the clause with operational covenants

While pre-closing covenants regulate specific conduct by the seller, a material adverse change clause covers external systemic influences and unforeseeable events beyond the parties’ control.

In practice, both tools must be aligned so that approved actions do not conflict with the definition of a material adverse change. The attorneys at ARROWS, a Prague-based law firm, help clients set financial thresholds so that they precisely match the actual financial model.

Most common mistakes in negotiations

A common mistake is an overly vague definition of an adverse change. While it may give the buyer a sense of flexibility, in reality it only increases legal uncertainty and the risk of protracted litigation.

The definition of an adverse change must exclude general economic factors affecting the entire sector. Another mistake is the absence of intermediate remedies. Instead of immediate withdrawal from the agreement, it is often economically more advantageous to agree on a mechanism for an automatic adjustment of the purchase price.

Competition law and limits on buyer control

Competition law sets clear and strict boundaries for the buyer’s control of the target business during the interim period.

Prohibition of premature implementation of a concentration

Until the concentration is approved by the Office for the Protection of Competition (ÚOHS) or the European Commission, the buyer must not in fact exercise control over the target business. A breach is referred to as gun jumping.

The contractual arrangement itself, if it grants the buyer overly broad veto rights over day-to-day operations, constitutes a breach of the law. The attorneys of ARROWS, a Prague-based law firm, help to balance these limits safely and prevent draconian fines.

Secure setup of information flows

Sharing detailed business information, especially between competitors, is prohibited during the interim period. For these purposes, a so-called clean team is typically established in practice, composed of selected individuals and external advisers.

Fast communication and deemed consent in the event of the buyer’s inaction minimize the risk that the transaction will be assessed as de facto management of the business. ARROWS, a Prague-based law firm, can help you prepare a practical internal manual for secure data sharing during the interim period.

Transactions subject to regulatory approval

When a concentration is being approved by the Czech Office for the Protection of Competition (ÚOHS) or the European Commission, the risks multiply. Until the decision becomes final and binding, both companies must act on the market as fully independent and competitive undertakings.

If a longer approval process is expected, pre-closing undertakings must not paralyze the operation of the business. It is necessary to choose flexible limits that allow the company to operate smoothly.

Negotiating undertakings in practice

Negotiating pre-closing undertakings requires finding a balance between the interests of the buyer and the seller.

The buyer’s perspective: control and stability

The buyer wants to minimize the risk of the business losing value before it is taken over. The ideal state for the buyer is the ability to veto all key decisions and have unlimited access to reporting.

Modern practice recommends focusing on key value drivers rather than striving for absolute control over the business. The approval process must be fast and operational. Setting short deadlines for responses and deemed consent in the event of inaction protects the business from operational delays.

The seller’s perspective: operational flexibility

The seller requires that flexibility for day-to-day operations be preserved and that its potential liability be predictable. The seller resists the buyer unjustifiably interfering with the running of the company before the purchase price is paid.

Minor administrative errors should never give the buyer the right to withdraw from the transaction. The seller typically insists on cure periods and on limiting overall liability by a financial cap and a time limit, similarly to quality warranties.

Procedural setup of contractual mechanisms

The key to a smooth interim period is clear procedural rules. The agreement must include a notice-and-cure mechanism for breaches with an appropriate time limit.

Defining materiality thresholds is essential to prevent speculative attempts to cancel the deal due to formal errors. Establishing clear communication channels and designating specific responsible persons on both sides prevents operational paralysis and disputes in the interim.

Model situations from transactional practice

The following examples illustrate how to set pre-closing undertakings correctly in different market scenarios.

Sale of a manufacturing business with bank financing

In the sale of a manufacturing company with ongoing approval proceedings before ÚOHS, a long interim period arises. The business must operate smoothly, repay loans, and carry out planned investments. The buyer requires restrictions on indebtedness, but the seller must not be paralyzed in responding to market demand. 

The solution is to permit investments that are in line with a pre-approved financial plan. The indebtedness restriction then does not apply to ordinary drawdowns under existing working-capital facilities. ARROWS, a Prague-based law firm, in such cases proposes safe limits and provides comprehensive representation of clients before ÚOHS.

Technology company with deferred payment

In the sale of a technology company with part of the purchase price tied to future performance (earn-out), the undertakings are key for both parties. The founders usually remain in management.

The buyer wants to prevent artificial inflation of short-term sales, while the founders require assurance that the investor will not deliberately slow down the business’s development after closing. Specialists at ARROWS, a Prague-based law firm, have extensive experience in structuring these complex earn-out arrangements.

Real estate transaction with an extensive portfolio

When transferring commercial real estate with dozens of tenants, the interim period lasts several months. During this time, leases are terminated, repairs are carried out, or insurance claims are handled. The agreement must not operationally paralyze the seller and force them to seek consent for every minor change to an existing lease.

In practice, pre-approved criteria (leasing guidelines) are used. If a new lease agreement meets the specified economic parameters, the seller may enter into it without the buyer’s prior approval.

Conclusion

Pre-closing covenants determine whether the buyer acquires the business in the expected condition and whether the seller can manage it effectively in the interim without the risk of contractual penalties.

The legal reality of these arrangements is complex, as it requires aligning competition law, value protection, and purchase price mechanisms. The attorneys at ARROWS advokátní kancelář have long specialized in M&A transactions and, for clients’ security, are insured for professional liability with a limit of CZK 400,000,000.

If you are dealing with a specific transaction, we will be happy to discuss your priorities with you and propose a safe covenant setup via email at consultation@arws.cz.

Read also:

• Pre-Closing Covenants in Share Deals: Seller Obligations and Key Risks
• Managing M&A Risks Between Signing and Closing: Protecting Deal Value
• Disclosure Letters in M&A: Structure, Risks and Common Mistakes in Czech Deals
• Reps & Warranties in M&A: How They Protect Buyers and Sellers
• Managing Risks in the Interim “Vacuum Period” of a Company Sale