- August 24, 2022
- Posted by: Ramkumar
- Category: Mergers And Acquisitions
Architecture Of the Acquisition Agreement
In an M&A transaction, the law firms draft the acquisition agreement, SPA/APA. Though the deal teams do not get involved in drafting the agreement, they need to understand the critical elements in the contract and how these components interact to build higher-order structures. As many budding M&A executives ask me what goes into a SPA, i highlight how the vital components in the agreement operate and when these elements become crucial and insignificant in a transaction in this post.
In a SPA, a deal structure can take the form of:
- Stock sale/Tender offer in public company deals
- A merger
- Asset Sale
In a stock sale, the buyer acquires the target’s stock. In a private deal, the buyer receives the target’s stock directly from the shareholders, and in a public M&A, the stock sale takes the form of a tender offer to buy shares from all shareholders. Such tender offers get subject to securities laws. In a private deal, the buyer can indemnify the seller to protect post-closing obligations. However, in a public M&A due to the wide dispersal of shareholders, the seller cannot indemnify any particular buyer to safeguard from any breaches in post-closing obligations. Further, shareholder vote is mandatory for public deals, creating higher uncertainty than private M&A.
In a merger, where two firms combine their assets and liabilities, the buyer’s entity is a Special purpose vehicle (a shell), and the target brings the Operating Assets to the merger. Sometimes, the target operates as a subsidiary to the buyer after the buyer gets the target’s shareholder approval.
In an asset sale, the target’s assets and liabilities get carved out from its other businesses and then sold to the buyer. If the target sells all its assets, then shareholder approval is needed; shareholder approval is unnecessary.
The buyer can pay cash or issue equities or a combination of cash and equities to target to fund the acquisition. The buyer can fix the purchase price or adjust depending on the working capital left in the target business on the closing date. In the case of equity issuances, the final purchase price changes based on the market value of the buyer’s securities on the closing date.
Further, the buyer can adjust the purchase price on the target’s post-closing performance. In private M&A, the buyer has Earn-out, while in public M&A, they leverage contingent value rights to provide additional purchase price payments if the target exceeds performance thresholds after closing. The earn-out/contingent value rights measurement spans multiple years, usually not exceeding three years.
Representations and Warranties
In a SPA, the seller uses reps/warranties written in affirmative form subjected to knowledge and materiality qualifications, whereas disclosure schedules include target-specific exceptions. Therefore, reviewing the disclosure schedule forms a core activity of the buyer’s due diligence.
Suppose the seller breaches the representations and warranties. In that case, the buyer can walk away from the transaction without closing if the reps are inaccurate at signing or become inaccurate during the deal’s closing. In the private M&A, the buyer can close the deal and then sue the seller for damages after closing when there is a breach of representations/warranties. The indemnities get subjected to deductible/thresholds, and the buyer recovers the amount only when the damages exceed the thresholds. However, in public M&A, it is difficult for the buyer to sue multiple shareholders; thus, the buyer holds back part of the deal consideration.
The covenants are affirmative obligations taken by parties to consummate transactions. For instance, the seller promises to operate the business in the ordinary course between signing and closing and would obtain necessary approvals from regulators/customers to close the transaction. Likewise, the buyer will get the required financing to consummate the deal.
In most M&A deals, signing and closing does not happen on the same day. This delay is because the parties need to secure customers/regulatory approvals after signing the SPA. Sometimes, the buyer can trigger material adverse effects to walk away from the deal or adjust the final purchase price if there is a significant effect on the performance of the target business between the signing and closing. In such cases, the buyer does not pay a break-up fee for refusing to close the deal. The MAE applies only when there is a deterioration in the target performance; thus, in the case of a recession/slowdown where the entire industry gets affected, the buyer cannot leverage the MAE to walk away from the deal. If the buyer terminates, it has to pay a reverse break-up fee.
Suppose the buyer does not complete the due diligence, cannot provide a financing plan or is not expected to satisfy covenants within a specified date (referred to as the ‘drop-dead date). In that case, either party can terminate the deal before closing.
Some buyers use quantitative measures to obtain protection against a downturn in the target business. For instance, buyers use EBITDA, revenue, and no of customers to evaluate the target performance. The buyer can terminate the deal if the above criteria do not meet the buyer’s thresholds.
In public deals, the no-shop provision restricts the target firm from reaching out to other prospective bidders. However, the condition does not apply when the potential bidders reach out to the target management with an attractive offer. The target can terminate the agreement with the earlier buyers and sign a new deal with the new buyer offering superior terms. Sometimes, the buyer allows the target a specific period called a go-shop window to approach other buyers providing better deals. After the go-shop period, the no-shop provision applies.
Solving Potential Problems
Most of the deal-making process is an exercise in addressing risks and solving potential issues of the buyer/seller. Therefore, a skilled deal maker must have the competencies to address various risks. For instance, if the target faces a potential liability, the buyer must adjust the purchase price, draft closing conditions or termination rights related to fixing these issues, or provide indemnity to protect the buyer from losses related to that liability. In addition, if the risk triggers termination, the deal maker must negotiate a potential break-up fee if applicable.
An adjustment in the purchase price helps the buyer recover any potential losses; for instance, a working capital adjustment compensates the buyer for the shortfall in working capital at closing. However, if the target’s overall business declines, the purchase price adjustment does not consider the potential loss in the target’s business in the future. Closing conditions/termination rights do not compensate the buyer but protect the buyer by avoiding the risk. Thus, indemnity protection applies after closing, where the buyer seeks protection post-closing, whereas a termination right avoids deal closing.
Therefore despite the buyer and seller making reasonable efforts to close the deal, either party can terminate if they understand in advance that the M&A deal does not survive closing conditions or if parties breach covenants.
Which is a better solution?
Terminating a deal, in my view, is similar to a rough justice and is vulnerable to shareholder class suits. For example, suppose the seller successfully challenges the buyer in court. In that case, the buyer pays significant penalties higher than the premium the buyer must pay over and above the target’s standalone equity value.
Thus, indemnity, in my view, is an elegant solution that compensates the buyer for its losses subjected to deductibles/thresholds. On the other hand, a termination right is an on/off switch that does not provide a solution. However, a closing condition might be a basis for the parties to negotiate a revised deal that reflects the economic reality better. However, repricing the agreement is not a condition by itself.
Indemnity for breaches of representations protects buyers from breaches occurring at signing and closing. Although payment for indemnities happens after closing, the indemnity does not cover breaches arising after the deal closes. Thus, a purchase price adjustment provides pre-closing protection, whereas an earn-out protects a buyer from the target’s failure to meet future projections.
Closing conditions help the buyer terminate the deal before closing if there is a breach of representations and covenants. However, the buyer does not get any protection if the breach happens after the transaction closes.
A skilled deal maker must understand the contours of the acquisition agreement. Further, he must appreciate potential protections and recourse in case of any breaches by the other party in the transaction. Although attorneys draft the SPA, the deal makers must be involved in the negotiations and closing conditions of the deal.