Mergers and acquisitions or "M&A" is a time-tested growth strategy for buyers and an exit strategy for sellers. But, did you know that many prospective deals never close? Moreover, various studies report that between 70% and 90% of deals that do close are considered "failures," or at least fail to deliver the expected value.
In this 3-part series, we will explore the M&A life cycle, offering practical legal and business insights to help guide you when contemplating an M&A transaction of your own. Part 1 reviewed key questions that potential buyers and sellers should consider and plan around before committing to an M&A transaction, and in part 2 below, we will explore the process for structuring and negotiating a purchase agreement.
Part 2 – Structuring and Negotiating an M&A Transaction
Once you've decided to move forward with a proposed transaction and your advisory team is in place, the hard work of structuring and negotiating deal terms can begin. What follows are some important considerations to keep in mind as you move to finalize a definitive M&A purchase agreement and close the transaction.
Key Consideration #1: Structuring the Deal
Team of Advisors
As discussed in part 1, seeking input from legal, accounting
and tax advisors to minimize the risk of overlooking critical
issues is essential during the exploratory phase. Once you decide
to move forward, it is still highly recommended that you continue
using an appropriate team of advisors to help structure the deal.
Otherwise, you may find yourself in the uncomfortable position of
having to renegotiate commercial terms later in the transaction, or
worse, a breakdown in rapport between the parties.
Seller's Concerns
M&A transactions can be structured as either a sale of stock or
assets, or as a form of merger. As seller, you will likely prefer a
stock sale for tax and other considerations. For example, the tax
implications of a stock sale are more favorable for sellers,
typically resulting in a capital gain or loss for their
shareholders, and possibly, a long term capital gain. However, with
an asset sale, certain sellers (C corporations) will be taxed twice
– once at the corporate level and again at the shareholder
level.
Another reason why sellers lean toward stock sales is the assumption of liabilities by the buyer. Because the buyer is acquiring the entire legal entity in a stock deal, it assumes all of the seller's liabilities, enabling the seller to exit the business completely. In an asset deal, the buyer can pick and choose which, if any, liabilities it is willing to assume. Finally, stock sales are less likely to require third party consents from the seller's key vendors and customers because the resulting change of ownership or control is not always considered an assignment.
Buyer's Concerns
As buyer, you are likely to be more partial to an asset sale for
multiple reasons. From a liability perspective, you will have
control over which assets you agree to purchase from the seller and
which liabilities you agree to assume, thereby avoiding those with
the potential for third party claims or possible balance sheet
liabilities (e.g., employees, creditors, etc.). In terms of tax
treatment, buyers of assets usually enjoy a "step up" in
basis (the cost basis of the assets becomes the buyer's
purchase price, rather than assuming the seller's lower cost
basis), and you may have the right to deduct a portion of the
purchase price immediately (depending upon the allocation).
Letter of Intent (LOI)
As noted in Part 1, the parties will typically sign an LOI once a structure has been agreed upon. The LOI summarizes the key commercial terms of the transaction, including:
- a description of what is being purchased (assets or stock),
- a list of liabilities being assumed (asset transactions only);
- the purchase price, how it will be paid (cash free and/or debt free), and any escrows or holdbacks to cover potential indemnification claims;
- representations and warranties of the seller; and
- any conditions to closing.
In some situations, however, an LOI is not entered into by the parties. For example, sellers using an investment banker to conduct an auction for the sale of their business typically skip the LOI and provide a form of purchase agreement to the bidding parties.
Key Consideration #2 – Preparing and Negotiating the Purchase Agreement
In most M&A transactions, buyer's counsel is responsible for drafting the initial purchase agreement, which will include the key commercial terms outlined in the LOI. Negotiations are then driven by a designated lead for each side. In many cases, the company's CFO or in-house counsel will fill this role; however, buyers that regularly engage in acquisition activity often have a team of skilled business development executives who manage acquisitions and lead commercial negotiations with the assistance of outside M&A counsel. And in large transactions, investment bankers may play a role in the negotiation phase, including coordinating across professional advisors on both sides of the table.
Common Issues in the Purchase
Agreement
The most heavily negotiated issues in a purchase agreement,
regardless of the deal's structure, are as follows:
Representations and Warranties
Since the seller's representations ("reps") and
warranties are specific to the business being sold, they carry
greater significance in terms of the overall transaction. They
provide the buyer with critical details about what it is being
purchased (e.g. key employees, IP, etc.), and serve as a potential
basis for future indemnification claims. As a result, negotiating a
seller's reps and warranties can be a rigorous process, and in
deals where the buyer has considerable leverage, this process may
start as early as the LOI stage.
Generally speaking, sellers aim to reduce their exposure to future indemnity claims by qualifying their reps and warranties (e.g. adding a reasonableness or materiality standard, limiting their survival period, or including exceptions in the purchase agreement or its schedules). Buyers will resist such limitations or qualifications, and in some cases, will argue to impose responsibility and financial consequences in the event of inaccuracies in the seller's reps and warranties.
Each transaction will vary based on the risk tolerance and negotiating leverage of each party. In very large transactions, representation and warranty insurance can help to limit indemnification exposure.
Indemnification
Indemnity provisions assign responsibility to one party for
losses incurred by the other if certain events occur, such as if
there is a breach (inaccuracy) of the reps and warranties or a
failure to comply with a covenant (promise) in the purchase
agreement. This section is also heavily negotiated, particularly
with respect to the following issues:
- Caps and Deductibles – Most indemnification provisions include a basket or deductible threshold which must be met before the obligation to cover a loss is triggered. It is also common to place a cap on recoverable losses. That said, caps and deductibles usually do not apply to certain "fundamental" reps and warranties (e.g. title, authority) or to indemnities relating to a breach of a covenant or a specific liability allocated to a party.
- Holdback and Escrows – A buyer may seek to hold back a portion of the purchase price or to place a portion of it in escrow to cover potential indemnification claims arising in connection with the seller's indemnification obligations or in relation to an identified contingency (e.g., a pending tax dispute or litigation matter).
- Other Legal Issues – An agreement's indemnification section can also involve other technical legal issues, such as materiality scrapes, sandbagging, exclusive remedies and control of the defense of third party claims. These issues are complicated and not always understood by company executives, underscoring the importance of working with an experienced M&A attorney who can advise as to their implications.
Purchase Price
While the purchase price can be as simple as a cash payment at
closing, it is normally more complex due to such factors as the
buyer's financing or its issuance of equity as part of the
purchase price; the risk of potential indemnification claims; or
uncertainty around the valuation of the assets, stock or business
to be acquired.
Below are some common examples of provisions impacting price and payment terms in M&A transactions:
- Earnouts – When buyer and seller cannot agree on the valuation of the assets or stock being purchased, an earnout provision may be included, providing a contingent payment of the purchase price, to be made post-closing, that is tied to specific performance targets which must be reached by the seller (such as revenues, EBITDA or obtaining a key contract). Although the concept of an earnout can appeal to both sides, this provision needs to be carefully drafted to avoid potential disputes over whether the specified performance target has been satisfied. They also require specificity and clarity regarding the operation of the business post-closing.
- Purchase Price Adjustments – Stock transactions often contain post-closing purchase price adjustments based on working capital, indebtedness, and in some cases, the seller's transaction expenses. When adjustment clauses are used, they are typically structured to allow a closing based on estimates of working capital (and indebtedness and transaction expenses, if applicable). After closing, the buyer is usually expected to then prepare a final working capital statement, which is used to determine if any adjustment in purchase price will be needed. The seller is typically given a specific period of time to review the final working capital statement and raise issues; and in the event of a dispute, an independent accountant is used for dispute resolution. Asset purchase agreements involving the acquisition of cash and accounts receivable may also contain post-closing purchase price adjustments based on working capital.
- Escrows and Holdbacks – In deals where the buyer negotiates to holdback a portion of the purchase price (and/or to place funds in escrow), a price adjustment provision for tax purposes may also be included to address what happens following resolution. In some transactions, a buyer may negotiate to hold back a portion of the purchase price for a short period of time (3-6 months) to cover potential working capital adjustments that may result in a reduction of the total purchase price.
Key Consideration #3 – Closing the Transaction
M&A transactions are closed either concurrently with the signing of the agreement or at a later date upon completion of certain closing conditions. For example, smaller transactions that do not trigger government anti-trust filings tend to close at signing. In these so-called "sign and close" transactions, all third party consents (landlords, counterparties to key customer and other agreements) and lien releases from secured lenders need to be obtained prior to signing. To help facilitate this, it is customary to require the seller to provide third party consents and payoff letters from secured lenders that are contingent on closing.
Larger transactions, such as those requiring financing, shareholder approval, multiple third party consents or other closing conditions, are usually structured to close at a later date. In these deals, it is in the best interests of both parties to define with clarity and specificity how the seller's business will be operated between signing and closing.
To discuss how any of these or other M&A related matters may affect your business objectives, please contact us.
Next in the Series
In Part 3 of our series, we will discuss post-closing integration
issues which are important to ensuring the success of the deal.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
