By: Kelly Dutremble
The Terms and Conditions (T&C’s) Made Simple panel of our 2018 VC and M&A Forum highlighted some of the major terms of an M&A transaction, discussed the strategic decisions involved in negotiating these terms, and reviewed recent trends. MBBP partner Joe Marrow moderated the panel and guided the panelists through the major points of a deal, including consideration choices, option treatment, earn outs, indemnification, and more.
Equity vs. Cash Consideration
Generally, cash is often preferable because it is less dilutive. However, Uday Seth, the Director of Corporate Development for Flywire Corporation, noted that in many smaller deals, the target is being acquired either for talent or a book of business, so using equity as consideration helps to align interests and incentives of the seller and the buyer. MBBP partner Dave Czarnecki noted that another area of negotiation is the allocation of equity consideration and cash consideration among the stockholders of the target in a mixed consideration deal. Seth agreed, noting that it is common that cash will be used to buy out outside investors, while either a mix of cash and equity or all equity will be used as consideration for management.
Treatment of Options
Czarnecki walked through the concern when determining how options will be handled in a transaction. A basic question is whether and to what extent the outstanding options will terminate. However, it is also important to think about option treatment in tandem with other deal terms. If a particular deal includes an escrow or an earn out, a decision has to be made regarding the allocation of the optionholders’ shares to such escrow or earn out. Tax implications can also complicate the matter. For example, sometimes individuals on the management team will have only options. If their options were to be rolled over into equity, this would create a taxable event.
Earn outs were identified as the riskiest parts of M&A transactions, because, as Amanda Jackson, Director of Business Development at SRS/Acquiom, noted, it essentially kicks the can down the road. Seth noted that the strategy of the deal can be indicative of the difficulty the earn out will present – for example, earn outs tend to be more successful when a target is acquired for a book of business, and less successful when the target is acquired for technology.
Marrow pointed out that it is also prudent to discuss how an acquisition of the buyer will affect the earn out. In some cases, the earn out will be accelerated if the buyer is acquired before the end of the earn out period. Termination without cause may also trigger someone’s entitlement to their earn out.
Indemnification and Escrow
According to Jackson, material disputes and indemnification claims occur in about 40% of deals, and about 30% have no disputes. These disputes can arise from claims regarding anything from capitalization table inaccuracies to fraud, but the area that SRS/Acquiom is currently seeing most of the claims come through is sales and use tax. Mischaracterizing revenue is also an active area. Marrow pointed out that a buyer’s concerns regarding a target’s intellectual property rights often lead to the negotiation of a special indemnity, even if there are no active claims yet. Jackson explained that in the deals in which disputes arise, it is not a guarantee that the escrow amount will go to the buyer; it sometimes is paid back to the seller.
The panelists agreed that representation & warranty insurance is a growing trend in the deals they work on. In particular, deals of smaller sizes are increasingly using representation and warranty insurance. As Czarnecki pointed out, the insurance makes drafting and negotiating the transaction documents easier, since it removes much of the risk of post-closing disputes. However, the diligence process can be more time consuming and exhaustive because the insurer will want to conduct their own diligence, on top of the buyer’s diligence, to determine what their risk exposure is.
Allocation of Proceeds
As time ran out, the panelist briefly ran through certain issues regarding the allocation of proceeds. Czarnecki explained how the allocation of proceeds can misalign the incentives of the preferred stock from the incentives of the common stock. For example, holders of non-participating preferred stock (provided their liquidation preferences were being fulfilled) would willingly leave money on the table in exchange for a lower escrow amount. Their payout would not be affected, and a lower escrow would mean they would have access to more of their money sooner (and with more certainty). Jackson acknowledged that waterfalls are becoming increasingly complicated. As noted above, the treatment of options, and the determination of whether optionholders will be required to participate in the escrow, earn out, and other holdbacks, will have an effect on the allocation analysis.
Stay tuned for our final panel recap: M&A Market Update.