Risk Allocation Mechanisms in Mergers and Acquisitions: Part 1 — PURCHASE PRICE CONSIDERATIONS
This is the first article in a series addressing some of the mechanisms used to allocate risks inherent in M&A deals.
Mergers and acquisitions (“M&A”) are heavily negotiated transactions that are documented in complex agreements covering legal, financial, business and tax matters. The main ways in which one company can acquire another is through a stock acquisition (either all or partial), an asset purchase, or a merger, each of which can involve the exchange of cash and/or ownership interests in one company to the other (and/or to its owners). Each party to an agreement in an M&A transaction seeks to minimize its risks and taxes while maximizing its rewards through risk allocation provisions in the agreement that take into account the objectives and needs of the parties. Though not all risks can be fully allocated in the documents drafted by counsel in an M&A deal based on the counsel’s past experience, risk allocation provisions are integral to mitigating risk and expanding the benefits for each party.
Some, though certainly not all, of the material risks that parties to an M&A negotiation must consider include:
- the likelihood of other bidders,
- the relative bargaining power between the parties,
- current and future circumstances affecting the target company and its industry,
- the nature of the buyer’s financial assurances, and
- the size of the transaction.
Risk allocation provisions tend to be more comprehensive during economic declines and recessions. In the current COVID-19 pandemic, many companies have experienced extreme disruptions with their business operations. The material and potentially long-term effects associated with this pandemic have given new perspective to risk allocation in commercial agreements.
More generally, negotiations for price adjustments should take into account potential current and future material risks. In evaluating the purchase price of the business being sold, the parties should consider the costs associated with running the business, including the fluctuating cost of materials, contracts with vendors, an increase or decline in clients or customers, current and future competitive pressures, and changes in the regulatory landscape.
Andy Tomat, Managing Director of Four Pillars, Inc., emphasizes the complex negotiations involved in M&A transactions by stating that “there are no standard templates for negotiating the terms of a business sale. Even smaller transactions may have complex needs based on the seller, the buyer, and the nature of the business. Thus, it critical that buyers and sellers work with experienced law firms that can provide the mindshare to understand their needs.”
In this article, we will focus on topics relating to the purchase price, including the use of digital currency as an alternative to fiat currency, the use of non-cash considerations, purchase price adjustments, and earnout mechanisms.
Holdback and Escrow Accounts
Depositing a portion of the purchase price in an M&A transaction in a holdback or third-party escrow account allows for more security for both parties to the deal. In a holdback account, the buyer holds back a portion of the purchase price after the closing until negotiated time periods have lapsed or other metrics have been satisfied. Unlike a holdback account which often is controlled by the seller, an escrow account is controlled by an unrelated third-party. Holdback or escrow provisions provide security from uncertainty arising out of post-closing purchase price adjustments, unforeseen financial losses arising after the closing, risks related to transfer taxes, and access to indemnifications arising out of breaches of representations and warranties. Further, a seller may benefit from negotiating to limit or cap indemnification liability to funds held in the holdback or escrow account.
The average portion of the purchase price held in a holdback or escrow account ranges from 10% to 20% of the total purchase price, with the amount being held in the account usually for 12 to 24 months following the closing. Sellers should understand the potential risks of agreeing to holdback provisions, especially where a buyer controls the account and goes bankrupt. Parties should Include language about remedies and procedures to seek remedies in accessing any amount held in a holdback or escrow account. Parties also should discuss how holdback or escrow account fees will be allocated, the percentage of purchase price to be held in the account, and the length of time before funds from the account may be released.
Non-cash consideration allows buyers to finance an M&A deal with alternatives sources of funding in lieu of using outside debt, including payment of the seller’s own equity, the contribution of assets, or a promissory note allowing for deferred payments with interest. In using a promissory note, the seller should negotiate for a security interest on the assets of the target company, perfect the security interest under the Uniform Commercial Code, and clearly describe the rights and remedies upon a default, including reclaiming, taking possession, maintaining, or preparing for sale or lease of the secured assets. The seller should also consider the effect of a sale or other disposition of the target company upon the buyer’s ability to pay the obligations under the note. In some circumstances, a seller can ask an owner or affiliate of the buyer to guaranty the buyer’s payment obligations. Further, the seller should require that the buyer obtain an insurance policy to insure the secured assets against loss or damage and in such amounts and forms as are customarily maintained by businesses similar to the target business. Often a buyer will finance an M&A deal using combination of cash and non-cash considerations.
Pre- and Post-Closing Purchase Price Adjustments
A provision allowing for adjustments in the purchase price just before or sometime after the closing date protects buyers from fluctuations that may occur between the time that the parties agree to a purchase price amount and the closing date. Generally, the parties will look at the net working capital adjustments of the seller’s business and make calculations to true up the net working capital component of the purchase price. This is done to insure that the seller is not tempted to accelerate AR while deferring AP in advance of the transaction. Parties should look at several factors that can affect closing date purchase price adjustments, including:
- Whether a delayed closing impacts the net working capital of the target company or industry
- Determining the value of the net inventory or fixed assets being acquired
- Providing reasonable time to calculate price adjustments
- Considering the impact of COVID-19 or other industrywide disruptions that may have on the business
Parties also may consider including a ceiling or an upper limit to any positive adjustment amount or setting a floor or a limitation on the negative adjustment amount to reduce dramatic shifts in closing date or post-closing purchase price adjustments.
Earnout provisions allocate risk by allowing the buyer to defer the payment of a portion of the purchase price to a later date through periodic contingent payments after the closing. In some cases, the earnout provision can bridge a valuation gap: When the buyer and seller are disagreeing as to the purchase price, the parties can at least agree on a minimum amount and allow the seller to “earn” the balance post-closing through the earnout mechanism.
Earnout provisions may incentivize the seller to participate in the business after the deal closes while providing an alternative way for the buyer to finance an M&A deal, in particular through the earnings of the business once the buyer owns and operates the business. This makes the earnout particularly attractive to buyers who do not have sufficient cash to complete the deal at the seller’s stated price. Staggering payments contingent on the performance of the business after closing also can protect the buyer from overpayment if the business does not meet the buyer’s expectation prior to closing. Another benefit of an earnout provision is that it incentivizes the seller to remain involved in the business – in particular if the seller is required to provide services through a transition services agreement – because the seller will want to maximize its chances of receiving the full earnout amount.
Earnout payments can be structured in many different ways, including periodic payments that are tied to the performance of a business post-closing. Determining the right metrics to use is based on the kind of business being sold and how success is measured for that business. The measuring period for earnouts is typically one to three years after the closing, and up to five years in few cases. Some of the factors to consider in determining the earnout calculations include:
- Insuring that the earnout is not considered ordinary income to the seller
- Setting appropriate milestones such as threshold amounts and measurement dates
- Determining how the metrics are measured and insuring they are auditable and not subject to interpretation
- Evaluating what individuals will control the business and their ability to meet the milestones
- Understanding the tax and accounting treatment of the earnout payments
- Providing for earnout payments upon an acceleration event (for example, if the target business gets sold or merged with an unrelated party during the earnout period)
- Determining the procedures for any objections a seller pay have if the full amount of the earnout payments are not paid (including the ability to conduct an audit)
If an M&A agreement contains a setoff right, the earnout can act as a bank for the buyer to set off any future claims that it may have against the seller (for example, for breaches by the seller of any of its representations and warranties). Poorly written agreements often result in litigation.
When carefully crafted, earnouts allow the buyer to modify the risk associated with overvaluation of a business while inducing the seller to participate in the growth and continued success of the business after the M&A deal closes. The COVID-19 pandemic has likely thrown a wrench into the calculation of earnouts in deals that have already closed, but parties should continue to consider using an earnout as a tool that could potentially benefit both sides to an M&A deal.
Digital Currency Payments
More and more, buyers and sellers are using digital currency – such as bitcoin – as an alternative form of consideration to fiat currency. This has forced the parties and their counsel to think through unique purchase price considerations to draft appropriate language in purchase agreements. Alternative forms of payment require analysis and discussions between the parties and their counsel regarding the risks and liabilities associated with digital currency, including a potential increase or decrease in the conversion rate and value of such currency, the liabilities that arise if the purchase price is returned, determining which party is responsible for the fees associated with the digital transfer, and the procedure used to verify the validity of the seller’s and buyer’s electronic wallets during the transfer. Although paying the purchase price in the form of digital currency may seem to be a simple and intuitive act, a comprehensive purchase agreement should list the rights and obligations of the buyer and seller to allocate the risk accordingly.
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