Inflation, supply chain disruption, interest rates and geopolitical risk mean that deal protection mechanisms are currently at the font of mind for prospective purchasers in private-treaty M&A transactions. While capital availability in the market remains strong, unsurprisingly, purchasers are exercising a high-degree of caution when it comes to M&A activity, in light of the current macro-environment.
There are a range of measures that can be implemented to assist in helping to bridge the gap between a purchaser’s and seller’s expectations on pricing and risk in challenging times such as this. In this article, we discuss the following deal-protection measures that parties may wish to consider when negotiating private M&A transactions in the current climate:
- Due diligence and exclusivity periods.
- Material adverse change (MAC) clauses.
- Earn-outs/deferred consideration.
- Holdback escrows.
1. Due diligence and exclusivity periods
At the outset of any M&A transaction, the purchaser should seek to have a clearly defined period within which they can conduct due diligence on the target company, which is generally (unless it is a contested process) accompanied by an equivalent exclusivity period.
Exclusivity periods are often requested by buyers to secure exclusive access to the seller and the target company, to allow the buyer to conduct due diligence on the target company and its assets. Pro-active sellers may also decide to offer exclusivity in order to attract buyers and demonstrate a genuine commitment to a particular sale process.
During the exclusivity period, the target company and the sellers are prevented from negotiating with, or soliciting and/or accepting offers from, any third parties, while the purchaser conducts its due diligence. By obtaining exclusivity, the purchaser will not unexpectedly find themselves in a competitive sale process, which may otherwise be a deterrent, given the time and costs involved in undertaking a due diligence process.
The longer the exclusivity period, the more thorough the due diligence process and investigations can be, which generally allows the purchaser to identify and quantify the potential magnitude of risks, which should lead to greater certainty around pricing and the warranty regime to be set out in the long-form sale agreement.
The exclusivity period should be specified in a term sheet that is legally binding (in part at least, particularly in relation to exclusivity) on the parties, including each of the sellers.
The duration of an exclusivity period will vary, depending on the size and nature of the transaction. For smaller private treaty transactions, exclusivity periods of around two months are generally considered customary. For larger transactions, exclusivity periods may be significantly longer than this, occasionally with an option to extend the exclusivity period if the purchaser and target agree.
Although due diligence is typically considered to be solely in the best interests of a purchaser, sellers can also benefit from allowing a purchaser to conduct thorough due diligence process in the following ways:
- Firstly, being well prepared for due diligence and having your house in order, including having an electronic data room that contains the relevant documents that a purchaser would expect to be provided for review, can demonstrate that the seller understands the business and that the target is well organised and run. Conversely, if a seller is disorganised or unprepared for due diligence, this can reflect poorly on them and the target and may raise questions in the mind of the purchaser as to how the target has been run.
- Secondly, a seller may seek to have a carve out from the seller warranties contained in the long-form sale agreement that prevents the purchaser from making a warranty claim against the seller in relation to anything that has been disclosed to the purchaser as part of the due diligence process. So, by allowing a purchaser to conduct fulsome diligence and ensuring all relevant material and risks are fully and fairly disclosed as part of that process, the seller should be reducing the risk of a warranty claim being made against them in respect of the information that has been disclosed to the purchaser.
- Thirdly, given most purchasers are highly motivated to ensure that there is no completion risk on the transaction, assuming they are well advised, they will conduct a thorough review to identify any consents or approvals that will be required prior to completion occurring. While this is primarily intended to reduce the completion risk for the purchaser, it also reduces post-completion risk for the seller because there will be less chance of a warranty claim being made on the basis that a particular consent or approval was not obtained.
2. Material adverse change clauses
A carefully drafted material adverse change (MAC) clause will mitigate the risk to which a purchaser would otherwise be exposed, with respect to adverse business related events or economic developments that arise up to completion.
MAC clauses are drafted by reference to a material adverse change occurring to the buyer, the target company or the broader market between signing (or a historic accounts date) and completion (often referred to as Bidder MAC, Target MAC and Market MAC).
MAC clauses are generally presented in the form of a condition precedent or a warranty, often both of which are found in a long-form sale agreement:
- MAC Condition Precedent – If a MAC Condition Precedent is not satisfied prior to the completion of the transaction (ie if there is an adverse business related event or economic development that occurs prior to completion) the purchaser will have the right to elect to terminate the agreement and not proceed with the acquisition.
- MAC Warranty – If there is a breach of a MAC Warranty (ie a MAC has occurred between the agreed accounts date and completion), the purchaser will have the right to recover damages from the seller by making (or threatening to make) a claim for breach of warranty following completion.
In long form sale agreements, MAC clauses are either defined in descriptive (qualitative) or prescriptive (quantitative) terms, as outlined below:
- Qualitative MACs – MAC definitions with qualitative measures tend to be broad in nature and based on subjective concepts.
- Quantitative MACs – MAC clauses with specific quantitative measures, on the other hand, provide a clear and objective basis for determining whether or not a MAC has taken place. Objective measures that are often found in quantitative MAC clauses include reductions in revenue or other financial metrics such as EBITDA, or increases in liabilities.
Ideally, a purchaser should seek to have a combination of both quantitative and broad qualitative measures included in a MAC clause. The quantitative measures provide a clear basis on which the purchaser could seek to rely on the MAC clause if certain specific metrics are not met, while the qualitative measures act as a backstop or catchall to protect the purchaser from unanticipated occurrences that may have a material impact on the long-term earnings potential or profitability of the target company.
Given there is little in the way of judicial guidance in relation to MAC clauses in the M&A context in Australia, parties should be mindful of general principles of contract interpretation when drafting and negotiating MAC clauses with qualitative measures. The current position adopted by Courts in Australia when interpreting contracts is that the rights and liabilities of parties under a provision of a contract are to be determined objectively, by reference to its text, context and purpose. In determining the meaning of the terms of a commercial contract, one should ask what a reasonable businessperson would have understood the relevant terms in the relevant contract to mean. That enquiry will require consideration of the language used by the parties in the contract, the circumstances addressed by the contract and the commercial purpose or objects to be secured by the contract1.
Ultimately, the way in which a MAC clause with a qualitative measure will be interpreted will depend on the drafting of the terms in the contract and will turn on the specific facts that have arisen in the circumstances in question.
3. Earn-outs/deferred consideration
Earn-out structures are a form of deferred consideration, under which part of the purchase price is calculated by reference to the performance of the target company’s business following completion.
Earn-outs can provide an effective solution in circumstances where a purchaser and seller have diverging views on the value of the target company. In order to overcome a potential impasse on negotiations over pricing, particularly in circumstances where the financial performance of a target company has been adversely affected, perhaps only temporarily, earn-outs can provide an effective solution.
Importantly, from a purchaser’s perspective, earn-outs provide a basis on which to ensure that the ultimate purchase price is based on the future performance of the target company following completion, rather than relying purely on what the seller has told the purchaser about the historic performance of the target company’s business.
Like MAC clauses, when drafting and negotiating earn-out clauses, it is important to ensure that they are clear, unambiguous and as specific as possible in order to reduce the risk of a dispute over how they should be interpreted.
4. Holdback escrows
Under a holdback escrow arrangement, a portion of the purchase price of an acquisition paid by the purchaser is placed in a third party escrow account, for an agreed period of time, to serve as security for the purchaser in relation to a range of post-completion matters. Holdback escrow arrangements can benefit both purchasers and sellers in the following ways:
- Benefit to purchasers – Purchasers benefit from holdback escrow arrangements as they allow purchasers to reduce their post-completion risk exposure by assuring that there will be a pool of funds, held by an impartial third party escrow agent, that can be accessed for things such as working capital adjustments, environmental or tax issues and general warranty claims that the purchaser may make.
- Benefit to purchasers and sellers – Purchasers and sellers both benefit from holdback escrow arrangements given they can help bridge a gap on valuations by allowing events or uncertainties that may have created the valuation gap to be resolved over the duration of the escrow.
- Benefit to sellers – Holdback escrow arrangements can benefit the interests of a seller if the parties agree that the holdback escrow should be the exclusive pool of funds that the purchaser can seek to claim on for any breach of a representation or warranty, thus placing a ‘cap’ on the seller’s liability.
Conclusion
There are a wide range of protection measures that purchasers and sellers may wish to implement when engaging in M&A activity in challenging markets. An experienced M&A advisor will be able to guide M&A participants through each of these, and other, options that are available to assist in closing out their transactions. Please contact our M&A team for a further discussion.
This article was written by Tom Morgan, Partner.
1Mount Bruce Mining Pty Ltd v Wright Prospecting Pty Ltd [2015] HCA 37 at [46]-[51].
