An extract from The Technology M&A Review, 1st Edition
Key transactional issuesi Company structures
Acquisitions are almost without exception executed by limited companies, regardless of the operational sector of a target business.ii Deal structuresPrivate M&A
Acquisitions of non-listed targets are invariably structured by way of a share sale, unless the assets of a target business are not housed within a discrete corporate wrapper. In the latter case, an asset purchase agreement or a share and asset purchase agreement would be used to memorialise the legal terms.Public M&A
Public takeovers in the UK may be implemented either by way of a contractual offer or a court-sanctioned scheme of arrangement. The key difference is the acceptance criteria to attain control of the target:
- for an offer, a bidder must secure acceptances from shareholders holding more than 50 per cent of the voting rights in the target in order for the offer to become unconditional. If the bidder also wishes to acquire shares held by non-accepting shareholders, it must have acquired or unconditionally agreed to acquire 90 per cent of the shares and 90 per cent of the voting rights in the target to which the offer relates (and so excluding any shares a bidder already owns) in order to take advantage of the squeeze-out regime under the Companies Act 2006; and
- in the case of a scheme of arrangement, once the bidder has secured approval of 75 per cent of each class of shares in the target (and a majority by number of shareholders), other shareholders will be compelled to sell their shares under the scheme, provided it is approved by the court.
Approximately 65 per cent of successful takeovers in 2019 were implemented by way of a scheme of arrangement, which represents a continuation of a preference for that structure among bidders over the previous five years.iii Acquisition agreement termsConsideration and pricing structure
Private acquisitions in the European market have increasingly been structured by way of a locked box pricing mechanism over the past 10 years, as opposed to the post-completion true-up mechanic that is preferred in the US. The central tenets of a locked box structure are:
- pricing is negotiated by reference to a historic (usually unaudited) balance sheet prepared by the seller (the locked box accounts). It is usual for the locked box accounts to pre-date an exchange by a few months (no more than six);
- a 'ticker' accrues on the equity value of the target business between the locked box accounts date and completion, which is intended to reflect the cash generation of the business in that period (and could therefore theoretically be positive or negative);
- the key buyer protection is an indemnity given by the seller or sellers for any extraction of value from the target business between the locked box accounts date to completion, referred to as a 'leakage' covenant; and
- certain items (for example, payment of vendor due diligence costs by the target) will be carved out of the leakage covenant as permitted leakage. It is customary for buyers to quantify such items and deduct them from the enterprise value as debt-like items.
Market practice in the UK has developed such that only mandatory regulatory clearances are accepted as conditions to closing. Unlike in the US, the risk of financial deterioration in a target business effectively passes to the buyer at exchange; material adverse change provisions (or similar) are incredibly rare. This norm has not been affected by the advent of covid-19, notwithstanding possible uncertainty around the future performance of targets.
The risk of satisfying any antitrust or foreign direct investment conditions customarily sits with buyers. It is common for buyers to be held to a hell or high water standard for satisfaction of such conditions in a sale contract. This requires buyers to take any and all steps to satisfy any conditions, including offering or accepting any remedies necessary to obtain approval (which, significantly, requires accepting the divestment of other assets in their portfolio).
Break fees, which are triggered by a failure to satisfy conditions to closing, are used more sparingly than in the US market, with UK sellers preferring to satisfy themselves as to execution certainty by conducting due diligence of the buyer's regulatory analysis and incorporating a hell or high water standard in the sale contract. Where they are included, care is required in drafting to ensure that the break fee would not be classified as a penalty clause, which would be unenforceable under English law to the extent that they are not proportionate to protect the legitimate interests of the beneficiary (in this case, the seller). It is therefore not uncommon, on private acquisitions, for sellers to prefer an indemnity for deal costs if conditions are not satisfied.
In the context of public M&A, break fees are classified as an offer-related arrangement under the Takeover Code and are prohibited as between a bidder and a target without the consent of the Panel (the regulatory body) on the basis that they may deter other bidders from making an offer. Panel consent, in practice, is rarely (if ever) given.Warranties
The UK market has developed such that financial sponsors do not provide warranty protection other than in respect of fundamental warranties (capacity and title). Operational warranties and any tax indemnity are usually provided by a target's management team, with recourse fully or partially supported by a warranties and indemnity (W&I) policy. Strategic sellers usually agree to stand behind operational warranties and a tax covenant, although the use of W&I is becoming more prevalent on competitive disposals by corporates.
Operational warranties are usually subject to a host of contractual limitations, most significantly:
- time limitations on claims (between 12 and 24 months post completion);
- financial limitations on claims, including:
- an exclusion of any claim below a de minimis amount (often equal to 0.1 per cent EV); and
- no liability for the warrantor until claims not excluded under the de minimis limitation reach a threshold (often equal to 1 per cent EV), although the buyer is usually entitled to recover from £1 once the threshold is exceeded;
- a maximum financial cap for the warrantor; and
- the exclusion of any claim to the extent the matters or facts giving rise to the claim are disclosed in a disclosure letter or data room, subject to meeting a fair disclosure standard, which can either be circumscribed contractually or by reference to the common law position.
Fundamental warranties are not subject to such limitations, other than (possibly) a time limitation on claims and a financial cap not exceeding the consideration payable to the warrantor.
The W&I market in the UK has grown over the past 10 years to the extent that operational warranties are almost invariably supported by a buy-side W&I policy on an auction sale. Underwriting is a granular process, with insurers seeking comfort in the quality and scope of diligence conducted by a buyer. As a matter of principle, identified risks are excluded from coverage (unless specialist insurance is sought), and underwriters also customarily exclude certain other baskets of claims (including transfer pricing, secondary tax liabilities, environmental issues and consequential loss). In the context of a target in the technology sector, it is essential that the buyer's due diligence is appropriately focused on issues that customarily arise in respect of such businesses (see Section VII).iv Financing
Sellers in private M&A transactions across Europe (both in competitive and proprietary transactions) usually require evidence of certain funds at exchange. This requirement originated in public M&A transactions (as a requirement of the Takeover Code), but has since been applied to private transactions as well. In the context of equity financing, financial sponsors structured as funds usually provide an equity commitment letter undertaking to fund the purchaser vehicle on completion. Sellers will either have direct or third-party rights to enforce obligations given by the funds in that letter. To the extent it is using debt financing, a buyer will need to ensure that the financial institutions providing the financing are committed to do so at exchange, with any conditions precedent limited to matters that are within the buyer's control. This has allowed buyers to avoid having to ask for a financing condition in their purchase agreement, and means that they can equate their certain funds cash-funding position as being on a par with that of competitive offers that are financed by only equity.
Debt financing providers will typically require security as a condition to the credit facilities and covenants to ensure that the assets material to the target business are not divested. The negotiation of a security package will be deal-specific; however, where the target business is a technology asset that has intellectual property (IP) material to its business, lenders will typically require security over such IP. Over the past few years, as inexpensive credit has become widely available as a result of low interest rates, there have been a series of high-profile examples of borrowers taking advantage of certain flexibilities in their credit agreements to dispose of their valuable intangible assets (such as IP) or to use such assets as collateral for new borrowings, or both. Towards the end of 2019, as credit markets tightened and moved away from such borrower-friendly norms, lenders became increasingly focused on including restrictions on the transfer or disposal of material IP outside of the restricted security group.v Tax and accounting
The government has introduced a new digital services tax (DST) that applies to revenue earned from 1 April 2020. Broadly, the DST will impose tax on businesses that exceed the annual thresholds at a rate of 2 per cent in respect of revenue that is attributable to UK users and arises in connection with certain in-scope digital activities.
A group will be liable to DST when its annual worldwide revenue from digital services activities exceeds £500 million and more than £25 million of such revenue is attributable to UK users. Broadly, the in-scope digital activities are social media services, internet search engines and online marketplaces.
The policy intention behind the new legislation is to address changes to the way that businesses are operating. Many of the targeted businesses that operate in the digital economy derive value from their interaction and engagement with a user base, and there is a misalignment between the place where profits are taxed and the place where value is created. The government believes that the most sustainable long-term solution is the reform of the international corporate tax rules. It intends to repeal the DST once an appropriate global solution is in place. However, achieving global consensus in relation to a tax that has been the subject matter of international criticism and debate, especially in the current political and economic climate, will no doubt be a difficult and drawn-out task. As such, it is critical that businesses become familiar with the DST, as despite its supposed temporary nature, it might be in place for longer than expected.
The DST only applies to revenue that is attributable to UK users. A UK user is defined as any user (an individual or legal person) that it is reasonable to assume is normally located or established in the UK. However, a provider of a digital service activity, any member of the same group as that provider and any employee of that group (provided they are acting in a professional capacity) are excluded from being considered a UK user.
Businesses that are potentially affected by the DST should undertake a review of their activities and determine whether they are within the scope of the DST. In addition, it is up to businesses themselves to make a judgement as to whether a user is a UK user. The legislation does not specify what is an acceptable source of evidence. However, the most commonly collated information comprises the following: a user's IP address, payment details and delivery details. Businesses should also continue to be aware of their GDPR responsibilities. The DST does not require businesses to collect additional personal data from their customers, and the obligation to ensure that personal data is being collected and processed in a lawful manner continues to rest on businesses themselves.
From a compliance perspective, although a DST liability is calculated on a group-wide basis, primary liability falls on the individual members of the group. As such, the group revenue will need to be allocated to each individual group member in relation to their proportion of the UK digital services-generated revenue. A group must designate an entity to be its responsible member, and it is such entity who will, going forward, be responsible for carrying out reporting and other obligations.vi Management incentivisation
Incentivisation of a management team post-acquisition remains a key issue in M&A, especially in competitive auction processes where a substantial rollover by management is anticipated. Financial sponsors customarily grant senior managers 'sweet equity' in the acquired business, which has limited value on day one (and can therefore be subscribed for at a low valuation) but will participate economically in an exit if the business continues to grow. Participation is usually by reference to a ratchet mechanism or hurdle that is linked to the financial performance of an asset. Corporates tend to offer less bespoke schemes that are linked to the performance of an overall business, not just the asset acquired. They are sometimes also able to offer publicly listed equity as part of executive compensation, which is likely to result in a more immediate realisation of value for the participant when compared to illiquid equity in a privately held vehicle.