18 Key Issues in Negotiating Merger and Acquisition Agreements for Technology Companies
18 Key Issues in Negotiating Merger and Acquisition Agreements for Technology Companies
By Richard D. Harroch, David A. Lipkin, and Richard V. Smith
Effectively negotiating merger and acquisition agreements for a privately held technology company involves addressing and resolving a number of key business, legal, tax, intellectual property, employment, and liability issues. Such agreements are often heavily negotiated, and a poorly negotiated transaction can result in significant risks to the selling company and its shareholders, including with respect to the certainty of closing the deal and potential post-closing indemnification liabilities to the buyer.
This article discusses a number of the hotly contested key issues in acquisitions of privately held technology companies. The ability to achieve success in any negotiation depends on a number of factors: the leverage a party has in the negotiation, the price and other key terms the parties may have already agreed upon at the letter of intent stage, the risks a party is willing to take with respect to closing conditions and post-closing liability exposure, whether there is competition among bidders for the target company, the quality of the lawyers involved, and the skill of the negotiating team.
1. Price/Consideration Issues
The price and type of consideration are issues that will need to be addressed early in the process, preferably in the letter of intent, and these go beyond agreeing on the “headline” price. Here are some of these issues:
- Whether the purchase price will be paid all cash up front.
- If the stock of the buyer is to represent part or all of the consideration, the terms of the stock (common or preferred), liquidation preferences, dividend rights, redemption rights, voting and Board rights, restrictions on transferability (if any), and registration rights. In addition, if the buyer is a public company, it will be important to consider whether that stock should be valued at signing or valued at closing, and whether a “collar” arrangement that limits upside and downside risk may be appropriate.
- If a promissory note is to be part of the buyer’s consideration, what the interest and principal payments will be, whether the promissory note will be secured or unsecured, whether the note will be guaranteed by a third party, what the key events of default will be, and the extent to which the seller has the right to accelerate payment of the note upon a breach by the buyer.
- Whether the price will be calculated on an “indebtedness free and cash free” basis at the closing (enterprise value) or whether the buyer will assume or take subject to the seller’s indebtedness and be entitled to the seller’s cash (equity value).
- Whether there will be a working capital adjustment to the purchase price, and if so, how working capital will be calculated. This is ultimately just an adjustment up or down to the purchase price. The buyer may argue that it should get the business with a “normalized working capital” and the seller will argue that if there is a working capital adjustment clause, the target working capital should be low or zero. This working capital mechanism, if not properly drafted or if the target amounts are improperly calculated, could result in a significant adjustment in the final purchase price to the detriment and surprise of the adversely affected party.
- If part of the consideration is an earnout, how the earnout will work, the milestones to be met (such as revenues or EBITDA and over what period of time), what payments are to be made if milestones are met, what protections (such as acceleration of payment of the earnout if the business is sold again by the buyer) will be offered the seller to enhance the likelihood of the earnout being paid, information and inspection rights, and more. Earnouts are complex to negotiate and tend to be the source of frequent post-closing disputes and sometimes litigation. Precision in drafting these provisions and agreeing on suitable dispute resolution processes are essential, although also difficult to accomplish.
2. Escrow/Holdback Issues
In many acquisitions of privately held technology companies, an escrow or holdback of a portion of the purchase price is negotiated to protect the buyer from losses due to breaches of the seller’s representations and warranties or covenants or specified contingencies (such as a shareholder’s exercise of dissenters’ rights). Sometimes there is a second escrow or holdback to help protect the buyer in the event of a post-closing price reduction based on a working capital adjustment provision. In certain transactions there may also be a special escrow/holdback to protect the buyer from specific matters, such as pending or threatened litigation. It is rare that a company can be sold on an “as is” basis without post-closing indemnities, in which case there would be no escrow/holdback. Here are some of the key issues associated with escrow/holdbacks:
- The amount of the general escrow/holdback for indemnification claims by the buyer and the period of the escrow/holdback (the typical negotiated outcome is a 5% to 15% escrow that is held by a third party for a minimum period of 9 to 18 months).
- With increasing frequency, in transactions with private equity bidders, it is becoming the norm for the majority of the escrow/holdback to be replaced with a provision that relegates the buyer to pursuing claims against a policy of “representations and warranties insurance” procured by the buyer or the seller for post-closing indemnification claims. Although this is not seen often in deals with strategic acquirers, if they are competing against private equity firms for an attractive target, strategic acquirers may feel compelled to agree to this structure as well.
- The seller will attempt to negotiate that the escrow will be the exclusive remedy for breaches of the acquisition agreement (except perhaps for breaches of certain defined “fundamental representations,” such as with respect to capitalization and organization of the seller, and for breaches of pre-closing covenants). Buyers who are willing to agree to this limitation typically will seek an exception for losses due to “fraud” or “actual fraud.”
- If a portion of the consideration paid in the transaction consists of the buyer’s stock, the buyer and seller will need to agree on whether the escrow will be all cash, all stock, or some combination of both, and how and when the stock will be valued for purposes of the indemnity. The negotiation on this topic becomes more complicated if the buyer’s stock is not publicly traded or if the escrow will include both preferred stock and common stock.
- In target companies with multiple (sometimes hundreds of) shareholders, it will be important for there to be a “shareholder representative” who post-closing represents on a unified basis the interests of the former shareholders with respect to indemnity and escrow/holdback issues. Traditionally this role was filled by one of the seller’s significant shareholders, but more frequently in recent years sellers have found it attractive to hire professional outside firms (such as Shareholder Representative Services or Fortis) that specialize in fulfilling this role.
3. Representations and Warranties of the Seller
The representations and warranties of the seller can be all-encompassing, covering all elements of a seller and the business operations of the seller, including financial statements, corporate authorization, liabilities, contracts, title to assets, employee matters, compliance with law, and much more. For the sale of a privately held technology company, the representations and warranties relating to its intellectual property will also be particularly important.
- The representations and warranties in the definitive acquisition agreement typically serve three buyer-driven purposes. First, the buyer uses the representations and warranties to confirm its due diligence findings, and what it has learned about the seller. Second, if, after signing, the buyer determines that the representations and warranties were untrue when made (or would be untrue as of the proposed closing date), the buyer may not be required to consummate the acquisition (and may be entitled to terminate the agreement). Third, if the representations and warranties are untrue at either of such times, the buyer may be entitled to be indemnified post-closing for any losses the buyer suffers arising from such misrepresentation by the seller.
- The seller should make sure that representations about the selling company are only made by the selling company. Occasionally, a buyer will argue that a major selling shareholder who controls the selling company or owns a major stake in the selling company should join the selling company in making representations.
- Careful M&A lawyers representing sellers negotiate materiality qualifiers, knowledge qualifiers, and thresholds for disclosure so that immaterial violations do not result in breach of the acquisition agreement. They also work closely with the seller to prepare a schedule of exceptions to the seller’s representations and warranties (commonly referred to as the “Disclosure Schedule”) which, if accurate and complete, will protect the seller and its shareholders from indemnification liability for inaccuracies in such representations and warranties. A similar negotiation takes place around the closing conditions and the terms of indemnification.
- The seller’s representations and warranties regarding its financial statements, intellectual property, contracts, and liabilities merit particular attention and are discussed in the following sections.
4. Financial Statement Representations and Warranties of the Seller
For the buyer, representations of the seller as to its financial statements are critical. The buyer will expect that the acquisition agreement will include, at minimum, the following representations and warranties related to the seller’s financial statements:
- That the audited and unaudited statements of income, cash flow, and shareholders’ equity for specified periods and as of specified dates (the “Financials”) have been prepared in accordance with generally accepted accounting principles (“GAAP”), or international financial reporting standards in some cases, consistently applied throughout the time periods indicated and consistent with each other.
- That the Financials present fairly in all material respects the seller’s financial condition, operating results, and cash flows as of the dates and for the periods indicated in the Financials.
- That there has been an absence of recent changes in the seller’s accounting policies.
- That the seller’s internal controls have been adequate in connection with the preparation of financial statements by the seller.
The seller’s M&A attorney will attempt to limit the scope of these representations and warranties by the time period covered (such as only for the current year (or portion thereof) and the past one or two years), and by specific exceptions that may be set forth in the Disclosure Schedule. The representations regarding unaudited financial statements are typically qualified to the effect that footnotes required by GAAP have not been included in the unaudited financial statements, and that there may be immaterial changes resulting from normal year‑end adjustments in a manner consistent with past practice.
Buyers that are public companies can be expected to insist that the seller prepare audited financials for certain time periods, which will satisfy these buyers’ SEC reporting duties. The seller needs to appreciate the risks associated with this demand, especially if the seller has not previously prepared audited financial statements (a common situation for many technology startups and emerging growth companies).
5. Representations and Warranties Related to Intellectual Property
The seller’s representations and warranties as to its intellectual property (“IP”) are among the most significant representations and warranties in the acquisition agreement. The buyer wants comfort that the seller is the sole and exclusive owner of each item of IP purported to be owned by it, and that such IP is not subject to any encumbrances or limitations that unduly restrict the seller’s ability to exploit such IP (or that reduce the value of that IP in the hands of the buyer), or give third parties rights to such IP (currently or as a result of the M&A transaction) that are inappropriate or materially detract from its value. The buyer will also want to know that the seller has the appropriate right, through a license (exclusive or otherwise) or other contractual arrangement, to use any IP owned by third parties that is material to the seller’s business. Finally, the buyer will want to know if the seller is subject to any pending or threatened legal proceedings challenging its IP or exposing the seller to significant damages or loss of its IP, including in particular patent infringement claims or litigation, as discussed in more detail below.
However, the seller will seek to narrow its IP representations in important respects. For example, the seller will seek to “knowledge qualify” representations related to its ownership of its IP and whether or not its activities infringe upon the IP of third parties. The seller will want to ensure that it is not required to make any representations and warranties as to its ownership of IP that speak to the period following the closing, when there may be factors beyond its control (including prior agreements entered into by the buyer) that give rights to third parties or otherwise limit the right of the seller or the buyer to exploit the IP.
The following are several examples of matters that may encumber or limit the buyer’s ability to exploit its owned IP following the closing of an acquisition:
- Claims by third parties that patents are invalid (as a result of the existence of “prior art” or otherwise)
- Liens on the IP in favor of banks or other lending institutions
- Claims by third parties that the IP or activities of the seller infringe their patents or other IP rights
- Inadequate evidence that the employees or contractors who contributed to the creation of the IP have assigned all of their rights in the IP to the seller
- Rights of first refusal, exclusivity, or similar rights in favor of third parties with respect to the IP
- The failure to have obtained any third-party consents necessary for the IP to have been transferred to the seller (if not originally developed by the seller)
- Broad licenses to the IP in favor of third parties that compete or may compete with the seller
- Open source issues (including the risk of IP that purports to be proprietary in nature but is actually in the public domain)
- The failure of the seller to have appropriately registered the IP with the applicable governmental body
6. Representations and Warranties Related to Intellectual Property Infringement
The buyer typically wants the seller to represent and warrant that:
- The seller’s operation of its business does not infringe, misappropriate, or violate any other parties’ patents or other IP rights.
- No other party is infringing, misappropriating, or violating the seller’s IP rights.
- There is no litigation and there are no claims covering any of the above that is pending or threatened, or that could be reasonably expected to be brought following the closing.
The scope and limitations of these representations and warranties are often heavily negotiated. The buyer is concerned about the risk of large unknown infringement claims that third parties may bring against the seller or the buyer after the signing or the closing. When an M&A transaction is publicly announced at signing (and there is a deferred closing that may be weeks or months later), it is not uncommon that third parties that are unhappy with the seller from an IP perspective may bring claims or lawsuits during this interim period to try to maximize their leverage (believing that the seller may fear that the buyer will “walk away” from the deal if the claim or litigation is not settled).
The seller often negotiates to limit the scope of the non-infringement representations and warranties by:
- Materiality qualifiers
- Knowledge qualifiers
- Representations being limited to infringement of issued patents (and not all other IP rights)
- Eliminating any ambiguous representations (such as that no third party is “diluting” the seller’s IP)
Here is an example of a pro-seller form of representation and warranty regarding IP non-infringement:
Intellectual Property. To the Company’s knowledge, as of the date hereof, the Company owns or possesses sufficient legal rights to all Intellectual Property (as defined below) that is necessary to the conduct of the Company’s business (the “Company Intellectual Property”) without any known violation or known infringement of the rights of others. To the Company’s knowledge, as of the date hereof, no product or service marketed or sold by the Company violates any license or infringes any rights to any patents, patent applications, trademarks, trademark applications, service marks, trade names, copyrights, trade secrets, licenses, domain names, mask works, information and proprietary rights and processes (collectively, “Intellectual Property”) of any other person. Since [date], the Company has not received any written communications alleging that the Company has violated or, by conducting its business, would violate any of the Intellectual Property rights of any other person.
The scope of the seller’s exposure for breaches of representations and warranties relating to IP infringement can also be limited by including protective language in the indemnification provisions of the acquisition agreement, including thresholds/deductibles, right to control the defense and settlement of third-party claims, and the limitation for recovery of IP infringement claims to the portion of the purchase price placed in escrow or some lesser amount (see item 14 below).
Often, a buyer may seek to lengthen the period post-closing in which it may bring claims relating to breaches of these IP representations and warranties (beyond the “survival” period applicable to other representations and warranties), and may seek to negotiate a remedy for breach of the IP representations and warranties that goes beyond the standard escrow/holdback that applies to other indemnifiable matters. The buyer may take the position in the acquisition of a technology company that “substantially all it is buying is the IP,” and thus that it is entitled to these broader protections. Conversely, the seller will want the IP representations and warranties to be treated just like the others in the acquisition agreement.
7. Representations and Warranties as to the Seller’s Liabilities
Buyers in acquisitions of technology companies typically ask for a broad representation and warranty that the seller has no liability, indebtedness, obligations, expense, claim, deficiency, or guaranty, whether or not accrued, absolute, contingent, matured, unmatured, known, or unknown, except as specifically disclosed to the buyer. The seller’s counsel will argue that the following should be excluded from this liability representation and warranty:
- Any items currently reflected in the seller’s current balance sheet
- Any items arising since the date of the current balance sheet and arising in the ordinary course of business consistent with past practice
- Any items arising pursuant to the seller’s contracts or employee plans
- Any items set forth in the Disclosure Schedule
- Any items that are the subject of any other representation or warranty contained in the acquisition agreement
- Any items arising from actions taken by the seller at the request of the buyer
- Any items arising from the seller’s failure to take action prohibited by the acquisition agreement where permission was sought from the buyer and permission was not granted in violation of the agreement
- Any items that result in obligations or liabilities below a specified dollar threshold set forth in the agreement
- Any liabilities or obligations not required to be set forth in a balance sheet prepared in accordance with GAAP
8. Representations and Warranties Regarding Contracts
The representations and warranties section of the acquisition agreement will include a key section regarding the seller’s contracts, and particularly the “material” contracts of the seller as defined in the agreement. Generally, these contracts will have been made available to the buyer and its counsel in an online “data room” prior to signing the acquisition agreement, but notwithstanding that, the buyer will still generally insist that this section of the agreement be comprehensive and protective of the buyer. See 20 Key Due Diligence Activities in an M&A Transaction. This section will typically require a listing or description in the Disclosure Schedule of all material contracts of the seller, which often include the following:
- Contracts involving a dollar amount over a designated threshold
- Contracts that restrict the ability of the seller to compete or do business in any jurisdiction or any business segment
- Contracts with “most favored nation” clauses
- Employment and consulting contracts
- Stock option and incentive arrangement plans and contracts
- Fidelity, surety, or completion bonds
- Indebtedness and security/mortgage interests
- Real property and certain equipment leases
- Guarantees of third party obligations
- Joint venture and partnership agreements
- Indemnification agreements in favor of third parties
- Intellectual property-related agreements
- Material NDAs or confidentiality agreements
- Other material agreements
The failure to list the required contracts in the Disclosure Schedule could entitle the buyer to walk away from the deal before closing, and lead to potential post-closing liability for the seller’s shareholders.
9. Representations and Warranties of the Buyer
The acquisition agreement will typically include the following representations and warranties of the buyer, among others:
- That the buyer has the full corporate authority and power to sign the acquisition agreement and close the transaction
- That the buyer is duly organized, validly existing, and in good standing
- That the acquisition agreement is valid and enforceable against the buyer and that it does not conflict with any agreements or documents to which the buyer is subject
- That the buyer has sufficient cash resources to pay the consideration for the deal
- That the buyer is not a party to any, nor has knowledge of any threatened, legal proceeding challenging the validity of the transaction
- That the buyer has not incurred and will not be liable for broker or finder fees, except as specifically disclosed
If the buyer will be issuing shares of its own stock (which may be the case where the buyer is a strategic acquirer) or raising financing to complete the transaction (which may be the case where the buyer is a private equity buyer), the buyer will typically be required to make additional detailed representations concerning such stock or financing and, depending on the amount of stock and the percentage of the transaction consideration that it represents, many of the other topics that are covered in the seller’s representations to the buyer. If a transaction is a “merger of equals” transaction (a combination of two comparably sized technology companies), then the representations and warranties may in fact be almost identical in both directions.
10. Pre-closing Covenants of the Seller
The acquisition agreement for a privately held technology company will also include a series of covenants applicable between signing and closing, except in the rare case where a transaction can be closed immediately after signing. Some of these are affirmative in nature (the seller is required to take the identified actions), but most of them are negative in nature (prohibitions on taking certain actions, even if they would normally have been in the ordinary course of the seller’s business). The seller will want these negative covenants to be limited and reasonable, with an ability to deviate from any prohibitions with the consent from the buyer if flexibility is needed, such consent not to be unreasonably withheld, delayed, or conditioned. The following are among the most typical pre-closing covenants:
- Requirement that the seller operate in the ordinary course between signing and closing
- Restrictive provisions that prevent the seller from taking actions outside of the ordinary course of business, including many specific restrictions such as limitations or prohibitions on borrowing money or encumbering assets
- Covenants to use commercially reasonable efforts to satisfy closing conditions
- Covenants to cooperate with the buyer to make regulatory filings and obtain regulatory approvals
- Covenants to use commercially reasonable efforts to obtain material third-party consents to the transaction
- Covenants to notify the buyer of any event that results in a breach of a seller representation and warranty or covenant
- Covenants regarding shareholder/Board approvals for the transaction
- Covenants regarding the exclusivity of the relationship between the parties (i.e., a “no shop” clause prohibiting soliciting alternative deals or even discussing unsolicited overtures from third parties, which in the case of a privately held company typically do not have a “fiduciary out” permitting or requiring the seller to entertain such overtures)
11. Covenants of the Buyer
In turn, the acquisition agreement will also include a section setting forth the buyer’s covenants, a number of which may parallel those of the seller, particularly in deals with a significant stock consideration component. Unlike the seller’s covenants, which cover only the pre-closing period, the buyer’s covenants will often cover both that period and the period following the closing. Typical buyer covenants include the following:
- That the buyer will use its commercially reasonable efforts to complete the transaction and make required regulatory filings
- That the buyer will, following the closing, continue to protect the existing company officers and directors under existing indemnification agreements and charter protections
- Particularly in the case of private equity buyers, covenants by the funds providing equity capital to guarantee the obligations of the special purpose entity formed to make the acquisition
- Notification obligations concerning any material developments that could affect the buyer’s ability to consummate the transaction
- Post-closing tax administration procedures
- Buyer’s registration obligations with respect to any stock it will issue to the selling shareholders, if applicable
- Limitations on issuance of press releases or public information on the deal without consent of the seller
12. Employee and Benefits Issues
M&A transactions, particularly in the case of technology companies where the use of stock options to incentivize employees is more common than in the case of other private companies, will typically involve a number of important employee and benefits issues that will need to be addressed in the acquisition agreement. The employee questions that frequently arise in M&A transactions are the following:
- What is the buyer’s plan for retention and motivation of the seller’s employees?
- How will the outstanding stock options issued by seller be dealt with in allocating the transaction consideration?
- Do any unvested options accelerate by their terms as a result of the deal? Some options held by management may be subject to a “single trigger” (accelerate solely by reason of the deal closing), and others held by management or key employees may be subject to a “double trigger” (accelerate following the closing only if employment is terminated for particular reasons and within a defined period). The option plan and related option grant agreements must be carefully reviewed to anticipate any problems.
- Will the buyer require key employees to agree to “re-vest” some of their vested options or rollover/invest some of their equity?
- Does the seller need to establish a “carveout plan” to appropriately pay employees at the closing (typically where the deal value is unlikely to fairly compensate them through their stock options), or a change in control bonus payment plan to motivate management to assist in the Board’s effort to sell the company?
- Will the acceleration of payouts to management or certain key employees from the deal trigger the excise tax provisions of Internal Revenue Code Section 280G (the so-called “golden parachute” tax)? If so, the seller may need to obtain a special 75% shareholder vote to avoid application of this tax liability (and the related loss of tax deductions to the seller).
- What are the terms of any new employment agreements with key management of the seller?
- If there will be termination of employment of some of seller’s employees at or shortly following the closing, who bears the severance costs?
- If the buyer is not a U.S. company and does not desire to grant stock options, what types of cash compensation plans will the buyer use to retain key employees of seller?
13. Conditions to the Closing
If there will be a delay between signing and closing, the acquisition agreement will need to set forth the conditions to closing, both with respect to the buyer and the seller. Some of these conditions are parallel (such as the need for antitrust or regulatory approval), but most of them are unique to one party or the other. The most common closing conditions that run in favor of the buyer include the following:
- The accuracy, in all material respects, of the seller’s representations and warranties in the acquisition agreement as of the signing date, as of the closing, or both. Sometimes the seller is able to negotiate for looser closing conditions, one that requires the buyer to close if an inaccuracy in the representations and warranties does not result in a “material adverse effect.” Conversely, certain fundamental representations and warranties, such as with respect to seller’s capitalization, may be subject to a tougher standard (being required to be accurate in all respects).
- The compliance by the seller with the seller’s covenants in the acquisition agreement.
- The obtaining of any necessary governmental consents (such as Hart-Scott-Rodino antitrust approvals).
The buyer may also insist on the following closing conditions, among others:
- The obtaining of consents that may be required from third parties (such as licensors or customers) under key contracts that may be terminable, or subject to renegotiation, if the seller fails to obtain the counterparty’s approval of a change of control of the seller.
- Absence of any governmental (and sometimes private) litigation seeking to enjoin the transaction, or any litigation material to the seller.
- Satisfaction by the seller of certain specific financial metrics, such as a specified amount of cash on hand just before closing.
- The execution of new employment agreements or offer letters with key executives and key employees of the seller.
- The execution of non-compete and non-solicitation agreements by the most significant shareholders (venture capital and institutional investors resist these).
- No “material adverse change” in the business of the seller between signing of the acquisition agreement and closing (the seller will insist on various exclusions to this condition).
- The obtaining of financing by the buyer (sellers will strongly resist this as a closing condition, arguing it introduces too much uncertainty and is outside of the seller’s control).
- Delivery of audited financial statements of the seller, usually to enable a public company buyer to comply with its securities law reporting obligations.
- Delivery of a closing balance sheet for the seller, typically to support a price-adjustment provision tied to working capital.
- Delivery by the seller of the consent to the acquisition by the holders of a very high percentage of the seller’s outstanding shares, and agreement by such shareholders to broad releases of liability in favor of the seller and buyer, and agreeing to abide by the indemnification provisions of the acquisition agreement, waiving dissenters’ rights.
- Remedial actions, such as removal of open source code from the seller’s software products.
14. Indemnification Provisions
A buyer will demand that the seller (or in the case of a transaction structured as a merger or stock sale, its shareholders) indemnify the buyer post-closing for breaches of representations, warranties, and covenants as well as certain other matters. Negotiating the terms, conditions, and limitations of these indemnification provisions is one of the most important negotiations in an M&A deal, since an indemnification payout by the seller or its shareholders can significantly reduce the net return from the original sale proceeds.
These provisions are among the most important to address, if possible, at the term sheet or letter of intent stage. It is rare that a seller’s leverage on these issues increases over time, particularly as the buyer conducts due diligence and may identify issues that it is actually (or purports to be) concerned about.
The most important indemnification points are as follows:
- Scope and Survival of Indemnification: The seller will seek to limit indemnification to breaches of representations and warranties and have the indemnification obligation terminate at some designated point after the closing (such as one year or less). Buyers will seek longer “survival” periods, both for regular representations and warranties and particularly for certain “fundamental” matters such as problems with the seller’s organization, capitalization, tax claims, and intellectual property claims.
- Caps on Exposure: The seller will seek a cap on its (or the selling shareholders’) indemnification obligation (usually 5% to 15% of the purchase price, consistent with the typical size of the escrow or holdback as described above), although it is common for the buyer to request that certain matters, such as IP claims, be subject to a higher cap (for example, 25% or 50% of the purchase price). Certain exposures, such as with respect to tax claims, could involve potential exposure of up to the entire purchase price, even though in practice the real exposure may be small. If there is representation and warranty insurance in the deal, this cap is often reduced to a small percentage of the purchase price (1% to 3%).
- Matters Not Limited by the Cap. The buyer will sometimes insist upon a variety of indemnifiable matters not being limited by a cap, such as claims for fraud or intentional breach of representations, or breaches of pre-closing covenants. Sellers resist these types of broad exclusions, but often the exposure for these matters can extend to the full purchase price.
- Thresholds and Deductibles: In almost every deal, the buyer will agree that it will not have recourse against the seller or selling shareholders unless and until its claims exceed (in total) an agreed upon threshold amount (e.g., 1% of the purchase price). Sometimes this amount is a “tipping basket” (once the amount is exceeded, the buyer is entitled to be indemnified for all damages, back to the first dollar), and sometimes it is a “true deductible” (the indemnity is limited to amounts over the threshold). Breaches of certain “fundamental” representations and warranties, and breaches for covenants and other special indemnities, are generally excluded from this threshold calculation, and are indemnifiable from dollar one.
- Control of the Defense of Claims: Although buyers usually are adamant that they should control the defense of any third-party claim, dispute, or lawsuit, sellers are not shy in resisting this position. The buyer is effectively spending the selling shareholders’ money and thus may not be as motivated as the selling shareholders to conduct the defense as effectively as possible, and may be motivated to settle claims for amounts beyond their true value (because such settlement has little or no cost to the buyer). Nevertheless, buyers usually prevail on this point, but with an agreement that they will defend any lawsuit vigorously and in good faith, and that any settlement must be approved by the representative of the seller or its former shareholders.
- Joint and Several Liability. To the extent that indemnification may be required by the selling shareholders under the acquisition agreement, sellers will argue that indemnification should be “several” (e.,pro rata based on each shareholder’s percentage interest in the seller) and not “joint and several” liability (which would make any single shareholder potentially liable for all of the losses alleged by a buyer). In addition, the seller usually insists (successfully) that no indemnifying shareholder be liable for more than the amount of sale proceeds actually received by the indemnifying shareholder, unless the cause of a buyer’s loss is actual fraud committed by such shareholder.
- Effect of Tax Benefits or Insurance on Indemnification Claims. Sellers will often ask that any tax benefits or insurance recoverable by the buyer related to an indemnifiable claim should be used to offset the indemnification obligation. Buyers, when they agree to this point, often negotiate exclusions (such as an acknowledgment that the buyer has no obligation to procure new insurance to cover this circumstance).
- Certain Exclusions. Sellers will often seek to have the acquisition agreement exclude losses that constitute punitive, consequential, indirect, or special damages or lost profits or losses that could have been avoided through reasonable mitigation efforts, or other “unforeseeable” types of damages. Sellers also try to include an “anti-sandbagging” clause, prohibiting a buyer from obtaining indemnification for a seller’s breach of a representation or warranty if the buyer had knowledge of the breach prior to the signing or closing of the transaction. These are often hotly contested provisions of the acquisition agreement.
15. Allocation of Various Risks
The primary purpose of many of the representations, warranties, covenants, and closing conditions in an acquisition agreement is to address the issue of which party should be allocated the risk if a problem arises.
For example, qualifiers such as “knowledge,” “materiality,” “material adverse effect,” and “material adverse change” are used to shift the allocation of risk to the buyer. The buyer can only recover if it proves that the seller knew of the problem, or if the scope of the problem exceeds the agreed materiality standard.
Beyond these general risk-allocation techniques, there are a variety of special risk-allocation scenarios that often present themselves in the negotiation of an acquisition agreement, such as:
- If the seller has litigation or claims pending, who bears the risk of an adverse judgment or settlement?
- If a material intellectual property claim has been asserted against the seller, who bears the risk of an adverse development?
- If the transaction is not approved by a regulatory agency (such as the Department of Justice or the Federal Trade Commission on antitrust grounds, or CFIUS if the buyer is a non-U.S. company and the transaction poses a risk to U.S. national security), is the seller entitled to any remedy, such as a termination fee from the buyer?
- If a key contract of the seller needs the consent of a party in a change of control transaction, can the acquisition close anyway pending approval, and who bears the risk if such approval is not ultimately obtained? If the third party is willing to consent but only if the seller makes a payment to the third party, who should bear the cost of such payment?
16. Guarding Against Fraud Claims: Disclaimers by the Seller
One of the most significant claims that an unhappy buyer can make against a seller is that the seller (or its representatives) committed fraud. Beyond alleging that the representations and warranties in the acquisition agreement were made fraudulently, an aggrieved buyer may allege that information provided to it in due diligence sessions with management or documents made available in a data room were false or misleading. Unfortunately, if buyer’s remorse sets in, it’s all too easy for a buyer’s lawyer to launch a lawsuit which includes an allegation of fraud, no matter how clean a seller’s business might have been, no matter how responsive the seller’s management has been to information requests, and no matter how meritless the claim really is. Although fraud is exceedingly difficult to prove, it is extremely easy to allege.
Recognizing that post-closing lawsuits are brought from time to time by unhappy buyers (as opposed to buyers truly harmed by seller misconduct), sellers sometimes frequently negotiate for some important precautions (which mitigate the risk of fraud claims) that have been sanctioned by the courts:
- Inclusion in the acquisition agreement of an express disclaimer made by the seller and acknowledged by the buyer that the seller is only making to the buyer (and the buyer is only relying upon) the particular representations and warranties set forth in the acquisition agreement. In particular, the seller should disclaim making any representations or warranties as to any projections, forecasts, or possible future operating results.
- Express acknowledgement by the buyer in the acquisition agreement that it has conducted its own investigation of the business of the seller and is not relying upon any representation or warranty of the seller (or any of its officers, employees, or advisors) other than those specifically set forth in the acquisition agreement. Since “reliance” is an essential element of fraud, the purpose of these types of provisions is to make it difficult or impossible for fraud to be alleged with respect to any matter outside the four corners of the agreement.
Here is an example of a disclaimer that the Delaware court in Abry Partners V, L.P. v. F&W Acquisition LLC deemed enforceable:
Acquirer acknowledges and agrees that neither the Company nor the Selling Shareholder has made any representation or warranty, expressed or implied, as to the Company or any Company Subsidiary or as to the accuracy or completeness of any information regarding the Company or any Company Subsidiary furnished or made available to Acquirer and its representatives, except as expressly set forth in this Agreement … and neither the Company nor the Selling Shareholder shall have or be subject to any liability to Acquirer or any other Person resulting from the distribution to Acquirer, or Acquirer’s use or reliance on, any such information or any information, documents, or material made available to Acquirer in any “data rooms,” “virtual data rooms,” management presentations, or in any other form in expectation of or in connection with, the transactions contemplated hereby.
Further, sellers are well advised to define exactly what is meant by the term “fraud.” Without limiting the scope of this term, a seller might have exposure beyond customary notions of “actual fraud” (such as liability for reckless statements, “constructive” or “implied” fraud, or even statements not relied upon by the buyer). In this regard, a seller should consider defining “fraud” consistent with typical state law definitions, such as the following:
‘Fraud’ means actual fraud under [Delaware] law (including the requisite elements of (A) false representation, (B) knowledge or belief that the representation was false when made (i.e., scienter), (C) intention to induce the claimant to act or refrain from acting, (D) the claimant’s action or inaction was taken in justifiable reliance upon the representation and (E) the claimant was damaged by such reliance and as established by the standard of proof applicable to such actual fraud).
With clauses of this kind in the acquisition agreement, the seller will reduce the chances that a buyer having second thoughts about the business that it has acquired will prevail in alleging that it was fraudulently induced to acquire the seller, or fraudulently induced to pay a greater price than it would otherwise have paid.
17. Termination Provisions
The termination provisions of the acquisition agreement set forth the circumstances when a party can terminate the acquisition agreement prior to a pre-agreed date (the “drop dead date”) where either party (if it is not in breach of the agreement) can typically walk free of the transaction if it has not been consummated by such date. (Of course, the parties can always mutually terminate the agreement if they so choose.) These termination rights include the following:
- By the buyer, if there has been a materially adverse effect with respect to the seller (as discussed above, the actual terms of this definition are heavily negotiated).
- By either party, if any law, rule, executive order, or other legal restraint arises which has the effect of making the acquisition illegal.
- By either party if the other party has material breached its representations and warranties or covenants to an agreed level of materiality typically tied to the related closing conditions (and such breach has not been cured within any designated cure period).
- By either party if specified regulatory approvals (such as antitrust or CFIUS clearance) have not been obtained by the drop dead date.
18. Dispute Resolution Provisions
The acquisition agreement should set forth how and where resolution of disputes will happen. Although the majority of acquisition agreements default to the court system, many buyers and sellers, particularly those who have been through prior dispute processes, often prefer to resort to an exclusive confidential binding arbitration provision, such as under the JAMS commercial arbitration rules in existence at the commencement of the arbitration, before one arbitrator chosen by JAMS. In deals involving international parties, international arbitration firms (such as the International Chamber of Commerce) should be considered for this purpose.
Such an arbitration provision allows for faster and more cost-effective resolution of disputes than litigation. Litigation can be extremely costly and last for many years during any appeal process. In certain cases parties may prefer litigation because it theoretically permits broader “discovery” of the opposing party’s documents and other evidence, but in most cases involving disputes over M&A transactions the discovery permitted under the arbitration rules is sufficiently broad to address these types of concerns.
Among the issues to be considered with respect to an arbitration provision are the number of arbitrators, the location of the arbitration, the scope of discovery, the time period for issuance of a decision, and how the respective parties will bear the fees and expenses of the arbitration. A common allocation of responsibility is a provision that states that each party will pay its own legal fees and costs, and 50% of the arbitrator’s fees.
See also these related articles:
- 22 Mistakes Made by Sellers in M&A Transactions
- 20 Key Due Diligence Activities in an M&A Transaction
- Negotiating an Acquisition Letter of Intent
- 30 Key Lessons Learned from M&A Transactions
For a comprehensive book on M&A, see Mergers and Acquisitions of Privately Held Companies: Analysis, Forms, and Agreements.
About the Authors
Richard D. Harroch
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on Internet, digital media, and software companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He was also a corporate and M&A partner at the law firm of Orrick, Herrington & Sutcliffe, with experience in startups, mergers and acquisitions, and venture capital. He has been involved in over 200 M&A transactions and has written a dozen articles for Forbes on M&A.
David A. Lipkin
David A. Lipkin is an M&A partner at the law firm of McDermott, Will and Emery in Silicon Valley. He has represented public and private buyers, target companies, founders, investment bankers, and others in large, complex, and sophisticated M&A transactions, including SoftBank’s $21.6 billion acquisition of a controlling interest in Sprint, and Broadcom’s $37 billion acquisition by Avago. Mr. Lipkin has been a leading M&A practitioner in Silicon Valley since 1999, prior to that having served as Associate General Counsel and Chief Information Officer of a subsidiary of Xerox, and practiced general corporate law in San Francisco. He is a member of the Board of Directors of the Law Center to Prevent Gun Violence, and has served on additional educational and charitable boards. He has been involved in over 200 M&A transactions.
Richard V. Smith
Richard Vernon Smith is a partner in the Silicon Valley and San Francisco offices of Orrick, Herrington & Sutcliffe, and a member of its Global Mergers & Acquisitions and Private Equity Group. He has over 34 years of experience in the areas of mergers and acquisitions, securities law, and corporate law. Richard has advised on more than 400 M&A transactions and has represented clients in all aspects of mergers and acquisitions transactions involving public and private companies, including negotiated mergers, exits of venture-backed companies, auction bid processes, cross-border transactions, distressed asset sales, leveraged buyouts, tender offers and exchange offers, going private transactions, mergers of equals transactions, hostile takeovers, proxy contests, takeover and activist defense, purchases and sales of divisions and subsidiaries and joint ventures.
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