Key issues in Mergers and acquisitions negotiations – Part 1

Mergers and acquisitions negotiations

In this blog, we shall discuss on the importance of effective mergers and acquisitions negotiations between the buyer and seller involving the sale of the technology company to address issues in business, legal, tax, financial, property and employment liabilities.
Lack of effective negotiation can result in uncertainty in the deal getting closed, pose risks to seller and its shareholders post acquisition or post indemnification risk to the buyer.
This blog discusses the key negotiations issues that can arise between the buyer and seller during a transaction.The success in any negotiations depends on the

  • Leverage that a party has in a deal,
  • Price and the deal structure that is agreed by the parties in Letter of Intent,
  • Terms agreed in the closing conditions and the
  • Post closing liability exposure

This post comes in two separate parts.The first part of the post is included here and the final part will be published tomorrow.

Mergers and acquisitions negotiations -Price/Consideration Issues

The price and type of consideration needs to be addressed in the Letter of Intent stage.Key issues to be negotiated include:

  • Whether the purchase price would be paid upfront and in cash?
  • In case of a stock transaction, the value of the stock, % of the stock, types of stock issued, voting rights on the stock, redemption and dividend payments, transferability of the stock needs to be negotiated.
  • If the buyer is a public company, then whether the stock price at announcement or closing of the deal is taken for the final purchase price needs to be negotiated.
  • In case of a promissory note as a buyer consideration, key issues like interest and principal payments, whether the note is secured/unsecured, presence of a guarantor in case of a default and how seller can accelerate the payments in the event of the breach needs to be negotiated.
  • Whether the transaction will be debt free and cash free at closing (Enterprise value) or if the buyer would discharge seller debts and are entitled to its cash.
  • Whether there will be a working capital adjustment to the final purchase price and if yes, how will the working Capital be calculated.The buyer would want a normalized working capital in order to continue running the business smoothly post closing where as seller would negotiate for the target Working capital to be zero or low.
  • In case of earnout consideration, earnout amount as percentage of final purchase price, earnouts payments subjected to completion of milestones (revenues/EBITDA targets), earnout periods and an option to accelerate the earnout payments if the buyer is selling the business again needs to be negotiated. Earnouts have issues in post closing disputes, hence drafting earnouts provisions clearly and having a post dispute resolution process can help in mitigating these issues post closing.

Mergers and acquisitions negotiations -Escrow/Holdback Issues

In many acquisitions of privately held companies, a portion of a final purchase price is held back as escrow payments to protect the buyer from the seller breach of representations and Warranties and in covenants conditions between the periods of signing and closing.
In some cases, additional escrow provisions are kept when there is a adjustment to purchase price due to working capital requirements post closing or when there is a risk to the buyer from pending issues like litigation or in case of IP infringement.
Some of the key issues for negotiation associated with holdbacks are:

  • The amount held in the escrow amount and the period of the escrow.The standard escrow amount is 12-15% of the deal price for a period of 12-18 months.
  • With increasing frequency of Private equity bidders, the entire escrow amount is replaced by the buyer claiming for any breach post closing through a Representation and Warranty insurance.The premium for this insurance is borne either by the buyer or seller.This usage of R&W insurance is prevalent in Private equity deals but rarely seen among Strategic acquirers.In the case of acquisitions of PE held portfolios, strategic buyers can be compelled to use this policy.
  • The seller will negotiate that the escrow amount will be the exclusive remedy for all breaches in acquisition agreemeents apart from the breaches of fundamental representations (including organization structure and capital structure) and covenants during the pre-closing deal phase.The buyer can agree to this limitation and may want an additional protection for losses due to fraud.
  • If the portion of the consideration in the transaction is funded by the buyer stock, then it needs to confirmed if the escrow amount will be all cash or combination of cash and stock and how the stock will be valued in case of indemnity. The negotiation becomes more complicated when the buyer stock is not traded publicly or if the stock in the escrow contains preferred stock in addition to common stock.
  • In target companies with multiple shareholders, the target company will appoint a shareholder representative who shall represent the target shareholders interest in case of disputes in indemnification and holdback issues.Sometimes, the target company will appoint a professional Shareholder representative services that specialize in this role.

Mergers and acquisitions negotiations -Representations and Warranties of Seller

The reps and warranties of the seller should include the entire business operations of the seller like Financials, Assets, liabilities, IP, tax, employee matters and compliance to law.

  • The reps and warranties in the definitive agreements is intended to confirm the due diligence findings of the buyer and its knowledge about the seller business.Then if these reps and warranties are found to be untrue either at the time of signing the agreement or during the closing, then the buyer can terminate the acquisition. If the reps and Warranties were found to be untrue post closing, then the buyer can be indemnified by the seller for the losses suffered.
  • The seller should ensure that all representations are made only by the seller and not by any of its majority shareholders.
  • Attorneys representing the seller negotiate on the materiality and knowledge qualifiers along with thresholds to ensure that immaterial violations do not result in the breach of the acquisition agreement. Further the attorneys will work along with the seller leadership to prepare a disclosure schedule which if complete and detailed can protect the seller from indemnification post closing.In addition the attorneys are also involved in the negotiations of closing conditions.

Mergers and acquisitions negotiations -Financials Statements Representations and Warranties of the Seller

For buyer, the seller reps and warranties in regards to its Financial statements is critical and needs to cover the following:

  • Audited and non audited income, cashflow and balance sheet of the Target is in accordance with GAAP or as per international financial reporting standards consistent to the specified periods and as of the date of the financials.
  • Financials truly represent and indicate the true financial condition of the seller income, cashflow and liabilities as of the specified date/periods.
  • There are no changes to the seller accounting policies recently and the seller have proper internal controls in place when preparing the financials.

The seller attorney may limit the scope of the financial representation only for the last financial year or till 1 year before and can add exceptions as set in the Disclosure schedule.

Mergers and acquisitions negotiations -Representations and Warranties related to Intellectual Property

The reps and warranties related to seller IP constitutes one of the most important negotiation issues between the buyer and seller.
The buyer needs to ensure that the seller is the only owner to the IP and IP does not have any encumbrances or limitations with regards to its usage. The buyer should ensure that it would be the exclusive owner of the seller IP post closing and would not be subjected to any third party claims as well as face any litigations which result in reducing the overall value of the IP.
Further the buyer should also ensure that the seller has all licenses available for using external IP which are critical to running of the business. The buyer should investigate whether the seller is involved in any legal issues either due to patent infringement or violating other party IP which can expose the seller to significant damages in the future.
The seller would narrow the IP representation through a knowledge qualifier related to its ownership of IP and not whether its activities infringe on the third party IP.In addition the seller would negotiate that the reps expire at closing as it does not want to be exposed to risks for the buyer actions on IP post closing.
Some of the reasons that could limit the buyer to use its owned IP post closing are:

  • Claims by third parties that patents are invalid
  • Liens on the IP in favor of the banks
  • Third party claims that the seller IP infringes their IP rights.
  • Right of refusal in favor of third parties with respect to IP
  • Failure to obtain third party consents to transfer the IP to the seller
  • Open source issues where the seller position IP as proprietary but is available for free in public domain.
  • The seller did not register the IP with the appropriate governing body.

Mergers and acquisitions negotiations -Reps and Warranties related to IP infringement

The buyer is particular that seller provides a representation and Warranty that:

  • Neither the seller infringe on other party IP and other infringe or is violating the seller IP
  • There is no current litigation or is there a potential for future litigation to happen in future post closing.

The scope and limitations of these reps are heavily negotiated as the buyer does not want to take the risk of large unknown claims from unrelated parties post consummation of the deal.
Generally many parties that either are unhappy or have issues with seller IP will stake claims to seller IP after deal is announced. They expect that the seller would compromise to strike a settlement in order to close the deal.
The seller limits the scope of the non infringement representations by introducing Material and Knowledge qualifiers.In addition, the seller would include Threshold and Deductibles to reduce its exposure to breach of representations due to IP infringement.
The seller would not want the escrow account to be used by the buyer to recover the claims due to IP infringement
The buyer would negotiate to lengthen the period post closing during which it can report breaches arising from IP infringement and also seek an alternative remedy to recover the claims apart from the standard escrow/holdback account used.
The buyer would argue that the majority of the acquisition value lies in the seller IP and hence is entitled to a broader coverage. The seller would argue that IP reps and warranties be treated like other normal reps.

Mergers and acquisitions negotiations -Reps and Warranties regarding Contracts

The reps and Warranties of the seller contracts which are material needs to negotiated to protect the buyer in the event of a breach.The seller contracts are uploaded in the data room during the due diligence for the buyer to analyse.
The contracts are listed as per the disclosure schedule which includes:

  • Customer/supplier Contracts with dollar amount above threshold
  • Employment and Consulting contracts
  • Stock options and incentives
  • Mortgages leases, Property and equipment leases
  • Joint Venture and Partnership agreements
  • IP, NDA and Confidentiality agreements

The failure to include all contracts in the Disclosure schedule could result in buyer walking away from transaction or can result in significant post indemnification liabilities to seller shareholders.

Mergers and acquisitions negotiations -Reps and Warranties of the Buyer

The acquisition agreement will also include the representation of the buyer. In case of the Merger of Equals transactions, the reps and warranties for both the parties are almost identical.
The following reps from the buyer are included in the acquisition agreement:

  • Buyer has the full power and authority to sign and execute the acquisition agreement
  • Buyer is organized and has a good standing in the market
  • The agreement is enforceable against the buyer
  • The buyer has cash and financing to pay for the deal.
  • The buyer can issue stock if it is a strategic acquirer or it can go for external financing if it is a Private equity firm.Hence the buyer needs to make representations on the amount of stock/financing raised and their corresponding percentage in the final consideration.

The part 2/Final part of the blog will be covered tomorrow

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