Guidance for Evaluating M&A Transactions
The American Bar Association recently released its 2015 Private Target Deal Points Study. The biennial study summarizes key terms from publicly-available agreements involving the acquisition of a privately-held target by a publicly-held buyer. The 2015 study analyzed 117 deals that closed in 2014 with transaction values ranging from $50 million to $500 million.
The study has long been used as a reference for those responsible for negotiating M&A transactions. Although directors of privately-held companies are not necessarily on the frontline of negotiations, their approval is needed before certain acquisitions or sales can be consummated. Accordingly, the study provides directors with guidance on M&A market trends that may be helpful in evaluating proposed transactions.
Guidance for Directors of Target Companies
When contemplating a business sale, a director of a target company should be largely concerned with maximizing shareholder value in order to meet their Revlon duties (under Delaware law) or other fiduciary obligations. Deal structure and payment terms are two areas that influence shareholder value.
Transaction Structure. Many sellers mistakenly assume that buyers will require a transaction to be structured as a sale of assets in order to protect the buyer from the target’s liabilities. The 2015 study discloses that asset transactions are actually relatively rare in deals with these demographics. The 2015 study shows that only 17% of transactions were asset transactions (the 2013 study reports 10%).
The prevalence of equity-based deals is not surprising. For example, targets with government contracts or a significant number of contracts with anti-assignment provisions prefer a stock sale or merger transaction to avoid the often arduous task of obtaining novations and consents (e.g., landlord approval) prior to closing. Targets that are taxed as C corporations also prefer non-asset transaction structures to avoid a double tax on the acquisition proceeds. Buyers can typically contractually address concerns regarding liabilities of the target and become comfortable with a stock purchase or merger structure.
Decreased Use of Escrows. The vast majority of reported deals (more than 75%) included an indemnification holdback or escrow to secure payment of a buyer’s losses post-closing. Notably, however, the number of deals without any escrow
or holdback in the 2015 study doubled over those analyzed in the 2013 study. The absence of an escrow or holdback increases the cash received by shareholders at closing. Though the study does not offer an explanation for the dramatic increase, the growth may be partly attributable to the increasing use of representations and warranties insurance. Buyers should nevertheless be aware that such insurance may not provide as much protection as conventional indemnification terms and conditions, including an escrow or holdback (for instance, if there are known breaches of reps and warranties).
Indemnification Limitations. Indemnification “baskets” help protect shareholder value. Generally speaking, a “basket” is an aggregate dollar value of losses that must be exceeded before any losses are recoverable by the buyer. The use of baskets in transactions increased slightly over the past two studies. Average basket size also increased from 0.61% of transaction value to 0.69% of transaction value.
A similar trend can be noted in the increased use of eligible claim thresholds (often referred to as “mini-baskets”). A mini-basket prevents a buyer from recovering for immaterial claims (for example, any single claim that does not exceed $10,000). According to the 2015 study, nearly 40% of transactions included mini-baskets.
Guidance for Directors of Acquirors
The 2015 study identified as least three trends regarding payment mechanics that help allocate risk in favor of the buyer.
Holdbacks vs. Escrows. As mentioned above, a buyer typically requests an escrow or holdback to secure post-closing indemnification obligations of the sellers or target company. While the use of escrows may have decreased, the 2015 study shows that the average size of escrows and holdbacks increased from 7.83% of transaction value in the 2013 study to 9.14% in the 2015 study.
The 2015 study does not provide a breakdown between the number of holdbacks versus escrows that are used. These are terms of art in the M&A world (with an escrow, the amount at issue is funded at closing, while a holdback allows the buyer to “hold” the funds until payment is triggered), and it is often advisable for a buyer to be as specific as possible in a letter of intent.
Contingent Consideration. The 2015 study suggests that use of earn-outs in transactions has remained fairly static over the past two years, appearing in approximately 25% of all reported transactions. Earn-outs offer the possibility of additional purchase price to sellers upon the achievement of certain conditions and a deferred payment schedule for the buyer. The 2015 study highlights that covenants regarding the post-closing operation of the target are trending more favorably to buyers.
As an example, fewer deals included an affirmative obligation of the buyer to run the target consistent with its past practices or the affirmative obligation to run the business in such a way as to maximize the earn-out. Further, Delaware courts have recently held that the absence of affirmative obligations for buyers does not impose an implied obligation on the buyers.
Special Indemnification Obligations. One way buyers may be responding to increased limitations on sellers’ indemnification obligations is by using stand-alone (or, “line-item”) indemnification requirements for specified matters or topics such as tax or environmental liabilities. Use of line-item indemnification has increased according to the 2015 study. Because these stand-alone indemnification obligations generally are not subject to a basket or mini-basket, a buyer can negotiate more effectively for protections in areas of greatest concern.
Though company officers and advisors are typically the individuals directly negotiating the terms of M&A transactions, directors tasked with evaluating and ultimately approving these transactions will benefit from a deeper understanding of deal trends for privately-held companies.
Andrew M. Lohmann (top) is a partner and chair of the Mergers & Acquisitions practice at Hirschler Fleischer (Richmond, Va.). He also serves as vice-chair of the firm’s Business Section. He may be reached at (804) 771-9572 or by email at email@example.com.
Lisa J. Hedrick is a partner with Hirschler Fleischer (Richmond, Va.). She is an active member of the American Bar Association’s Mergers and Acquisitions Committee, and she served on the working group for the organization’s Private Target M&A Deal Points Study for 2011 and 2013. She may be reached at (804) 771-9554 or by email at firstname.lastname@example.org.