The terms of all M&A transactions are set forth in a contract known as the “purchase and sale agreement” between the acquiring and selling parties. The contract can take the form of a stock purchase agreement, asset purchase agreement, tender offer document, or merger agreement. Regardless of the form, the contract contains a number of clauses that are similar in all situations.
M&A transactions can be structured as an asset or stock sales. In an asset sale, the specific assets (and liabilities) being sold (including everything from office supplies to goodwill) are listed in the purchase and sale agreement. Alternatively, the purchase and sale agreement may simply include a general description of the assets being sold (e.g. “all assets used in Target’s business”).
The tone of the transaction documents (that is, how they are biased in favor of the buyer or seller) depends on the relative negotiating leverage of the parties and the type of transaction. In an auction, it is typically the case that the selling party is charged with drafting the transaction documents so that it can more readily compare competing bids. In a negotiated transaction, however, the buyer usually drafts the documents. In either case, the initial tone of these documents will be determined by the competitiveness of the auction process.
It is important to understand which parts of the purchase and sale agreement are normally subject to negotiation and which are less important and/or boilerplate clauses. Understanding the contract fundamentals is useful in negotiations surrounding the contract. Investment bankers often act as counterweights to lawyers in deciding which clauses are relevant to a transaction.
Anatomy of Purchase and Sale Agreements
The following tables describe key sections of a typical agreement between the buyer and seller:
Exhibit 1.1 – Key Sections in Purchase and Sale Agreements
|Representations and Warranties||
|Conditions to Closing||
Execution provisions provide for the transfer by the seller of the assets or stock of the target to the acquirer in exchange for the purchase consideration. The consideration may take a number of forms, including cash, stock (common or preferred), deferred compensation, and warrants. The execution provisions also include the definition of any collars or other price protection mechanisms.
In an M&A transaction, a portion of the purchase price may be withheld or deferred. This can be accomplished through hold-backs, escrows, earn-outs, contingent value rights (“CVRs”), or other contingent payments. While such mechanisms are often useful to bridge differences over price, there are often significant hurdles in implementing them from a practical point of view. This can be due, in part, to the fact that these payments may be dependent on future business performance that will be under the control of the buyer.
The execution provisions also address purchase price adjustments. In general, this refers to clauses that define how the purchase price will be adjusted for changes in such items as working capital, net debt, or other operating metrics between signing and closing of the deal. It is important to be aware of the method of dispute resolution. For example, if the remedy for a dispute is a long and costly litigation process, there is less incentive for the seller to stay true to the agreement. However, if the resolution is done by arbitration, there is a much quicker and surer remedy for the buyer, so the seller is likely to be more cautious about trying to circumvent the language and spirit of the contract. Price adjustments become more important the longer the period between signing and closing of a transaction.
Exhibit 1.2 – Purchase Price Adjustments
|Working Capital Adjustments||Generally, this adjustment can be most important for financial buyers who are trying to arrange financing and where working capital may impact the credit statistics. Additionally, detailed adjustments are often made in working capital-intensive and/or seasonal industries, such as retailing. Furthermore, it may be useful to have a working capital adjustment clause as a mechanism to ensure that the business is operated in the ordinary course of business. Negotiation of working capital adjustment clauses centers on establishing the appropriate target level of working capital.|
|Net Debt Adjustments||In situations in which net debt is to be assumed by the buyer, it is important to define how net debt is calculated and determine how much debt is expected to be on the balance sheet at closing. For example, if a buyer is willing to pay $1bn in enterprise value for a business, subtracting $400mm versus $500mm of net debt will mean a significant difference in value to the equity holders. Hence, it is important to understand whether the price is defined in terms of enterprise value or equity value. The net debt adjustment also defines whether cash flows of the business between signing and closing are allocated to the buyer or, more typically, the seller. This may be especially important in businesses that are cash flow negative.|
|Operating Metric Adjustments||There may be situations where an acquirer will insist on an adjustment to reflect business performance between signing and closing. This is especially true in situations where there is uncertainty as to the underlying business performance or the financial estimates in use. If an acquisition and the related financing are made on the basis of an EBITDA multiple, for example, the buyer may want to be able to adjust the purchase price to reflect any deterioration of the business.|
Representations and Warranties
Representations and warranties include the statements and assurances that a seller makes regarding its ability to sell the business, the consents required to sell the business, and the condition of the business. The representations are the statements about the business, and the warranties are the assurances that those statements are true and accurate.
Representations and warranties serve three principal purposes:
- They must be true and accurate at both signing and closing; otherwise, the buyer may be able to delay closing or terminate the deal
- Breaches of reps and warranties form the basis for indemnification claims
- They support the due diligence process and the determination of purchase price adjustments
Typical statements regarding the condition of the business being sold relate to:
- Accuracy of the financial statements
- Existence of significant contracts
- State and existence of physical and material property
- Existence or non-existence of environmental claims or liabilities
- Sufficiency of assets (e.g. intellectual property)
- State of accounts receivable
- Employee benefits
A seller will generally not make representations regarding its future financial performance or its “prospects”.
In addition to straightforward statements regarding the existence or state of the company being sold, the seller will often seek to qualify certain statements. This is frequently done by way of a “materiality” qualifier or a material adverse change (“MAC”) clause, which limit the statement by excluding small (non-material) discrepancies. The strength of the materiality threshold, or MAC clause, and the exceptions they provide, is often a topic of significant negotiation.
In addition, a selling party may seek to limit certain reps and warranties by a “knowledge” qualifier, which limits the truth and accuracy of a statement based on the knowledge of certain individuals. In these situations, it is important to define not only what is being qualified, but who is actually expected to have this knowledge. Typically, this is limited to a group of people such as the executive officers of the seller or the company being sold.
Covenants regulate the actions that buyers and sellers are allowed to take between signing and closing. They also form the basis for closing conditions and indemnification. Basically, breaking a covenant implies that a condition to closing has been violated, and the party not in breach will be able to claim indemnification from the other party, or possibly terminate.
Covenants can cover a wide range of topics, but they generally fall into three broad categories:
Exhibit 1.3 – Covenant Categories
|Operation of Business||
Conditions to Closing
Conditions to closing provide an acquirer with protection against not getting what it is paying for and create certainty for the seller. Basically, they regulate the steps that enable the two parties to close a transaction. they also regulate the “bring down” of reps and warranties (i.e. confirming that all reps and warranties are still true and accurate at the time of and as a condition to closing).
Conditions to closing regulate the consents the parties must seek, including antitrust (HSR) and other regulatory consent, such as FCC and FDA. Third party consents include minority shareholder consents and change of control provisions embedded in operating agreements or other contracts. It is important to limit the scope of the consents sought, as a buyer or seller may use the inability to obtain a non-material consent as a mechanism to terminate the deal. In a private transaction, there is usually no reason to condition closing on getting shareholder approval, since the shareholders will generally be the signatories of the contract.
A financing condition is often used in deals involving a financial sponsor who needs to raise cash in the capital markets. From the point-of-view of the seller, it is preferable, however, to have solid financing commitments in place at signing, as this provides greater certainty that the deal will close. A seller might require a financial sponsor to obtain a bridge loan commitment, for example, in order to sign. From the point-of-view of the financial sponsor, it can be expensive to secure such committed financing. Also, any such financing will typically contain its own set of conditions, or “outs”. Thus, even though the contract may not have any financing out, the financing commitment itself will almost always have a market out.
There may be additional conditions, such as labor or tax-related conditions, depending on the circumstances. Lastly, the conditions to closing typically include a material adverse change clause, which locks the buyer and seller into the transaction despite minor (i.e. non-material) changes to the business.
Indemnifications arise in private transactions (in which there is an identifiable seller to stand behind the contract after closing) to protect the buyer against pre- or post-closing breaches of the covenants and/or reps and warranties. Indemnification typically involves a payment from the seller to the buyer to compensate the buyer for losses incurred due to such breaches. In most cases, there is a materiality threshold for such breaches. An acquirer will only be indemnified for breaches of reps and warranties for the “survival period”, which is usually until closing or a defined period of time thereafter (but usually no longer than one or two years, except in the case of tax and environmental reps, which are typically longer).
Indemnifications can be structured in several ways. The size and mechanism for the indemnification is often the subject of significant negotiation and, depending on the circumstances and the probability that they will be invoked, can be used as a point of a negotiation to influence other parts of the deal, such as overall purchase price. Specifically, indemnification clauses may include any of the following:
- A minimum size of any individual claim (the “minimum”)
- A larger minimum threshold that must be reached before reimbursement can be sought (the “basket”)
- A limit on the aggregate amount of claims (the “cap”)
Often, the buyer will require the seller to deposit an agreed amount (can be up to the amount of the cap) into an escrow account for the duration of the survival period to back up any indemnification claims. For example, in a situation where the selling entity is a special purpose vehicle or joint venture company and is expected to liquidate at the time of closing, the lack of recourse to a corporate parent may cause a buyer to require an escrow. The indemnification process is generally the sole remedy for contractual breaches, and there it is therefore important that the limit of the indemnification under the agreement reflects the potential impairment(s).
Exhibit 1.4 – Contingent Value Rights Example
Contingent payments may also have implications for future M&A activity of the acquirer. In 2011 and 2012, Bank Financial Corp. (a fictional bank based on an actual bank) acquired several banks and issued CVRs to selling shareholders as part of the deal consideration. Under the terms of the CVRs, Bank Financial would only make payments to selling shareholders if the performance of acquired loan portfolios met certain loss expectations over a 5-year period from transaction close. This innovative deal structure hedged against unforeseen deterioration in the credit quality of the acquired loan portfolios.
At 9/30/12, the fair value of Bank Financial’s CVR obligations stood at just $0.5mm. However, the terms of the CVRs stipulated that a change-in-control at Bank Financial within 5 years from transaction close would make Bank Financial liable to CVR holders for the full value of the CVRs, or $41.6mm. As a result, a potential acquirer for Bank Financial would need to “pay up” to settle this incremental $41.1mm liability realized upon a change-in-control, possibly affecting the acquirer’s perception of the attractiveness of the deal (at an assumed Bank Financial purchase price of $1bn, this incremental liability represented approximately 4% of the purchase price).
Termination clauses describe the situations in which a seller or buyer has the right to terminate the deal. Termination rights are invoked when one or more of the conditions to the transaction are not and cannot be fulfilled. In order to further limit the uncertainty regarding such a situation, a termination date is usually specified as well. This date (called the “drop-dead” date in the U.S. and the “long-stop” date in the UK) is the subject of negotiation and must take into consideration the expected regulatory process and the time necessary to reasonably obtain other approvals and consents.
Many purchases and sale agreements include break-up, or termination, fees. In the event one party terminates the transaction, such fees would be paid by that party to the other party. Break-up fees signal a commitment by both the buyer and seller to consummate the deal and act as a deterrent to unilateral termination of the deal.
Break-up fees help cover the costs of planning, negotiations, due diligence, and legal or financial advisory incurred in the course of pursuing the deal. For example, if the seller receives and accepts a competitive offer, the break-up fee help protect the buyer’s investment in the transaction. In situations where there is significant regulatory uncertainty and the parties have different views on the ability to close the transaction, it may be possible to use a break-up fee as an inducement to the “doubting” party to enter into the transaction.
Sometimes, however, break-up fees can be so large as to make it difficult for the seller to accept a superior bid, even if the offer on the table is not in the best interest of the target’s shareholders. Although break-up fees can provide real benefits to the parties in a deal, the seller must weigh them against the adverse consequences they may have on competitive negotiations.