M&A deal terms will almost always vary based on the specific context of the transaction, including the deal price, structure and each party’s negotiating leverage. Although no amount of data can replace context-specific analysis, data-driven decision-making continues to make its way into negotiations and can, under the right circumstances, provide useful benchmarks to inform market practice on a given topic, including the frequency of a given term in similar deals. We have reviewed several frequently cited deal studies involving private targets1 and offer these selected observations.
Increased use of earn-outs. Continuing the trend noted in our previous Market Trends Snapshot, the number of deals with earn-outs to bridge valuation gaps between buyers and sellers continues to increase. Approximately 14% of deals in the non-life sciences sectors and 71% of life sciences deals used an earn-out in 2015, according to SRS (FORSITE: 20% and 52%, respectively). In the ABA Study, which tracks publicly filed and often larger private deals, earn-outs were included in approximately 26% of the surveyed deals overall.
In agreements with an earn-out, a portion of the consideration payable to the seller is deferred and made conditional upon the operation or financial performance of the acquired business (now owned by the buyer), including (in some circumstances) the achievement of certain non-financial milestones post-closing. In order to improve the likelihood of receiving an earn-out, a seller may require a buyer to undertake certain obligations as to how the buyer will operate the business post-closing. Notably, the studies reported a decrease in provisions affording sellers control of the business post-closing. According to the ABA Study, in 2012 and 2010, buyers had agreed to “maximize the earn-out” for the seller in 6% and 8% of deals, respectively. However, in 2014, no buyers agreed to this covenant. As a less restrictive alternative, buyers agreed to run the business “consistent with past practice” in 18% and 27% of deals in 2012 and 2010, respectively. However, in 2014, only 3% of buyers agreed to this covenant. At the other end of the spectrum, according to a new data point in the ABA Study, approximately 32% of the relevant deals studied expressly allowed the buyer to operate the business post-closing “in Buyer’s own discretion.”
These statistics, although noteworthy, may not reflect recent developments in Delaware case law holding that, where an agreement already contains express provisions addressing the buyer’s obligations in an earn-out, the buyer has no independent obligation under an implied covenant of good faith to try to maximize value or pay an earn-out and that the buyer’s obligations will be interpreted based on the plain language in the contract. Well-advised sellers, therefore, should include in the contract express covenants requiring the buyer to adhere to a specific standard of conduct to achieve the earn-out. It will be interesting to see what impact these cases will have on this data point in future years.
Increased use of attorney-client privilege provisions and waiver of conflicts. In late 2013, the Delaware Court of Chancery held that unless otherwise specified in the purchase agreement, the default rule is that the target company (i.e. the buyer) is the sole holder of the attorney-client privilege over pre-merger communications after closing. In light of this decision, the ABA tracked, for the first time, the number of deals where the seller’s/target’s attorney-client privilege was expressly reserved by the seller in some fashion and found that the carve-out was used in 46% of the deals surveyed (FORSITE: 54%).
As a related matter, there also seems to be a growing trend in the number of deals allowing the attorneys that represented the sellers/target company in the transaction to continue to represent the sellers after the closing. In 2014, just over half of the deals studied by the ABA, SRS and Fortis contained a conflict waiver by the buyer, up from 14% in 2010 according to the ABA.
Continued emphasis on, and negotiation of, the materiality scrape. The materiality scrape (meaning that all materiality and material adverse effect limitations in the representations and warranties are ignored) for purposes of the indemnification provisions is now incorporated in some form in the vast majority of deals (ABA: 70%; SRS: 84%; FORSITE: 78%). According to the ABA Study, this percentage jumped significantly from prior years where materiality scrapes were included only in 28% and 49% of deals surveyed in 2012 and 2010, respectively. The frequency of the buyer-favorable formulation that “scrapes” materiality for purposes of determining whether there has been a breach of representations and warranties (as opposed to calculating damages or losses only) has also varied (ABA: 57%; FORSITE: 36%; SRS: 42%). We acknowledge that this data point may be offset on a deal-by-deal basis by the size and type of the indemnity basket, among other things, and should be read in tandem with these related limitations. However, the studies seem to indicate that this admittedly lawyer’s point continues to be negotiated.
Treatment of third-party claims. Indemnification of third-party claims has become one of the most heavily negotiated provisions in a purchase agreement. As a result, the ABA Study began tracking some new statistics with respect to indemnification of third-party claims. In 19% of the deals surveyed, buyers are expressly indemnified for third-party claims regardless of whether a breach of the underlying representation has been proven.
In 85% of transactions according to the ABA (FORSITE: 57%), the seller has the right to control the defense of a third-party claim. However, in the vast majority of these cases (ABA: 78%; FORSITE: 96%), this right is subject to exceptions such as if the potential liability exceeds the cap and/or escrow, if there is a conflict of interest, if the claim involves criminal allegations or, most commonly, if the claim seeks non-monetary damages. Moreover, in cases where the seller has the right to control the defense, there are almost always (ABA: 90%) some limits on the ability of the seller to settle the claim, such as a requirement that the settlement includes a complete release, the relief involves monetary damages only or the buyer provided written consent.
Despite more detailed coverage of third-party claims generally, the vast majority of agreements according to the ABA remained silent as to certain important issues such as: (i) if the buyer has a consent right but rejects a proposed settlement, should the liability of the seller be limited to the amount of the proposed settlement and (ii) should the buyer be entitled to its defense costs irrespective of whether there is an actual breach? We can expect that there will be more focus on these issues going forward.
The non-reliance provision. In order to preclude fraud claims based on oral or other statements made outside of the representations and warranties in the agreement, parties often include a provision in the contract that the seller is making “no other representations” other than those that are expressly contained in the agreement. However, recent Delaware decisions have held that in a post-closing lawsuit for fraud, a “no other representations” provision is not enough and that in order to effectively preclude a claim for extra-contractual fraud, the defendant (usually the seller) must demonstrate that the plaintiff (usually the buyer) affirmatively agreed to disclaim reliance on extra-contractual statements in the agreement.2 According to the ABA Study, 40% of deals included an express non-reliance clause by the buyer (SRS: 35%; FORSITE: 42%). Given the recent case developments, we would expect sellers to request these non-reliance clauses as a matter of course going forward.
Management carve-out. In a management carve-out, a portion of the deal’s proceeds are paid to the seller’s management, usually in cases where management would otherwise receive little or nothing for their equity ownership due to liquidation preferences. According to the SRS Study, management carve-outs are usually (though not always) paid in distressed situations where the deal price is less than the value of the equity capital paid into the company.
Of the total deals surveyed by SRS in 2015, 18% had a management carve-out, which is similar to the percentage of deals with a carve-out in the prior four years surveyed. When carve-outs were paid, the median size of the carve-out, as a percentage of transaction value (not including any earn-out), was 10% in 2015, up from 6.8% in 2014.
When structuring a management carve-out, attention should be paid to the effect of the carve-out on the common stockholders and will be scrutinized by a court (see Trados) if the proceeds are disproportionately paid out of proceeds that would have otherwise gone to the common stockholders.
Survival periods. Consistent with prior years, about half of the deals surveyed had survival periods for general representations and warranties of 18 months (SRS: 45%; FORSITE: 51%), with the next most-frequent survival period being 12 months after the closing. In the deals surveyed by the ABA, the vast majority continued to have general survival periods of between 12-18 months; however, the total number of deals in this range was meaningfully less than in prior years. Notably, 6% of all deals in 2014 surveyed by the ABA had no survival period, which could be a reflection of the increasing number of deals using transactional insurance.
So-called “fundamental” representations and warranties (such as with respect to due authorization, due organization and capitalization) continue to be carved out from the general survival period. In about 50% of cases where fundamental representations were carved out, the fundamental representations survived for the “statute of limitations” according to the SRS and FORSITE. (Statute of limitations periods vary state by state. In Delaware, the period is 3 years.) In 19% of the deals surveyed by SRS (FORSITE: 29%), buyers successfully requested that breaches of fundamental representations survive “indefinitely.”
In Cigna v. Audax (2013), the Delaware Court of Chancery held that an indemnification provision in a merger agreement that allowed the purchaser to claw-back consideration from stockholders for breaches of fundamental representations that were capped at the purchase price and not limited in duration violated Section 251 of the DGCL because such a provision was unknowable and therefore violated the language in the statute which requires parties to “state the merger consideration.” In response to the case, the SRS Study looked at survival periods for fundamental representations before the Audax ruling and compared them to the periods in deals structured as mergers that were signed after the Audax ruling and found that the number of merger agreements that specified an “indefinite” survival period post-Audax decreased from 28% in 2012-2014 to 17% in 2015. The study also found a slight decrease in deals structured as mergers that capped indemnification to the purchase price, noting that slightly more deals post-Audax (10% vs. 6%) used a value less than the purchase price to cap breaches of fundamental representations.
In 2014, the Delaware legislature amended the commercial code to allow parties to extend the survival period for a breach of contract claim beyond the statutory limit to up to 20 years. A synopsis to the law provides examples of ways that a party may extend the statutory period, such as by including in the contract: “a specific period of time” or “an indefinite period of time.” It is not clear whether the amended commercial statute fixes the lack of specificity issue noted in Audax by providing that an “indefinite” survival period shall mean 20 years. However, it appears that at least some deal parties may be approaching the issue conservatively.
Stand-alone indemnities. More than a majority of the deals surveyed by the ABA, SRS and Fortis contained stand-alone indemnities beyond the standard line items for breaches of representations, warranties and covenants. Specified indemnities were available for taxes (generally 70%), payments to dissenting stockholders (ABA: 31%; SRS: 72%; FORSITE: 73%;) and accuracy of closing certificates including the payment spreadsheet (SRS: 69%; FORSITE: 50%).
Other common types of stand-alone indemnities included indemnities for payments for transaction expenses, litigation, fraud and willful misrepresentation and purchase price adjustments.
Excluded losses to indemnification. The vast majority of deals continued to expressly exclude punitive damages from the indemnity and remained silent with regard to losses due to “incidental damages” and “diminution in value.” “Consequential damages,” on the other hand, were expressly excluded in a meaningful number of deals (SRS: 32%; ABA: 44%).
Indemnification caps. The median cap for general breaches of representations, warranties and covenants was about 10% of transaction value. (In our experience, this percentage seems to decrease as the transaction value of the deal increases.) Fundamental representations were carved out from the cap in the vast majority of cases (FORSITE: 87%; SRS: 76%). For fundamental representations that are carved out from the general cap, damages were usually capped at the purchase price (SRS: 82%; FORSITE: 92%).
Indemnification baskets. The median basket for breaches of general representations, warranties and covenants was about 0.5% of transaction value, regardless of the type of basket. The vast majority of deals contained carve-outs from the general basket for breaches for fundamental representations, fraud and taxes.