A Comprehensive Approach to a Successful M&A Deal
Authors: Aditya Kasiraman, Bharati Vidyapeeth (Deemed to be University), Pune.
Corporate Law is one of the booming fields of law and mergers and acquisitions form the heart and soul of this area of practice. In an ever competitive market, it is very crucial for big corporates to make their presence felt. As a result such firms constantly look for opportunities to expand their business and consolidate their market power. As easy as it seems from the outside, it is an extremely arduous task to successfully execute an M&A deal. There are various factors that are taken into consideration and they need to be carefully negotiated by both the parties. This paper aims to provide a detailed insight into the important issues that are connected to an M&A deal and how they can be effectively negotiated to ensure the overall success of the transaction.
While negotiating an M&A deal, it is extremely important to employ a meticulous approach and identify all possible issues that may creep up. The endeavour must be to resolve these issues in the beginning stages of the deal itself (ideally at the term sheet stage or as soon as possible after the execution of the term sheet). The acquirer and the target company must keep the following points in mind when negotiating an M&A deal. Few issues in an M&A deal are as follows:
A transaction can be structured in three ways: (i) stock purchase, (ii) asset sale, and (iii) merger. The acquirer and the target company have their own set of legal practices and considerations for which they compete against one another for each of the above three alternatives. Therefore, it is vital to recognise both parties’ interests and identify material issues when deciding on a particular deal structure. Few important considerations that need to be considered before finalising on a deal structure include: (i) transferability of liability, (ii) stockholder approval and (iii) tax consequences.
As for the first consideration (transferability of liability), unless specifically mentioned in the contract, the target company’s liabilities are transferred to the acquirer by the operation of law. The situation is the same in the case of a merger as well, unless otherwise stated in the contract, the surviving entity assumes all the liabilities of the other entity by operation of law. However, in an asset sale only those liabilities which are designated as assumed liabilities are transferred to the acquirer while the non-designated ones still remain the obligation of the target company.
As for the second consideration (stockholder approval), the board of directors of the target company can grant approval of the asset sale at the corporate level without obtaining the individual stockholder’s consent. However, in situations when unanimity is not achievable a merger is a pragmatic solution to negotiate a mutually acceptable stockholder approval threshold to finalise a deal.
The third and final consideration (tax consequences), depends upon the deal structure. Based on the deal structure, a transaction can be taxable or tax-free. As for asset sale and stock purchase, these deal structures have immediate tax implications for both the parties. But for mergers, because of their structure a certain portion of the acquirer’s stock can receive tax deferred treatment.
CASH VERSUS EQUITY
Another factor which is decisive in ensuring a successful execution of an M&A deal is the method of payment employed. Deal financing can be finalised by cash or equity. Cash is the most liquid and the least risky method in comparison to equity financing because from the perspective of the target company, the true market value of the transaction can be ascertained and it removes any contingency payments thereby effectively pre-empting rival bids. On the other hand, equity financing involves payment of the acquirer company’s equity to the stockholders of the target company. Equity financing is particularly beneficial to the acquirer as unlike debt financing, the acquirer is not required to make repayments on the investments. Therefore, issuance of equity offers more flexibility to deal structures. Ultimately the payment method to be determined is dependent on the value estimation that the acquirer places on itself (the tendency of the acquirer to offer equity financing when they believe their equity to be overvalued and cash when the acquirer believes their equity to be undervalued).
WORKING CAPITAL ADJUSTMENTS
Normally, in an M&A deal working capital is included as a component of the purchase price. This is done to satisfy the acquirer that the target company can meet the requirements of the business post closing and fulfil its obligations towards customers and trade creditors. An effective working capital can ensure protection to the acquirer in controlling the actions of the target company including (i) accelerated collection of debt, or (ii) delayed purchase of inventory or selling inventory for cash for timely payment to the creditors. An ideal working capital adjustment involves the variation between the sum of cash, accounts receivable, prepaid items and inventory minus the accrued expenses and the accounts payable. This is known as the Net Working Capital (NWC). It is noteworthy to realise that while calculating the NWC, certain unusual or atypical factors and cyclical fluctuations are also taken into consideration to arrive at an ideal figure.
ESCROWS AND EARN-OUTS
The term sheet should clearly mention any contingency payments to the purchase price paid, including any escrows and earn-outs. The objective of the escrow is to find a way out for the acquirer in situations where there are breaches of the representations and warranties committed by the target company. Escrows are a standard part of every M&A transaction but the terms of an escrow can vary significantly. Generally, escrow payments are in the range of 10-20% of the total purchase consideration and a payment period ranging from 12 to 24 months from the date of closing. On the other hand, earn-out provisions are employed to bridge the gap on valuation that may exist between the acquirer and the target company. Earn-out provisions are generally dependent on the future performance of the business, with the target company and its stockholders eligible to receive additional consideration only if certain conditions are met.
REPRESENTATIONS AND WARRANTIES
The acquirer expects the agreement to contain detailed representations and warranties by the target company with respect to various matters such as degree of authority, intellectual property, capitalisation, financial statements, tax provisions, compliance with law, employment provisions and other material contracts. It is of paramount importance for the target company and the target company’s counsel to review these representations carefully because any breach can invite indemnification claims from the acquirer. In addition, the disclosure schedule which describes the exceptions to the representations is the target company’s “insurance policy” and hence should be as detailed as possible. Another important representation (also known as “10b-5” representation under US laws) requires the target company to make a general statement that no representation or warranty contains any untrue statement and there is no omission of any material fact necessary to the agreement so as to not make it misleading.
Target indemnification provisions are one of the most important provisions in any M&A deal and are hence very diligently negotiated. The initial issues to be determined while negotiating a target indemnification provision is the type of indemnification claims that will be capped at the escrow account. There are certain instances wherein all claims may be capped at the escrow. There are, however, exceptions to this case. If the claims are resulting from fraud or intentional misrepresentation, they usually go beyond the escrow and are instead capped at the overall purchase price. Additionally, breaches of intellectual property or tax may also go beyond the escrow. Another term for which negotiations take place in a target indemnification provision, is the provision of a “basket” for indemnification purposes. This means that a minimum claim amount must be reached before the acquirer may seek indemnification. What this provision of basket does is, it avoids the nuisance of disputes over small amounts.
JOINT AND SEVERAL LIABILITY
The joint and several liability of the target company’s stockholders is related to the concept of indemnification. Mostly, transactions involve multiple stockholders from the target company and hence one of the primary issues to be considered regarding indemnification from the acquirer’s perspective, is the extent to which each of the target company’s stockholders will participate in any indemnification obligations post closing (whether joint and several or several but not joint, liability will be appropriate). If the target company’s stockholders are jointly liable, then each is individually liable to the acquirer for 100% of the future potential damages. But in cases where the liability is several, each stockholder of the target company pays only for their relative contribution to the damages. It is a given that the acquirer will always desire to make each stockholder of the target company responsible for the full amount of any potential claims. However, such stockholders generally resist this approach but even more so, where there are controlling stockholders or financial investors.
NON COMPETE & NON SOLICITOR CLAUSES
In every M&A deal, there is a covenant not to compete or solicit by the selling shareholder(s) of the target company, to not for a certain post closing time frame or after termination of employment with the target company/acquirer, (i) engage in any business activity which is competitive with the target company/acquirer, or (ii) attempt to lure away customers or employees of the target company/acquirer. In order to ensure the enforceability of such restrictions, they must be (A) reasonable in time and scope, and (B) supported by consideration (typically M&A deals involve the sale of a business and payment to the selling shareholders of a material amount of the consideration and hence such consideration is deemed adequate for purposes of enforceability both in terms of scope and multiple years of duration).
There is a section of the definitive agreement which will include the list of closing conditions which must be met by the parties in order to close the transaction. There are also situations when the detailed list will be included in the term sheet itself. The conditions include items such as appropriate board approval, the absence of any material or adverse change in the target company’s financial or business conditions, requisite stockholder approval, the absence of litigation and the delivery of a legal opinion from the target company’s counsel. One of the heavily negotiated closing conditions is the stockholder voting threshold which is crucial for the approval of the transaction. Although the target company’s operative documents state the requirement of a lower threshold, acquirers typically request a very high threshold for approval (usually around 90-100%) out of concern that stockholders who have not approved the transaction might exercise appraisal rights. Therefore, the target company must review its stockholder structure meticulously before committing to such a high threshold (although from the target company’s perspective, the more stockholders approve the transaction the better, but at the same time the target company also does not want the acquirer to just walk away from the transaction).
This study represents the fast paced and highly complex world of mergers and acquisitions in the corporate sector. In present times mergers and acquisitions have become a common phenomenon and are now an indispensable part of corporate growth. They have a vital role to play, especially in today’s booming global economy. This growing importance of mergers and acquisitions in the corporate world aptly supports Darwin’s theory of evolution i.e. survival of the fittest. Mergers and acquisitions are now increasingly being used by corporates around the world to achieve a larger size and asset base, to facilitate faster growth and to increase competitiveness in the market by achieving economies of scale. All this can be done only by executing a successful M&A deal and in turn this can be achieved only by carefully considering all the above mentioned pointers.
www.morse.law ; Top Ten Issues in M&A Transactions by Mary Beth Kerrigan