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Typically, the purchase price in a private M&A transaction is adjusted based on the target company’s estimated working capital as of the closing date. This gives the sellers the benefit of assets such as cash and receivables, but nets out debt, payables and other liabilities. The parties then go through a working capital adjustment process after closing to finalize the closing date numbers, with any change from the estimated working capital serving as an adjustment to the final purchase price. Based on data that Fortis Advisors has collected from over 500 M&A deals where it has served as the post-closing shareholder representative, 64% of such deals include a post-closing adjustment provision to finalize the working capital (see the Forsite™ M&A Deal Tool, including accompanying analyses):
However, this common working capital adjustment process can lead to an unintended consequence: forcing recalculation of every holder’s merger proceeds, escrow contribution, pro rata percentages and other metrics post-closing. This problem can be avoided through a simple provision in the merger agreement (as described below).
At the closing of an M&A transaction, the parties agree to distribution of the proceeds based on the purchase price (including the estimated working capital) as applied to the capital structure of the acquired company. That capital structure may include preferred stock (that may have a built in preference on payment), common stock and stock options. In addition, the parties typically agree that a percentage of the amount to be distributed should be set aside in escrow to secure the selling shareholders’ post-transaction indemnification obligations. These calculations can be quite complex, involving sophisticated spreadsheets to properly allocate all items of consideration.
Once the working capital is finalized post-closing, any negative adjustment typically is paid to the buyer out of escrow (either the indemnity escrow or a special escrow set aside for the adjustment). A positive adjustment usually is treated as an increase to the purchase price, and the amount of the adjustment is distributed to the stockholders. However, distributing the adjustment to shareholders may not be as simple as paying each stockholder its pro rata share: changing the purchase price can result in modification of every number in the closing spreadsheet that originally allocated the purchase price.
The problem arises when different classes of stock and options receive different payouts. Preferred stock may receive a preference plus its value as common stock equivalent. Common stock likely receives its common value. Stock options receive their common value net of the applicable exercise price for the options. Thus, each type of stock and option will receive a different payout, and a different percentage of the purchase price. Then, a set percentage of those proceeds will be contributed to escrow.
As a simple example, preferred stock may receive $5 per share, common stock may receive $3 per share, and stock options (net of exercise price) may receive $2 per share. Assuming an equal number of preferred, common and options, the preferred would end up with 50% (5/10) of the proceeds, with 30% and 20% for the common and options, respectively. From those amounts, each class of security would contribute some amount (e.g. 10%) to the indemnity escrow.
When the purchase price changes post-closing, the amount received by each form of stock and option will change equally (e.g. every share gets an additional $1 per share). Thus, as adjusted, the three classes would receive $6, $4 and $3 per share, respectively, which translates to 46% (6/13), 31% and 23% of the proceeds going to each class of securities. However, the preferred previously contributed 50% of the escrow; as adjusted, the preferred should only represent 46% of the escrow, while the common and options should represent an increased share of the escrow. Thus, the increase in purchase price requires modification of escrow contributions (and any other amount taken from or attributed to each class of securities at closing).
The parties can avoid a substantial modification to the all the numbers calculated at closing by fixing the percentage payouts for each class of stock at closing. For example, the merger agreement could provide that any positive working capital adjustment will be paid out proportional to each stockholder’s contribution to the escrow fund. Another alternative is for the merger agreement to include a pro rata payout definition applicable to any positive working capital adjustment. Either of these methods avoids having to re-open the complex closing spreadsheet and recalculating every number to account for what may be a small change in the overall consideration payable to the shareholders.
At the closing of most private M&A transactions, a portion of the consideration (often 10-20%) is either held back by the buyer or set aside in a third-party escrow to secure the selling company’s covenants, representations and warranties made in connection with the M&A transaction. Based on data that Fortis Advisors has collected from over 500 M&A deals where it has served as the post-closing shareholder representative, 93% of such deals include either an escrow or a holdback. In addition, the data shows that many deals have a second “special escrow” covering specific matters or issues (as described below). Fortis Advisors data (available with accompanying analysis in the Forsite™ M&A Deal Tool) shows that 26% of all deals have at least one additional special escrow:
These special escrows work either separate from or in conjunction with the primary escrow, and cover certain specific matters such as (1) adjustment of the purchase price post-closing following determination of all account balances as of the closing date, (2) intellectual property representations, (3) specific existing or threatened litigation or (4) estimated tax issues, with the frequency of these special escrows set forth below:
Two of these special escrows that deserve particular attention are intellectual property escrows and litigation escrows.
Intellectual property escrows often are included in M&A transactions to enable longer survival periods for IP representations and warranties. Often the buyer is willing to allow standard representations and warranties made by the seller to expire 12- to 18-months post-closing, at which time escrowed funds are released to the shareholders. However, the buyer may desire a longer survival period for IP representations and warranties. The IP may be fundamental to the buyer’s purchase decision, but problems with the seller’s, and then the buyer’s, right, title and interest in the IP may not manifest themselves for three or more years. Thus, the buyer may insist on an extended escrow period to protect the buyer’s investment in the seller’s company and IP. Rather than extending the term of the primary escrow, the buyer and seller can compromise by allowing the primary escrow to expire and be released early, with a second, longer IP escrow serving to protect the buyer over IP issues.
A second common special escrow is one established to protect the buyer against a filed or threatened lawsuit known at the time of the closing. The buyer and the seller typically negotiate an amount for such an escrow equal to the maximum reasonable loss on the claim (regardless of the merits), with the unused funds released to the shareholders immediately on settlement or resolution of the claim. The buyer benefits from having a dedicated amount in addition to the primary escrow to handle the matter, and the selling shareholders benefit both from immediate release of excess funds on resolution and through the ability to negotiate enhanced control rights over the defense and resolution of the claims.
However, a special escrow covering a filed or threatened claim comes with a significant downside. At closing, the merger agreement typically is provided to the selling shareholders in connection with seeking approval of the transaction. The shareholders also receive a complete description of the financial terms and flows of consideration. Thus, all the shareholders will become privy to the existence of the special escrow. We have seen a number of cases where, despite confidentiality obligations, the terms and amount of the special escrow has been shared with the claimant (and in some cases, the claimant is also a shareholder). This has emboldened the claimant to seek the maximum recovery, knowing money has been set aside to pay that recovery. As a way to deal with this issue, the special escrow amount could be added to the primary escrow, and that “signaling” would not exist.
M&A transactions present a wide range of situations where conflicts of interest can arise. As a leading post-closing shareholder representative on private M&A transactions, we have faced these issues many times on behalf of selling shareholders. Effectively dealing with these issues requires more than just being a neutral party relative to the shareholders. Understanding disparate interests and their relative priorities, as well as being able to effectively communicate with and align interests, are critical factors necessary to achieve results.
The interests in an M&A transaction go beyond the buying company and selling company, extending to the shareholders (and the subsets of preferred, common, option and warrant holders), the management team, the other employees, third party lenders and third party vendors. In a recent transaction where Fortis was served as shareholder representative, a number of difficult conflict issues arose based on the disparate interests of the constituents.
A buyer agreed to acquire a selling company for $150 million in cash and a potential $30 million earn-out based on post-closing sales of the seller’s products. The cash at closing was sufficient to pay back the preferred (mostly venture capital) investors. If earned, the earn-out would allow the common stock holders and option holders to receive an equivalent amount per share as the preferred investors.
At closing, the buyer required that $15 million of the closing cash be placed in escrow to secure the seller’s indemnity obligations under the purchase agreement. The shareholders set aside a $500,000 expense fund to engage counsel and other professionals in the event of claims against the escrow or issues involving the earn-out (with any unspent funds eventually returned to the preferred shareholders).
When Fortis was engaged to serve as shareholder representative, we understood that our constituents were not similarly situated, and thus may not be aligned on all issues. Our group included preferred holders, who had already received 90% of their capital and had only an interest in the escrow/expense funds, common holders whose primary interest was in the earn-out, and option holders who were former seller employees (including seller’s CEO) that had been hired by buyer, with potential divided loyalties between their interests as a selling shareholder and as a buyer employee.
One year post-closing, the buyer provided notice that the earn-out would not be paid, claiming sales of seller’s products were insufficient to trigger payment. We communicated buyer’s position to the selling shareholders, and began investigating buyer’s claim. In speaking with different shareholders, it was not surprising that the views on how to proceed varied.
Common shareholders who had no continuing relationship with the buyer were adamant that the buyer must have acted in bad faith. In their view, the sales targets were easily achievable had the buyer continued to market and sell the products in good faith. Those shareholders were ready to file a lawsuit, with costs paid out of the expense fund, to go after the $30 million earn-out.
Preferred shareholders were generally sympathetic to the common shareholders; however, they were less enthusiastic about the expense fund being used to pay the costs of a lawsuit for the sole benefit of the common shareholders. First, the preferred shareholders wanted to preserve the expense fund for use in defending against any claim related to the $15 million escrow. Second, since the preferred holders were entitled to any unspent portion of the $500,000 expense fund, they weren’t inclined to expend it on a matter in which they had no financial interest.
The former option holders, who were now working for the buyer (led by the CEO), had mixed motives. They were interested in maximizing recovery on their holdings in the seller, but did not want to be part of a litigation against their current employer. They especially did not want to end up in a position where they had to testify in a lawsuit against the buyer.
Fortis, serving as shareholder representative on the deal, recognized and understood all of the conflicts described above and acted swiftly and efficiently to come to a resolution with all parties involved. A crucial element of this was the fact that Fortis was able to proceed in a neutral manner on behalf of all constituents since Fortis had no economic interest in the matter—Fortis’ focus was the shareholders’ collective interest. If any seller securityholder had agreed to serve as shareholder representative, not only would that individual holder have had to deal with the conflicts among all the constituents, the holder also would have had a personal interest in the matter that could be in conflict with other holders depending on the category to which it belonged: preferred holder, common holder or option holder/current buyer employee.
So how did we resolve these issues? Fortis engaged in a series of good faith negotiations with buyer around the earn-out, focusing on the buyer’s efforts to achieve the earn-out, what was required under the merger agreement, whether principles of good faith and fair dealing applied, and the likely results and impacts on the business and employees of various paths from paying the earn-out to getting involved in protracted litigation.
Ultimately, the parties settled the matter through a partial payment of the $30 million earn-out. We believe it would have been difficult for any one securityholder serving as shareholder representative to have achieved this result. Invariably, even the mere appearance of impropriety based on a shareholder’s self-interest can hinder resolution.
As a leading shareholder representative for merger and acquisition transactions, we have collected thousands of data points on terms and conditions from our deals (with data and analysis available in our Forsite™ M&A Deal Tool). In analyzing the data, we have seen a dramatic shift in the survival period for the “fundamental” representations and warranties in merger agreements. As explained below, this has occurred in response to a ruling by the Delaware Court of Chancery in late 2014.
As background, when negotiating merger and acquisition transactions, the buyer requires the selling company to make multiple representations and warranties regarding, for example, its financial condition, the adequacy of its intellectual property rights, the absence of litigation and claims, and other matters of importance to the buyer. The buyer then requires the selling shareholders to indemnify the buyer for any losses it incurs based on breach of those representations and warranties. The seller, seeking finality around the transaction on behalf of its shareholders, negotiates for a limited window post-closing (the “survival period”) during which the buyer may seek indemnification for any such breach.
Our data in the Forsite™ M&A Deal Tool
shows that the survival period for representations and warranties is predominately 12 to 18 months, with little variation outside of that range over the past three years.
The buyer, however, will require that certain “fundamental representations” survive beyond that survival period. Fundamental representations may include matters such as the seller’s capitalization, payment of pre-closing taxes and any breach of representations and warranties based on intentional misrepresentation or fraud. Historically, those fundamental representations survived indefinitely: if the buyer at any time in the future suffered a loss based on breach of a fundamental representation, the buyer could seek redress from the selling company shareholders.
In late 2014, the Delaware Court of Chancery issued an important ruling impacting the survival period of fundamental representations. In Cigna Health and Life Ins. Co. v. Audax Health Solutions, Inc., C.A. No. 9405 (Del. Ch. Nov. 26, 2014), the Court ruled that indemnification obligations in a merger agreement that were indefinite and that could equal the entirety of the consideration received in the merger were potentially unenforceable.
Since that time, based on the data in the Forsite™ M&A Deal Tool, we have seen a major shift in the survival period of fundamental representations, with an indefinite survival period dropping from 34% of all transactions in 2014 to 15% in 2015. We anticipate that the percentage of transactions with indefinite survival of fundamental representations will continue to drop in 2016 as fixed survival periods increasingly become the standard in definitive documents.
Drilling down further into the data, we note that the survival periods for fundamental representations also depend on the specific representations being carved out from the general survival period. For example, claims for breach of representations based on fraud typically survive for the longest periods: indefinitely in 51% of all transactions and through the end of the applicable statute of limitations 32% of the time. Breach of representations based on the capitalization of the seller also survive for extended periods, but the numbers are reversed, with indefinite survival occurring 29% of the time and statute of limitations survival occurring 53% of the time. Per the chart below, breach of representations based on intellectual property have extended survival periods, but for much shorter time frames than fraud and capitalization: in 83% of transactions, the extended survival period for intellectual property representations is two years or less.
In the definitive agreement for every merger and acquisition transaction, the selling company will make multiple representations and warranties regarding, for example, its financial condition, the adequacy of its intellectual property rights, the absence of litigation and claims, and other matters of importance to the buyer. Many of these representations and warranties will be qualified as to materiality. For example, a standard representation may state that “seller’s financial statements represent the condition of the company in all material
respects” or that “there are no material
claims or lawsuits pending or threatened against seller.”
Although buyers often agree to have representations and warranties qualified by a materiality standard, increasingly those buyers want the seller and its shareholders to indemnify the buyer for losses without regard to the materiality of those losses. For example, while the seller may represent that there are no material claims pending against the seller at the time of closing, if the buyer suffers any loss from a pre-closing claim (regardless of whether or not that loss may be deemed material), the buyer may want the seller to pay for the defense and resolution of the claim. Thus, buyers increasingly insist on “materiality scrapes” that remove any materiality qualifiers for purposes of determining buyer’s losses or seller’s indemnification obligations.
In analyzing the data in the Forsite™ M&A Deal Tool, we found that over the past four years, 82% of the transactions where we served as Shareholder Representative included a materiality scrape provision:
The concept of materiality can arise in multiple contexts within an M&A transaction, and the materiality scrape clause may apply narrowly or broadly depending on the parties’ negotiations. For example, materiality may be a factor in the following clauses:
A condition to closing an M&A transaction may be that there has been no “material change” in the seller’s business between the time of signing the definitive agreement and closing the transaction.
As noted above, the seller’s representations, warranties and covenants may be qualified by a materiality standard.
Seller’s obligation to indemnify the buyer against claims and losses may be limited to material losses.
A broad materiality scrape “reads out” the materiality clause from all of those provisions. This can lead to unintended results; for example, every business will change in some immaterial way on a daily basis, so eliminating the materiality clause from the closing condition (no. 1 above) could render closing of the transaction impossible.
More typically, the materiality scrape applies to either or both of (a) the seller’s representations, warranties and covenants for the purpose of determining whether any breach has occurred (no. 2 above) and (b) calculation of losses arising from any breach (no. 3 above). Data in the Forsite™ M&A Deal Tool
indicates that the majority of the time, the materiality scrape applies to calculation of losses:
In the context of calculating loss, the buyer often argues that establishing a claims deductible is the best way to protect a seller from small claims rather than limiting the buyer’s ability to seek indemnification to only “material losses.” Buyers further assert that fixed deductibles bring certainty to the issue, avoiding post-closing disputes over the definition of “material” in the context of any given transaction.
At the closing of many merger and acquisition transactions, a portion of the consideration in the deal is set aside to create a shareholder representative expense fund. This expense fund can cover expenses that may be incurred on behalf of shareholders during the post-closing period. For example, the selling shareholders may need to engage an accountant to analyze and dispute the buyer’s calculation of a purchase price adjustment, engage attorneys to defend against an indemnification claim made by buyer or engage attorneys to enforce the selling shareholders’ rights related to a potential earn-out.
In analyzing the data in the Forsite™ M&A Deal Tool, we found that over the past four years, 74% of the transactions where we served as Shareholder Representative included an expense fund. We recommend that every transaction include an appropriately-sized expense fund.
If an expense fund is not established at closing, the shareholder representative may be limited in its ability to engage professional service providers to protect the interests of the selling shareholders. One alternative to establishing an expense fund at closing is, when a post-closing issue arises, to raise funds as needed from the selling shareholders. However, a number of dynamics make that practice difficult:
Windows to respond to purchase price adjustment calculations, claims, disputes and earn-out analyses can be very narrow, leaving insufficient time to raise the necessary funds.
Selling shareholders may have different capacities or desires to contribute money post-closing to defend a claim for indemnity or prosecute the selling shareholders’ rights.
Some selling shareholders—particularly the larger funds—may need to cover a disproportionate amount of the costs if smaller shareholders are unwilling or unable to participate.
Often times it can be impractical to solicit contributions from all shareholders.
Non-participating selling shareholders may question or potentially dispute the terms of any expense fund contribution (g.,
priority of recovery, interest payments and other benefits of participating in providing expenses funds to the shareholder representative).
The shareholder representative must be cognizant of providing information about a dispute broadly to the selling shareholders. It could be discoverable in litigation.
Setting up an expense fund at closing avoids all of these issues. It both proportionately burdens all selling shareholders with their pro rata contribution and proportionately benefits selling shareholders by providing protection. In addition, buyers are well aware of the amount of the shareholder representative’s expense fund at the initial closing, and that can influence how aggressive a buyer may be in calculating working capital and earn-outs, and bringing claims for indemnification against the selling shareholders.
Moreover, the shareholder representative typically seeks advice and approval from major selling shareholders before engaging professionals and otherwise incurring expenses payable out of the expense fund, allowing the selling shareholders to maintain a level of control over how the expense funds are utilized. Finally, upon resolution of all issues in a transaction, any unused portion of the expense fund is distributed pro rata back to the selling shareholders.
Accordingly, we advise that all selling shareholders establish an appropriately-sized expense fund for the shareholder representative to both protect the selling shareholders’ interests and avoid issues that can arise through attempts to raise an expense fund post-closing.
When a company agrees to be acquired, some shareholders dissent from the transaction, arguing that the company did not negotiate a fair price for the sale. To address this, most states provide a mechanism for dissenting shareholders to obtain a third-party appraisal of their shares. If the appraisal process results in a higher acquisition price, the dissenting shareholders receive that higher price for their security holdings in the sold company. Buyers recognize this risk, and typically demand that the selling securityholders indemnify the buyer against the cost of the appraisal process (including the impact of the higher price).
In Delaware (the legal home of many acquired companies), Section 262 of the Delaware General Corporation Law provides for such an appraisal right. As written, it also provides an incentive for shareholders to exercise appraisal rights: once the appraisal process concludes, the shareholders usually are entitled to the appraised price plus interest from the time the merger closed at a rate equal to 5% over the Federal Reserve discount rate. In our current low interest rate environment, many investors consider receiving an almost risk-free 5% on funds a strong return. Thus, securityholders can take advantage of the appraisal process (that can take two or more years to resolve), with the worst case being a 5% annual return on the merger proceeds.
The Delaware State Bar Association has recognized this issue, and has proposed an amendment to Section 262. The amendment would allow the buyer to limit the accrual of interest by paying early the merger proceeds to the dissenting shareholders. Then, the dissenting shareholders would be entitled to interest only on the difference (if any) between the final appraised amount and the original merger proceeds amount.
If adopted by the Delaware General Assembly, we will follow the data to see if it impacts the frequency of shareholders exercising their appraisal rights.