Terms to Negotiate in an M&A Transaction
Acquisition agreements in M&A transactions are often long, complex documents. Although each deal has different issues and the treatment of those issues will depend on factors like the nature and structure of the particular transaction and the relative bargaining position of the parties, there are certain key provisions that are commonly negotiated in almost all acquisition agreements.
Although these key provisions all involve some combination of commercial and legal considerations, certain of them–such as Consideration, Earnouts, Escrow and Governance/Social Issues–tend to be more commercial in nature, whereas others–such as Purchase Price Adjustments, Representations and Warranties, Closing Conditions and Indemnification–tend to be more legal in nature.
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Founder Tip: While your M&A counsel will help you navigate the legal terms, negotiating the commercial terms is often primarily the job of the founder.
| Provision | Commentary |
|---|---|
| Consideration | The most common forms of consideration consist of (i) cash, (ii) promissory note(s) (i.e. debt), (iii) stock, or (iv) any combination of the foregoing. The type of consideration paid often has tax consequences for both the buyer and the seller, and thus tax advisors should be consulted. Generally speaking, sellers prefer the certainty of cash as opposed to the potential upside of stock consideration. However, in certain situations, sellers might prefer receiving stock in the buyer for tax-related reasons. This approach can help defer capital gains realization and potentially qualify the stock for QSBS (Qualified Small Business Stock) treatment provided that certain conditions are met. |
| Purchase Price Adjustments and Earnouts | The purchase price is either fixed at the closing or subject to adjustment thereafter once the value of the target company as of the closing is confirmed. The most common purchase price adjustment is based on the working capital of the target business, but it can be based on other metrics, such as the valuation of specific assets or the level of cash and debt. Earnouts—a mechanism in which at least part of the purchase price is payable after the closing if the target business achieves one or more certain financial or operational targets within a specified period of time—are often used when the parties cannot agree on the value of the target business. Sellers generally prefer the certainty of a fixed purchase price paid entirely at closing, but purchase price adjustments are quite common. |
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Founder Tip: Founders should consider whether and to what extent (e.g. as an employee or consultant, and for how long) they will work for a buyer post-closing. If a founder remains involved in the business following the transaction, he or she may be more willing to entertain an earnout as part of the deal consideration because he/she will still be able to exert (at least some) influence on the results of the business, and thus on the likelihood of achieving the earnout targets. If, on the other hand, a founder wants to completely separate from the business, he/she will more likely prefer not to have an earnout and instead to receive all deal proceeds at or soon after closing.
| Escrow | Although buyers can pay the purchase price in full at the closing, part of it is often withheld in an escrow account to secure purchase price adjustments in favor of the buyer or seller indemnification obligations (i.e. 5-10% of the purchase price is held in escrow for 12-18 months from the closing). Common negotiation points include the amount of the escrow, its length and the mechanics for its release. Sellers generally prefer to receive the entirety of the purchase price at the closing and to have no escrow. |
| Scope of Assets and Liabilities (for an Asset Acquisition) | In most asset acquisitions, the buyer acquires only the assets and liabilities it identifies and agrees to acquire and assume. The in-scope assets and liabilities are typically either specifically identified and listed, or the asset purchase agreement states that all of the seller’s assets and liabilities are to be transferred to the buyer, except for those specifically excluded. Sellers generally prefer the latter approach because it requires less diligence and reduces the amount of liabilities that will remain with the seller following the closing. |
| Governance/Social Issues | Depending on the exact nature of the transaction, the parties may need to work through key governance/social issues regarding the operation of the combined businesses post-closing, such as the name of the entity, the location of its headquarters, the composition of its leadership and board of directors, the role and title of the founder, whether the seller’s brand and product will remain in existence, etc. The outcome of these types of issues tends to be very deal specific and dependent on the relative bargaining position of the parties and whether the founder will remain involved in the business following closing. |
| Representations and Warranties | Representations and warranties are statements of fact and assurances made by the parties that, among other things, (i) disclose material information about the parties and the stock or assets and liabilities being sold, (ii) allocate risk between the parties, and (iii) serve as the basis for an indemnification claim in case of a breach of contract by one of the parties. They are usually the longest part of the acquisition agreement and are often heavily negotiated. Although buyers do give representations and warranties, those of sellers tend to be far more extensive. Buyers generally seek to obtain comprehensive and unqualified representations and warranties from sellers, whereas sellers seek to minimize the number and scope of their representations and warranties through qualifications such as materiality, knowledge and time. |
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Founder Tip: Founders should make sure to spend sufficient time closely reviewing the seller’s representations and warranties with legal counsel to confirm their accuracy, as these are often the source of potential liability down the road (i.e. indemnification claims by the buyer).
| Closing Conditions | If the signing and closing of the transaction do not happen simultaneously, each party will require that the other satisfy certain conditions prior to closing. Some of these conditions apply to both parties, whereas others only bind one of the parties. If a party has not satisfied a condition applicable to it, then the other party generally is not obligated to close the transaction until the condition is satisfied. Sellers typically prefer there to be fewer conditions to closing in order to increase the likelihood that the closing will actually occur. |
| Covenants | A covenant is a promise to take an action (an affirmative covenant) or to refrain from taking an action (a restrictive covenant). Certain covenants apply between signing and closing, such as obligations on the seller regarding how to operate the target business, whereas others apply post-closing, such as non-compete and non-solicitation obligations on the seller. In general, buyers prefer having more covenants in place to manage the behavior of sellers both before and after closing, while sellers prefer fewer covenants. |
| Indemnification | Indemnification is a post-closing remedy for losses incurred under an acquisition agreement typically arising from: (i) a breach of or inaccuracy in a representation or warranty; (ii) a failure to perform a covenant; and/or (iii) an agreed-to allocation of liabilities between the parties (such as a particular litigation or tax issue of the target company). The indemnification provisions tend to be one of the most heavily negotiated sections of the acquisition agreement. Although both parties typically have indemnification obligations, it is more likely that the buyer will seek recovery than the seller because the latter provides far more extensive representations and warranties than the former. In general, buyers seek to obtain comprehensive and unqualified indemnification provisions, whereas sellers seek to minimize the scope of their indemnities through limitations such as caps, baskets (thresholds or deductibles), and shorter survival periods. |
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Founder Tip: Founders should make sure to closely review and consider the impact of all covenants to ensure that they will be abided by, especially any of those that will affect future conduct by the founders post-closing, such as non-compete and non-solicitation obligations.
Assaad Nasr, Guest Writer, is a Corporate Partner and Co-Head of the M&A group at Buhler Duggal & Henry LLP
The information in this article is provided solely for general educational purposes and is not intended as legal advice. This article should not replace competent legal counsel from a licensed attorney in your state. 1984 and its affiliates expressly disclaim any and all responsibility and/or liability for any consequences resulting from the use of this article or any other document found on 1984’s website.