Creative acquisition strategies are offering both buyers and targets additional opportunities to grow their businesses through M&A. One strategy that we are seeing parties use is the “option to acquire” structure, which addresses both the needs of a target company to develop a product or business on the one hand and the desire by a buyer to identify growth opportunities on the other. In an option to acquire transaction, the buyer agrees to pay the target an option fee in exchange for the exclusive option to acquire the target for a fixed price during an option period subject to certain conditions and agreements that are set forth in a fully negotiated and executed acquisition agreement. As part of the arrangement, the parties may also enter into a collaboration agreement covering certain development activities of the target during the option period, with the achievement of the developments functioning as milestones to the buyer’s ability to exercise its option to buy. The collaboration agreement is usually separate from the option and acquisition agreement. Sometimes, the specific terms of the option may also be set forth in a standalone option agreement that is separate from the acquisition agreement.
Option to acquire deals can occur at any stage of a target’s life cycle. In the startup context, these deals are commonly called “build to buy” transactions because, in a sense, the buyer is providing the potential target with the necessary financial resources needed to build the target’s product or business into a venture that the buyer would be willing to buy. More mature companies may also enter into option to acquire deals to further develop an existing business segment or to seek backing for a pivot in the company’s strategic direction for a particular product or business. Options to acquire are fairly common in the medical device and life sciences industries and have been used by big pharma to identify new drug candidates. However, an option to acquire transaction also provides attractive opportunities for funds and companies in other industries as well, as a way to get an inside track on new technology.
Why do parties structure deals as option to acquire transactions?
Generally these structures are used when a target has a business or product that needs to be further developed to get to a “proof of concept” or other point where the buyer is willing to purchase the target or asset outright. Usually, the target requires additional financing to fund the development activities but the buyer is unwilling to provide the often-substantial development funding without obtaining some security that it will have the exclusive option to acquire the target in the future.
In an option to acquire structure, the target can obtain non-dilutive financing (in the form of the option fee) in exchange for an agreement by the target to sell the business or product to the buyer at a fixed purchase price if the development is successful and the buyer wishes to exercise the option. If the target has financial backers, the option to acquire structure also gives the financial backers greater confidence that there will be a liquidity event during the option period if the development work is successful. From the target’s perspective, the option to acquire structure provides necessary funding to proceed with the development of the business or product and provides an incentive to the target’s management and its stockholders, who may wish to make a further investment in the target, to reach the developmental milestones in the agreement so that a liquidity event is realized.
In a typical option to acquire transaction, the option fee is typically non-refundable. The buyer may also make an equity investment in the target during the option period, however the option fee itself is generally not convertible into equity of the target if the option is not exercised.
The acquisition agreement is negotiated and executed at the time the option is granted. Why is it structured this way?
A buyer typically will not commit to pay an option fee unless the buyer can exercise the option and effect the purchase of the target without the target or its stockholders being able to back out of the transaction because they think the target is more valuable than the agreed upon price. The option fee essentially pays for a lock on the value as agreed upon by the parties on the date of the option grant.
In order to make the transaction “self-executing,” the merger agreement (or if there are only a few stockholders, the stock purchase agreement) is executed at the time the option is granted. Immediately following the option grant, the required stockholder approval of the merger is solicited and obtained so that there is no uncertainty that the buyer will be able to acquire the business or product at the relevant time. By obtaining stockholder approval of the merger immediately after the option grant, the target can promise not to solicit or shop the deal without having to obtain the typical “fiduciary out” for any competing bid that is received by the target during the option period. See our discussion of the target board’s fiduciary duties below.
Option to acquire deals can also be structured as an asset purchase that may or may not require stockholder approval or as either a merger or asset purchase at the buyer’s election. (Typically the asset purchase would have a higher purchase price than the merger structure to compensate the equity holders for tax and other disadvantages of structuring the deal as an asset sale. If structured as an election, the purchase price may also reflect the additional costs of having to fully negotiate both structures in order to make the transaction self-executing).
Can the target’s board approve the grant of an option and an acquisition agreement with fixed consideration even if the purchase may not actually occur until a future time when the target could be more valuable?
The target’s board of directors is subject to the same fiduciary duty standards in connection with the approval of an option to acquire transaction as it would be in connection with the approval of the sale of the target under relevant state law. In accordance with the target board’s fiduciary duties, before approving an option to acquire transaction, the board should consider the target’s strategic alternatives, including the availability of other financing, the target’s prospects, and risks and uncertainties facing its business. As part of this process, the target board should pay close attention to the process for selling the company (including identifying potential buyers of the target and potential development partners) as well as the process for concluding that an option to acquire transaction is the best alternative for the target and its stockholders under the circumstances. The board should also consider the method for valuing the company, the terms of the option (including the option fee), the terms of the acquisition agreement if the option is exercised and any other relevant factors.
Target boards that are composed primarily of representatives of funds and other financial backers of the target and management have to be mindful of the fact that the board may not be considered “disinterested” under applicable law. Therefore, if the transaction is challenged by a stockholder in litigation, the transaction will be subject to a higher level of judicial scrutiny that is applicable to conflicted transactions. In Delaware, this higher standard is called the “entire fairness” standard of review. Under “entire fairness,” the defendants must demonstrate that the transaction is entirely fair to the common stockholders – in both process as well as price. See our article on this topic.
If the target intends to complete a financing transaction with certain existing investors in conjunction with the option to acquire transaction, the target board should also be mindful of its fiduciary duties to the target’s stockholders. For example, it may be prudent for the target to conduct a rights offering to enable other stockholders of the target to participate in the financing or take other procedural steps to ensure that the transaction is fair to the common stockholders.
How is the option period typically set?
The option period will differ from deal to deal but typically the option period is not based on a fixed period of time but rather is tied to the completion of a particular development effort such as the receipt of final results from a clinical trial or the completion of product development for a particular product.
The target needs to be mindful of creating clarity about when the option period ends. Generally it is best to have an objective milestone that causes the option period to end. However, if an objective milestone is not feasible, the parties may need to negotiate appropriate dispute resolution procedures for resolving whether the event triggering the end of the option period has occurred so that the target is not paralyzed by the uncertainty of whether the option has expired or is still in effect (and unable to finance its business in the meantime). A target will also need to focus on its working capital and financing requirements during the option period, considering the indefinite length of the option period and the potential for unanticipated delays, and should make sure that it has the flexibility to finance its operations during the option period and, if the option is exercised, during the pre-closing period under the merger agreement.
How should the representations, warranties and covenants in the acquisition agreement work during the option period?
The target should be thoughtful about what representations and warranties it is willing to give in the agreement relating to the option period as compared to the comprehensive representations and warranties that a target would typically give in a traditional merger agreement. It should also factor in the relevant time periods associated with the transaction, including the length of time of the option period. Representations and warranties that are given at signing typically need to be “brought down” at the time the option is exercised and then again at the closing of the merger agreement. So, for example, if an option period is expected to last a year or two, the target will need to consider whether it can give comprehensive representations and warranties at the signing that would need to be brought down and expected to remain true when the option is exercised and then again when the merger is closed, which could be several years down the road. Alternatively, the target could give simplified representations and warranties at the signing of the option and merger agreement and then more comprehensive representations and warranties (that could be modified by a disclosure schedule) in connection with the process relating to the exercise of the option. (Generally, the buyer is given a right to conduct continuing due diligence throughout the option period but also given a right to give at least one conditional notice of exercise of the option that triggers an obligation of the target to deliver a disclosure schedule against the comprehensive representations and warranties in the merger agreement and buyer is given an opportunity to withdraw the option exercise following receipt of the disclosure schedules.) At the very least, the target should be willing to give representations and warranties relating to the grant of the option and the enforceability of the option at signing. The representations and warranties with regard to the other time periods are often subject to vigorous negotiation.
In addition, the target should also consider indemnification and other risk allocation issues with regard to the various periods involved, and if indemnification would be appropriate during the option period given that the target has received only an option fee and the buyer has not committed to acquiring the target.
For operational and antitrust reasons, the target should consider the scope of operating covenants that may apply during the option period and should not just agree to the pre-closing covenants that typically are included in a merger agreement. The buyer, however, should be able to get some operational covenant protection during the option period so that the target is not fundamentally changed during the option period.
Can the parties seek clearance of the acquisition under the Hart-Scott-Rodino Antitrust Improvements Act (HSR) before the option is exercised?
Yes, HSR clearance for the transaction can be obtained based on the option and merger agreement even if the option has not yet been exercised. Seeking HSR clearance before the option has been exercised has the advantage of reducing the time between the option exercise and the closing of the acquisition. However, the acquisition must be closed within one year of receiving the HSR clearance or else a new HSR clearance would need to be obtained. A buyer, therefore, may prefer to wait until it makes the decision to exercise the option before seeking HSR clearance.
Because a target’s stockholder approval of the merger agreement is usually obtained immediately after the option is granted, HSR clearance may be the only significant closing condition to completion of the acquisition. Therefore, the parties will need to consider the potential timeline for obtaining HSR clearance on the overall transaction process and consider what effect, if any, a delay in receiving the clearance (e.g., due to the fact that the buyer may acquire other businesses or engage in other activities during the option period that may change the substantive antitrust profile of the transaction) may have on the transaction as a whole and on the target in light of the target’s current and prospective funding requirements.
How do option deals impact the target’s employees and ongoing operations?
If a buyer has entered into an option to acquire transaction with a private target, the parties may choose not to disclose publicly that they have entered into the agreement in order to avoid a disruption to the target’s business. Parties should assume, however, that the target’s employees will become aware of the transaction relatively quickly if not at signing, particularly if the employees are equity holders in the target and the transaction is structured as a merger that requires stockholder approval of the transaction. Even if stockholder approval from employees is not required, an employee with equity stock may receive related notices needed for a waiver of appraisal or dissenters rights.
Accordingly, the target should consider the potential impact of the option to acquire transaction on employee retention and recruitment of new employees. Also, as part of its preliminary due diligence, a target should consider well in advance of entering into an option to acquire agreement with a buyer whether it has any material contracts or relationships with suppliers or other third parties, including competitors of the buyer, that could be adversely impacted by the option to acquire transaction and plan accordingly.
Can a buyer seek to renegotiate the terms of the acquisition agreement before the option is exercised?
Yes, assuming that the target does not have a “put” right in the contract, a buyer will not be obligated to exercise the option and, therefore, can seek changes to the merger agreement before it agrees to exercise the option. A target, however, does not have to agree to any such changes to the executed acquisition agreement. Changes that adversely affect stockholders that previously approved the agreement may also be required under applicable state law. For example, in Delaware, if the agreement is structured as a merger, any amendments that could impact the purchase price or make other changes to the terms and conditions in the agreement that adversely affect the stockholders would require approval by the target’s board and stockholders. Therefore, a buyer’s leverage to seek changes to the merger agreement during the option period may be limited and will depend, among other things, on market conditions and a target’s specific circumstances, including the willingness of the target’s financial backers to allow the buyer to walk away from the deal without exercising the option to acquire the target or asset.
On the other hand, as discussed above, a target’s ability to renegotiate the terms of the acquisition are very limited. Assuming that the option is structured correctly and stockholder approval has been validly obtained, absent fraud or other breaches of the agreement, a target (and its stockholders) generally should not have the leverage to increase the purchase price or improve the escrow, indemnification or other terms of the merger agreement during the option term.