Key Issues in Mergers and acquisitions negotiations – Part 2

Mergers and Acquisitions negotiations – part 2

This post is the final part of the topic on key issues to be negotiated in Mergers and acquisitions negotiations agreements.
The link to 1st part is here
In continuation to the previous post the other key issues on mergers and acquisitions negotiations are mentioned below

Mergers and acquisitions negotiations – Pre-Closing Covenants of the Seller

The acquisition agreement will involve a series of covenants between signing and closing except for acquisitions where the deal is signed and closed in the same day.
These covenants are affirmative in nature where the seller is required to take an action between the signing and closing.Some covenants can be restrictive which prohibits the seller to take an action without the buyer consent even though these actions are necessary for the ordinary course of business.
The seller would want these restrictive covenants to be minimal or would want the buyer consent immediately so that important decisions are not withheld or delayed.
Typical pre-closing covenants would include:

• Seller operate the business in normal course between signing and closing.
• Restrictive covenants prohibiting the seller from performing certain actions include borrowing money from outside or encumbering assets.
• Covenants to provide conditions to closing for the seller
• The seller needs to support the buyer in regulatory filing and to get approval
• The seller should obtain third party consents which are required for transfer of customer, supplier and other material contracts.
• Get shareholder/board approval for the transaction
• The seller should notify the buyer of any breach in its representation and warranty
• Exclusivity period is imposed on the seller between the selling and closing so that seller does not solicit any counter deal from other parties

Mergers and acquisitions negotiations -Covenants of the Buyer

The buyer covenants are pretty much similar to the seller particularly in deals that involve a significant stock component.The only difference would be that the buyer covenant would include both the pre-closing and post-closing conditions of the deal.
Typical buyer covenants would include:

• Buyer would do it’s best effort to close the deal and secure regulatory approvals.
• The buyer should notify the seller on any developments that could affect the buyer ability to consummate the deal.
• Post closing tax administration procedures
• Limitations on press releases regarding the deal without the seller consent

Mergers and acquisitions negotiations -Employee and Benefits issues

Employee stock options are very common in technology companies in order to incentivize and retain critical talent.Hence an acquisition involving a tech company would require significant employee issues to be addressed.
Common negotiation issues include:

• Buyer plan for retention and motivation of the seller employees
• Does the employee stock options provided to the seller employees needs to be vested and bought by the buyer as part of the deal consideration
• How does the unvested options accelerate during the closing.The management unvested options are generally accelerated on closing where as for key employees, the unvested options shall be triggered only when the employees are terminated within a specified period post closing. Hence the options plan needs to be carefully reviewed to anticipate any problems.
• Does the seller need to create a carve out plan in order to compensate employees who are not satisfied with the deal incentives.In addition, the seller management may issue a bonus on change of control in order to solicit support from the management for sale.
• Will the acceleration of payouts due to the trigger in change of control attract IRC Section 280G/ Golden Parachute tax?In that case the seller needs to get 75% shareholder approval to avoid this tax liability.
• New key employment agreements of the seller management with the buyer
• If the seller employees are terminated immediately on closing of the deal, then who shall bear the severance costs?
• Other compensation plans apart from the stock options to retain the skilled employees.

Mergers and acquisitions negotiations -Conditions to Closing

If there is a delay between the signing and closing, the acquisition agreement need to have conditions to closing for both the seller and buyer.
Some of the conditions are common for both buyer and sellers – Getting anti trust approvals and board approvals.There are some conditions which are unique to buyer and seller and sometimes favorable to the buyer.

• The accuracy in the seller representation and Warranty during the signing and closing.The seller may try to negotiate that the buyer close the deal in case of any deviations even though it does not have a material effect on the deal.The buyer would be very tough on the fundamental reps which includes seller capitalization.
• Compliance by the seller with seller covenants in the acquisition agreement
• Obtaining governance approvals like HSR – Hart Scott Rodino Anti trust approvals
• Obtaining consents from key customers which are subjected to change of control provisions and that may cause the contract to be terminated or renegotiated post change of control when the seller is unable to get approvals
• No litigations pending against the seller
• Execution of offer letter for seller management and its key employees
• Execution of non-compete and non-solicitation agreements by the seller leadership and shareholders
• No material adverse change in the seller financials between the signing and closing
• Delivery of audited financial statements of the seller so that the buyer can comply with its security reporting requirements
• Delivery of closing balance sheet to support the price adjustments in the Working capital
• The seller majority shareholders needs to waive off the dissenter rights and agree to the indemnification provisions of the agreement

Mergers and acquisitions negotiations -Indemnification Provisions

A buyer would want the seller to indemnify him for any breaches in representations, warranties and covenanants post closing.
Drafting indemnification agreements with terms, conditions and limitations is the most crucial part of negotiations as post closing liabilities on the seller can significantly reduce the net return of the proceeds.
These provisions are identified as early as in Term sheet stage.The seller leverage reduces as the deal proceeds forward from due diligence after the buyer identifies issues that are of key concern.

Scope and Survival of Indemnification

• The seller would want to limit the scope and indemnification to breaches of reps and warranties to expire in short period and not survive for more than a year of closing.
• The buyer would want to extend the indemnification for reps to longer periods especially for breaches of fundamental reps related to the seller organization, tax liabilities, IP claims and capitalization.

Caps on exposure

• The seller will seek a cap on indemnification obligations upto 5-15% of the total purchase price which is the typical size of the escrow/holdback account.
• The buyer will seek additional cap of 25-50% on IP claims and tax liabilities.If the parties use a Representation and Warranty insurance, then the cap is reduced to 1-3% of the final purchase price

Matters not limited to cap

• The buyer would not want to use cap for breaches related to fraud or where there is an intentional breach of representations by the seller.
• In the event of such instances, the buyer would want coverage of total purchase price.

Thresholds and Deductibles

• The buyer would not have recourse against the seller for claims that does not exceed minimum threshold. Once the claims exceed thresholds, the claims can be indemnified from the first dollar in case of tipping basket or the claims indemnified for amount above threshold in case of deductibles.
• For breaches in fundamental reps and warranties, covenants these are excluded from threshold calculations.

Mergers and acquisitions negotiations -Control of Defense of Claims

In case of law suits/third party claims, the buyer will allow the seller the right to defense of its claims and position.In the event of settlement, the buyer should not go for settlement without the approval of seller.

Joint and Several Liability

• The seller indemnification should be prorated based on its stake in the entity. The seller would negotiate that no single largest shareholder shall be liable for all losses held by the buyer, in other words it refuses to be liable for Joint and Several liability.
• No shareholder can be indemnified for more that the amount of sale proceeds received unless the breach is due to fraud.

Effect of Tax benefits/Insurance on Indemnification claims

The buyer can leverage tax benefits for any indemnification claim.The seller would negotiate that the tax savings from indemnification claims should offset the obligation.

Anti Sandbagging Clause

The seller would prohibit indemnification for any breach in representation that the buyer had knowledge of prior to signing/closing of the transaction.

Mergers and acquisitions negotiations -Allocation of various risks

• The primary purpose of reps, warranties, covenants and closing conditions is to address which party should be allocated risk for issues.
• Qualifier such as knowledge, material, material adverse effect and material adverse change are used to protect the seller.The buyer can indemnify only when the claims exceed the scope.

Apart from this, there would be multiple scenarios where the risk allocation needs to be done.

• For pending litigation, who bears the claims for adverse judgement.
• In case of an IP claim against the seller by the customer, who bears the risk for adverse development
• In the change of control clause, who bears the risk when the seller is unable to get approvals from third party.If the third party request for payments for consent in change of control, then who bears the cost

Mergers and acquisitions negotiations -Termination Provisions

The termination provisions set forth the circumstances where either party can walk away from the deal before the agreed date.These rights include the following:

• Either party can terminate if the deal is not legally valid
• Either party can terminate when the other party has breached the representations, warranties and covenants above the specified materiality
• If regulatory approvals are not obtained

Dispute Resolution Provisions

The acquisition agreements should set forth how resolution of disputes would take place.Although many agreements default to a court system, it is better to go through arbitration process which are fast and less costly.

Conclusion

• Mergers and acquisitions negotiations is a comprehensive task which requires combination of negotiation skills and deep understanding of deal issues.
• Drafting definitive agreements should be clear and detailed that needs to cover all the key deal issues along with indemnification coverage for buyer and seller in case of breaches in representations and warranties, covenants and Closing conditions