As merger and acquisition activity has started to pick up, this would be a good time to look at some of the techniques that both buyers and sellers can use to get hard deals closed.
What makes a deal hard is going to vary, on a case by case basis, but in recent times the COVID-19 pandemic has been one of the biggest factors. Frequently huge declines in revenues, operating margins and net income have made it more difficult for buyers and sellers to close.
Representation and warranty insurance
Representation and warranty insurance (“RWI”) has been around for a long time but is now available for deals under $30 Million. Most commonly created in favor of the buyer, buy-side RWI protects the buyer if something that the seller said in the deal documents turns out to be false. Seller or buyer can pay for a RWI policy which provides flexibility in the deal structure.
Pros: Can reduce the need for detailed due diligence, provides more cash to seller sooner, and preserves the relationship between buyer and seller, which is important if the founder or key executives are staying on post-closing.
Cons: Uncertainty around what constitutes a falsehood or when the insurance company will pay the claim, and not available on very small deals.
Purchase price adjustment
A purchase price adjustment (“PPA”) is an adjustment that is made to the purchase price based on as of the closing date financial results. In its purest form, a PPA is neutral because it can result in an upward adjustment if the results were better than expected, or downward adjustment if the results were lower than expected.
There are various metrics the parties can use:
- working capital
- cash
- debt, or a combination of two or more of the preceding
Pros: Very common, neutral if properly drafted, provides comfort to both sides that the latest financial results will be taken into account to finalize price.
Cons: The parties must agree on the metric, its definition, and how the financial results will be calculated from an accounting standpoint.
Earnout
An earnout is an agreement whereby the buyer agrees to pay a portion of the purchase price from the operations of the newly acquired business. An earnout is a contractual right the buyer gives the seller to receive a portion of the purchase price using a formula that is a percentage agreed upon metric.
The most common metrics are:
- revenue and
- EBITDA
Some buyers view earnouts as a necessary element to reduce bad deal risk.
Pros: Instills confidence in the buyer that the business will continue to generate the expected financial results, defers buyer payment, which if required to be made in cash can be a big advantage.
Cons: Seller has to wait to before receiving the earnout amount, seller is dependent on the buyer running the business, and uncertainty in the event of a subsequent sale of the acquired company.
Holdback
A holdback is a contractual arrangement whereby some portion of the purchase price is held back and paid to the seller, or buyer if the risk materializes, at a later date. Typically, the buyer funds the holdback by depositing some amount of the purchase price into an escrow account.
Holdbacks can be used to cover certain risks such as tax liabilities, litigation costs, or governmental investigations. In some cases, a holdback can also be used to ensure that a key executive actually provides the agreed upon transition and consulting services post-closing.
Pros: Assists the parties in closing the deal when there are serious risks that cannot be easily and accurately measured prior to closing.
Cons: Delays payment to seller, can be the subject of litigation if the parties disagree on whether the event in question happened and the related cost and expense of dealing with the event.