M&A Negotiating Trends: M&A Buyers Respond to Seller
Special Report
M&A Negotiating Trends: M&A Buyers Respond to SellerFriendly Market By: Sean Arend and Andrew Hubley
M&A Negotiating Trends: M&A Buyers Respond to Seller-Friendly Market By: Sean Arend and Andrew Hubley Over the past few years, several practitioners and banks have observed that the mergers and acquisitions (M&A) market in the United States favors the seller.1 To evaluate how buyers are reacting to this trend, we analyzed deal terms contained in 795 private-target M&A agreements concluded between 2013 and 2016 and included in the SRS Acquiom “MarketStandard” database.2 Additionally, we analyzed data concerning approximately 42,600 private-target M&A deals contained in the Bloomberg Law® Deal Analytics database to understand general market trends and provide context for our review of the substantive deal terms.3 Our main goal was to determine how certain terms in M&A agreements have shifted in recent periods and to offer context for why the changes may have been occurring.
2
June 2017
2017 SRS Acquiom M&A Deal Terms Study An analysis of deal terms in private-target M&A transactions that closed between 2013–2016
POWERED BY
© 2017 SRS Acquiom Inc. All rights reserved.
/
Our analysis identified shifts in a number of deal terms to a more seller-friendly formulation. These shifts coincided with market trends that have generally favored sellers, suggesting that sellers exercised greater leverage in negotiations. However, our analysis also showed that buyers are devising creative provisions that limit or curb the effects of seller-friendly terms. In this article, we first discuss factors that may have contributed to the rise of more seller-friendly terms. We then review five M&A terms that have become more seller-friendly during the past several years, and we identify the tactics buyers have used to limit or curb the increasingly seller-friendly terms.
initial document drafting, the auction gives a seller a stronger negotiating position, from which it can focus on ensuring potential buyers do not modify terms that it considers critical to the deal. Additionally, auctions facilitate competition, as the seller’s financial advisers often identify several interested parties to bid against one another in competition for the target company. The presence of more than one bidder may mean that the seller can retain its control over the bidding process beyond the initial bids and can play bidders off of one another in negotiations. This leverage may permit a seller to extract additional submissions and drive deal terms that favor its interests in ways that are not typically possible in a one-on-one negotiated sale. Another factor contributing to sellers’ market strength is the increasing number of private buyers, both private companies and private equity funds, participating in the M&A market. According to Bloomberg Law data, the percentage of private buyers, including private equity buyers, jumped from 53.4 percent in 2014 to 64.5 percent of buyers in 2017.
Private Deals as % of Total Deals
Private Deals as % of Total Deals
14000
70 63.1
12000
More Auction Sales and Private Buyers Mean More Seller-Friendly Terms The shift toward more seller-friendly terms is likely due to several factors, including the increased use of auctions to market and sell target companies and an increase in the numbers of private buyers participating in the market. Recently, sellers have increasingly relied on auctions, rather than negotiated sales, to market target companies to buyers.4 In an auction, the seller typically dictates the initial sale terms. For example, an auctioning seller typically prepares the initial draft of the purchase agreement, while in a negotiated sale the buyer typically prepares the first draft of the sale agreement. By controlling the process and
© 2018 by The Bureau of National Affairs, Inc.
53.4
64.5
60
54.5
10000
50
8000
40
6000
30
4000
20
2000
10
0
0 2014
2015 Total Deals
2016
2017
% Private Acquirers
Source: Bloomberg Law
The larger number of private buyers has changed the personality of the M&A market. Large public companies often have significant financial resources and market
3
power that provide leverage in negotiations that private companies or private equity funds may lack. Conversely, private buyers may be more attractive than public buyers, since they may be more amenable to accepting seller-friendly terms. In addition, private buyers – and particularly private equity buyers – are more likely to maintain a post-closing relationship with sellers. In fact, private buyers often rely on the seller or the target’s existing management to continue operating the business after the sale or, at a minimum, to assist with an extended transition. As a result, a private buyer may be incentivized to ensure that the sellers do not feel taken advantage of during negotiations. Comparatively, large public buyers are more likely to have the resources and experience to conduct post-closing integration without assistance from the seller or pre-closing target management.
Additionally, our analysis of SRS Acquiom data showed that the median multiple of return on investment (transaction values as multiples of total equity capital invested in the target company) was higher for 2016 deals at 4.6x, compared to 3.9x and 3.7x in 2015 and 2013, respectively, also implying higher valuations.
Average Deal Size Average Deal Size $120.00 $118.04
$118.00 $116.03
$116.00
$114.00
$112.00
$110.0
$110.00
Lastly, in order to compete with public strategic buyers, private equity buyers have increasingly used representation and warranty insurance (discussed below in the section entitled Limiting the Duration of Escrows) to sweeten the deal for sellers. By insuring a portion of the liabilities that may result from the sale, buyers limit their post-closing exposure extra-contractually and therefore do not need the same range of protections in the contract itself. This risk-shifting is important for private equity buyers. They typically must generate post-closing returns within a limited time frame, and unexpected post-closing liabilities may affect the ability to deliver post-closing returns to investors.
Average Deal Size on the Rise (but Limitation of Potential Damages) Purchase price is possibly the most critical negotiating point for most M&A transactions. If the market and negotiating leverage are shifting in a more sellerfavorable direction, one would expect average deal values to rise. Our analysis tends to confirm that prediction. According to Bloomberg Law data, between 2015 and 2017, average deal size has grown over 4 percent. This jump is a sign that sellers may be negotiating higher deal prices than they were a few years ago.
4
$108.00 2015
2016
2017
Source: Bloomberg Law
Median Multiple of Return
Year
2013
2015
2016
Median Multiple of Return
3.7x
3.9x
4.6x
Note: 2014 data is unavailable. Prior to 2015, this data was compiled on a biannual basis. Source: SRS Acquiom, private target transactions (publicly reported and non-public).
Several market factors may have facilitated the rise in average deal size and valuations, including: (1) the relative ease of obtaining financing for M&A deals; (2) the increased competitiveness of the M&A market; and (3) the participation of more private equity buyers, which tend to offer higher prices to compete with public strategic buyers in certain market segments. Although buyers have been willing and able to pay higher prices, they are increasingly negotiating for the express allowance of so-called “diminution in value” damages in M&A agreements. Diminution in
value damages provide the buyer a right to claim damages if a seller’s misrepresentation led the buyer to negotiate a different purchase price than it would have otherwise. In 2016, express inclusion of diminution in value damages increased to 23 percent, up from 18 percent the year before. Additionally, the express exclusion of such damages declined to 10 percent in 2016, down from 12 percent in 2015. The rise in the express inclusion of such damages is notable given that a New York federal court recently found that diminution in value damages are general in nature and therefore must be expressly excluded for a seller to avoid liability.5 Taken together, these two trends – the increase in average deal size and the inclusion of provisions expressly granting buyers the right to diminution in value damages – show that while sellers have been successful at obtaining higher prices, buyers are responding by seeking assurances that they are receiving the benefit of their bargain.
Increased Seller Negotiation of Earnout Parameters Earnouts are generally buyer-friendly provisions. They make payment of a portion of the purchase price contingent upon the achievement of postclosing financial milestones. Typically, parties actively negotiate the specific milestones (e.g., revenue or income level targets) and standards for operating the business, and they often prove to be significant points of contention. Sellers worry that the buyer may intentionally operate the target business in a manner that causes the target to miss the milestones in order to avoid paying an earnout.
business were essentially nonexistent in our analysis of 2015 deals, appearing in just 5 percent of agreements. In 2016, the number of agreements containing such covenants jumped to 20 percent. This is a win for sellers that agree to earnouts, as it provides some comfort that the full purchase price will eventually be paid. One reason for the jump in the post-closing operation covenants may relate to the larger number of private equity buyers currently in the market. After closing, private equity buyers typically do not combine the target business with a pre-existing business. In contrast, public and private strategic buyers combine the target’s operations with their existing business, eliminating redundancies and duplicative roles, which allows them to reduce overall costs while growing revenue. Thus, private equity buyers may be more likely to agree to such a covenant, as they do not face the same integration issues that strategic acquirers often face. A major concern for buyers regarding the earnout provision is that a buyer may be obligated to make earnout payments while simultaneously being forced to engage in arbitration or litigation to recover for a seller’s breach. To address this mismatch, buyers have increasingly sought to offset any outstanding indemnity claims against amounts due under an earnout. In 2016, the use of these offsetting provisions jumped over 10 percent from the previous year, appearing in 88 percent of agreements in 2016 compared with 76 percent in 2015. With the jump in covenants limiting the buyer’s post-closing operation of the business and the tightening of escrow terms (discussed below), it is likely that buyers will continue to push for such offsetting provisions in the future.
Sellers appear to have taken a two-pronged approach to addressing their concerns. First, they have had some success at excluding this obligation altogether: earnouts appeared in 20 percent of deals in 2016 compared with 23 percent during the prior year. Additionally, sellers have increasingly negotiated covenants to ensure that the buyer does not try to avoid making earnout payments. This type of covenant might obligate the buyer to operate the business consistently with the seller’s past practice or it might require the buyer to operate the business so as to maximize the earnout payments, for example. Buyers’ covenants regarding operation of the post-closing
© 2018 by The Bureau of National Affairs, Inc.
5
Earnouts (Non-Life Sciences Deals*): Covenants, Acceleration, and Offsets Subset: 2015 & 2016 deals with earnouts, excluding life sciences deals
Subset: 2015 & 2016 deals with earnouts, excluding life sciences deals
8% 18% 100%
84%
95%
80%
76%
80%
6%
16%
76%
5%
24%
20%
2015
2016
Covenant to run business in accordance with seller’s past practices
4%
2015
2016
Covenant to run business to maximize earnout payments
88%
20%
2015
2016
Earnout accelerates (fully or partially) on change in control of earnout assets
2015
2016
Buyer can offset indemnity claims against future earnout payments
Included
Express yes
Not included
Express no
Silent
* For a more detailed analysis of SRS Acquiom’s life sciences deals, please see the 2016 SRS Acquiom Life Sciences M&A Update. ** Generally subject to exceptions, such as if the subsequent buyer assumes the earnout obligations. Source: SRS Acquiom, private target transactions (publicly reported and non-public).
Limiting the Duration of Escrows Unlike earnout provisions, escrow provisions are included in most M&A agreements, appearing in 86 percent of 2016 agreements. Sellers are increasingly focused on reducing the time that funds are held in escrow. Our analysis showed that the median duration for general escrows declined from 18 months in 2014 and 2015 to 16 months in 2016. Of course, the seller
6
is without full benefit of the consideration for as long as the purchase price remains in escrow. This decline is also significant because the longer funds remain in escrow, the more likely they may be used to satisfy indemnification claims. In addition to being able to reduce escrow durations, sellers have also been able to avoid an increase in the size of escrows. Over the past four years, the median size of general escrows has remained flat at roughly 10 percent.
Subset: Deals with escrows/holdbacks and/or expense funds Median indemnification escrow/holdback size
Median post-closing expense fund recently, however, buyers appear willing tosize* give some ground when negotiating general escrows. Two major 0.35% factors have contributed to this trend: (i) the increase in0.30% specialty escrows; and (ii) an increase in the use of representation and warranty insurance.
14%
12% 10.0
10.0
10.0
0.25%
10.0
10%
0.25%
0.23%
0.22% The use of 0.20% a specialty, or separate, escrow for purchase price adjustments jumped to 39 percent in 2016, up 0.20% from only 27 percent the previous year. This trend 0,15% indicates that while buyers may be willing to give ground on terms relating to general indemnification 0,10% escrows, they still seek protection for areas of special concern (e.g., purchase price adjustments).
8%
6%
4%
2%
0.05%
0% 2013
2014
2015
2016
As % of transaction value
Source: SRS Acquiom, private target transactions (publicly reported and non-public).
Many buyers consider escrows important because they provide protection against the risk that they are dealing with sellers that may not have the funds available to indemnify the buyer if a breach occurred. More
The second key factor impacting escrow negotiations 0% is the rise of representation insurance. 2013 2014 and warranty 2015 2016 According to data from insurer, value the number of As one % of transaction representation and warranty policies underwritten *Funds established at closing to fund post-closing between 2013 and 2016 jumped over 200expenses. percent.6 If this trend continues, we may see the size and duration of general indemnification escrows continue to decline. In fact, there has already been a significant impact: some M&A parties skip a general indemnity escrow, and the buyer instead relies on the insurance policy as its sole recourse.
Post-Closing Purchase Price Adjustments: Thresholds and Separate Escrows Subset: 2015 & 2016 deals with post-closing purchase price adjustments in the consideration mechanics section of the acquisition agreement (as opposed to the indemnification section only)
Adjustment only if threshold exceeded Yes 13%
Inner circle = 2015 Outer circle = 2016
Source of payment if buyer-favorable adjustment 2016
Separate escrow 39%
Yes 13%
Payment not from indemnity escrow 7% No separate escrow 61%
Payment from indemnity escrow 93%
No 87%
2015 No 87%
Separate escrow 27%
Generally, payment out-of-pocket from securityholders.
Payment not from indemnity escrow 7% No separate escrow 73%
Payment from indemnity escrow 93%
Source: SRS Acquiom, private target transactions (publicly reported and non-public).
© 2018 by The Bureau of National Affairs, Inc.
7
Increase in Deductible Baskets but More Limitations on Material Breaches Sellers are also succeeding at negotiating the inclusion of limiting payments of buyer claims through the use of “deductible baskets.” Under a deductible basket, which is considered a seller-friendly term, the buyer receives payment for only those claims above the negotiated threshold; the threshold thus operates as a “deductible.” From the seller’s point of view, a deductible basket prevents the buyer from “nickel-anddiming” the seller for every insignificant breach. In 2016, the use of deductible baskets jumped to 42 percent, up from 30 percent the previous year.
Number of RWI Policies Number of RWI Policies 350
300 250
200
150
100
50
0 2013
2014
2015
2016
Source: Aon and Winston & Strawn
In addition to successfully pushing for the use of deductible baskets, sellers have also successfully negotiated increases in the average size of both deductible and tipping baskets. With a “tipping” or “first dollar” basket, the buyer receives payment for all claims, not just those in excess of the threshold, but only once the value of claims exceeds the threshold amount. In 2016, the average threshold for deductible baskets increased to 1.21 percent of the transaction value, up from 0.73 percent in 2015. During the same time period, the average threshold for tipping baskets increased to 0.70 percent from 0.64 percent. This combination means that buyers are receiving smaller payouts for indemnification claims while also needing to incur greater damages to be eligible for reimbursement. As sellers squeeze indemnification rights, buyers agreeing to deductible baskets have increasingly negotiated for the inclusion of a “double materiality” scrape. Materiality scrapes instruct the reader when to ignore materiality qualifiers found in the representations and warranties (e.g., for determining whether a breach has occurred, in the calculation of damages or in both instances). If the agreement instructs the reader to ignore materiality qualifiers
8
in both the determination of breach and for the calculation of damages, it is commonly referred to as a “double materiality scrape.” Buyers agreeing to a deductible basket often prefer inclusion of a double materiality scrape because, from its perspective, the seller already has protection from immaterial claims through the use of baskets, and it can eliminate postclosing disputes over what is and is not material. Our analysis indicates that agreements containing a double materiality scrape nearly doubled from 2015 to 2016 (increasing from 19 percent to 34 percent).
Baskets as a Percentage of Transaction Value Subset: 2015 & 2016 deals with baskets
Basket type
2015 Average
2016 Average
2015 Median
2016 Median
Deductible
0.74%
1.21%
0.71%
0.75%
First dollar
0.64%
0.70%
0.54%
0.54%
Source: SRS Acquiom, private target transactions (publicly reported and non-public).
“Materiality Scrape” Inclusion 2016 Deals 2016 Deals
Materiality qualifiers not Materiality disregarded qualifiers not 16% disregarded 16%
Materiality qualifiers Materiality disregarded qualifiers 84% disregarded 84%
For determining data breach only 20% For determining data breach only 20% For determining damages only 46% For determining damages only 46% For determining breach and damages 34% For determining breach and damages 34%
Materiality qualifiers Materiality disregarded qualifiers 84% disregarded 84%
For determining data breach only 23% For determining data breach only 23% For determining damages only 58% For determining damages only 58% For determining breach and damages 19% For determining breach and damages 19%
2015 Deals 2015 Deals
Materiality qualifiers not Materiality disregarded qualifiers not 16% disregarded 16%
Source: SRS Acquiom, private target transactions (publicly reported and non-public).
With increasing use of deductible baskets, coupled with rising basket thresholds, we expect buyers to continue to negotiate materiality scrapes or pursue other methods (e.g., representation and warranty insurance) that ensure they have recourse in the event of seller breaches.
Accuracy of Representations at Closing Becoming More Seller Friendly Another shift in favor of sellers is a rise in the inclusion of a material adverse effect (“MAE”) standard in the requirement that representations and warranties be accurate as of the closing date
© 2018 by The Bureau of National Affairs, Inc.
in order for the closing to occur. This provision is a closing condition often referred to as an “accuracy of representations” condition. The use of such MAE qualifications jumped 12 percent to 43 percent in 2016 (compared to 31 percent in 2015 agreements). The change is significant. We are unaware of any court that has found that a buyer has established an MAE, essentially prohibiting the buyer from walking away from the transaction even if the seller’s representations and warranties are inaccurate.7
9
Accuracy: Materiality (2015/2016 deals) 9%
9%
11%
5%
11%
5%
63%
63%
64%
52%
64%
52%
With 5%the increased use of MAE in this closing condition, buyers are responding by seeking the inclusion of a sandbagging provision. Sandbagging provisions permit buyers to seek post-closing indemnifications for 52% breaches that it was aware of at or prior to closing. In 2016, pro-sandbagging provisions appeared in 58 percent of the agreements analyzed, up from 52 percent the prior year.
5%
52%
Buyers seeking sandbagging provisions would likely argue that if they are being 28% 37% 31% 43% to close their transaction despite forced known seller breaches, that decision should not prejudice their right to seek post28% 37% 31% 43% closing indemnification for those breaches. 2015 2016 2015 2016 not familiar with M&A agreements At signing At signing At closingThose At closing may consider sandbagging provisions a 2015 2016 2015 2016 MAE “gotcha” game in which buyers knowingly At signing At signing At closing At closing “In all material respects” bait sellers into breaches and then elect to “In all respects” MAE close over them so as to clawback a portion “In all material respects” of the purchase price. However, until courts Year-Over-Year Trend Source: private target transactions (publicly reported and non-public). “InSRS allAcquiom, respects” change their views on what constitutes an MAE, sandbagging provisions may be the Year-Over-Year Trend only effective method for buyers to counter Year-Over-Year Trend the inclusion of an MAE in the accuracy of representations closing condition. 54%
54%
1%
1%
1%
52%
1%
3% 0%
3% 0%
45%
47%
45%
2014
42%
42%
2013 2013
45%
47%
45%
2015
Pro-sandbagging provision included
2014
2015
Pro-sandbagging provision included 2016
Anti-sandbagging provision included Silent
Anti-sandbagging provision included Source: SRS Acquiom, private target transactions (publicly reported and non-public). Silent
10
58%
58%
52%
52%
52%
2016
Conclusion Our analysis has shown that sellers have succeeded in leveraging a favorable market environment to push certain terms in their favor. In other words, perception is, to some extent, reality. However, M&A negotiations have not become one-sided, and buyers still exercise significant power. For each shift in sellers’ favor, buyers have pushed back, with some effect. Unless general market trends change, we would expect sellers and buyers to engage in a continuing game of whack-a-mole, with buyers continuing to search for ways to limit sellerfavorable provisions as they pop up.
About the authors Sean Arend is Managing Director, Corporate Development and General Counsel, for SRS Acquiom. He manages all company legal, risk, and compliance matters and assists with strategic alliances and early stage product development. Prior to SRS Acquiom, Sean served as General Counsel in a venture-backed technology company, Senior Counsel in an industry-leading public company, and an attorney at Cooley LLP. Andrew Hubley is a Senior Legal Editor at Bloomberg Law focused on M&A and private equity. Prior to Bloomberg Law, Andrew was a Corporate Associate with an Am Law 100 law firm. Prior to practicing law, Andrew was a strategy consultant advising Fortune 500 clients on business and strategic decisions.
See William Blair, Merger Tracker – Q1 2017 (noting that sellers are seeking to take advantage of the seller-friendly M&A market by accelerating the sale process); see also, Oliver Brahmst & Carolyn J. Vardi, Private Equity Adapts in a Seller’s Market, White & Case Jul. 31, 2017 (noting that “PE firms are under pressure to deploy capital in a market that has favored sellers in recent years”); Gibson Dunn, M&A Report – How Representations and Warranties Insurance is Transforming Risk Allocation in M&A transactions, Nov. 27, 2017 (stating that buyers are relying on rep & warranty insurance more frequently due to, among other things, “an increasingly competitive, sellerfriendly deal climate . . .”). 2 SRS Acquiom maintains a proprietary database of M&A agreements, most of which are not publicly available. The database includes statistics on drafting points for selected provisions in the agreements. As part of our analysis, we analyzed drafting trends in the 795 M&A agreements included in the SRS Acquiom database for deals occurring between 2013 and 2016. 3 We reviewed data concerning the approximately 42,561 M&A deals announced between January 2013 and October 2017, valued at less than $1 billion U.S., involving a U.S. private target company and contained in the Bloomberg Law Deal Analytics database. 1
© 2018 by The Bureau of National Affairs, Inc.
See, e.g., How to Navigate and be Successful During the Investment Banker-Led Auction Process, Pepper Hamilton LLP (Nov. 3, 2017), http://www.pepperlaw.com/ podcasts/how-to-navigate-and-be-successful-during-the-investment-banker-led-auctionprocess-2017-11-03/. 5 Powers v. Stanley Black & Decker, Inc., 137 F. Supp. 3d (S.D.N.Y. 2015) (“Where, as here, a party purchased a company on the basis of inaccurate warranties, the injured party is normally entitled to the benefit of its bargain . . . That is sensible because general damages include those damages that are the natural and probable consequence of the breach. Therefore, where the seller makes representations about the business he is selling, the natural and probable result is that the business is actually worth less than the buyer paid, and diminution in value damages therefore compensate the buyer for the value of the promised performance.”). 6 See, Oscar A. David, et al., The Real Deal Webinar Series: Negotiating Favorable Representation and Warranty Insurance Policies – Lessons Learned from Litigating Claims at *5, WINSTON & STRAWN LLP, (May 11, 2017), https://www.winston.com/images/ content/1/2/v2/123093/Real-Deal-Webinar-5.11.17.pdf (listing market statistics from Aon for the years of 2013 through 2016). 7 Although we are unaware of any cases finding an MAE, it is possible (and indeed likely) that buyers have used seller breaches that may rise to the level of an MAE to negotiate favorable revisions to the agreement in lieu of seeking litigation. 4
11
© 2018 The Bureau of National Affairs, Inc. 0118-JO25009 04-1363
M&A Negotiating Trends: M&A Buyers Respond to SellerFriendly Market By: Sean Arend and Andrew Hubley
M&A Negotiating Trends: M&A Buyers Respond to Seller-Friendly Market By: Sean Arend and Andrew Hubley Over the past few years, several practitioners and banks have observed that the mergers and acquisitions (M&A) market in the United States favors the seller.1 To evaluate how buyers are reacting to this trend, we analyzed deal terms contained in 795 private-target M&A agreements concluded between 2013 and 2016 and included in the SRS Acquiom “MarketStandard” database.2 Additionally, we analyzed data concerning approximately 42,600 private-target M&A deals contained in the Bloomberg Law® Deal Analytics database to understand general market trends and provide context for our review of the substantive deal terms.3 Our main goal was to determine how certain terms in M&A agreements have shifted in recent periods and to offer context for why the changes may have been occurring.
2
June 2017
2017 SRS Acquiom M&A Deal Terms Study An analysis of deal terms in private-target M&A transactions that closed between 2013–2016
POWERED BY
© 2017 SRS Acquiom Inc. All rights reserved.
/
Our analysis identified shifts in a number of deal terms to a more seller-friendly formulation. These shifts coincided with market trends that have generally favored sellers, suggesting that sellers exercised greater leverage in negotiations. However, our analysis also showed that buyers are devising creative provisions that limit or curb the effects of seller-friendly terms. In this article, we first discuss factors that may have contributed to the rise of more seller-friendly terms. We then review five M&A terms that have become more seller-friendly during the past several years, and we identify the tactics buyers have used to limit or curb the increasingly seller-friendly terms.
initial document drafting, the auction gives a seller a stronger negotiating position, from which it can focus on ensuring potential buyers do not modify terms that it considers critical to the deal. Additionally, auctions facilitate competition, as the seller’s financial advisers often identify several interested parties to bid against one another in competition for the target company. The presence of more than one bidder may mean that the seller can retain its control over the bidding process beyond the initial bids and can play bidders off of one another in negotiations. This leverage may permit a seller to extract additional submissions and drive deal terms that favor its interests in ways that are not typically possible in a one-on-one negotiated sale. Another factor contributing to sellers’ market strength is the increasing number of private buyers, both private companies and private equity funds, participating in the M&A market. According to Bloomberg Law data, the percentage of private buyers, including private equity buyers, jumped from 53.4 percent in 2014 to 64.5 percent of buyers in 2017.
Private Deals as % of Total Deals
Private Deals as % of Total Deals
14000
70 63.1
12000
More Auction Sales and Private Buyers Mean More Seller-Friendly Terms The shift toward more seller-friendly terms is likely due to several factors, including the increased use of auctions to market and sell target companies and an increase in the numbers of private buyers participating in the market. Recently, sellers have increasingly relied on auctions, rather than negotiated sales, to market target companies to buyers.4 In an auction, the seller typically dictates the initial sale terms. For example, an auctioning seller typically prepares the initial draft of the purchase agreement, while in a negotiated sale the buyer typically prepares the first draft of the sale agreement. By controlling the process and
© 2018 by The Bureau of National Affairs, Inc.
53.4
64.5
60
54.5
10000
50
8000
40
6000
30
4000
20
2000
10
0
0 2014
2015 Total Deals
2016
2017
% Private Acquirers
Source: Bloomberg Law
The larger number of private buyers has changed the personality of the M&A market. Large public companies often have significant financial resources and market
3
power that provide leverage in negotiations that private companies or private equity funds may lack. Conversely, private buyers may be more attractive than public buyers, since they may be more amenable to accepting seller-friendly terms. In addition, private buyers – and particularly private equity buyers – are more likely to maintain a post-closing relationship with sellers. In fact, private buyers often rely on the seller or the target’s existing management to continue operating the business after the sale or, at a minimum, to assist with an extended transition. As a result, a private buyer may be incentivized to ensure that the sellers do not feel taken advantage of during negotiations. Comparatively, large public buyers are more likely to have the resources and experience to conduct post-closing integration without assistance from the seller or pre-closing target management.
Additionally, our analysis of SRS Acquiom data showed that the median multiple of return on investment (transaction values as multiples of total equity capital invested in the target company) was higher for 2016 deals at 4.6x, compared to 3.9x and 3.7x in 2015 and 2013, respectively, also implying higher valuations.
Average Deal Size Average Deal Size $120.00 $118.04
$118.00 $116.03
$116.00
$114.00
$112.00
$110.0
$110.00
Lastly, in order to compete with public strategic buyers, private equity buyers have increasingly used representation and warranty insurance (discussed below in the section entitled Limiting the Duration of Escrows) to sweeten the deal for sellers. By insuring a portion of the liabilities that may result from the sale, buyers limit their post-closing exposure extra-contractually and therefore do not need the same range of protections in the contract itself. This risk-shifting is important for private equity buyers. They typically must generate post-closing returns within a limited time frame, and unexpected post-closing liabilities may affect the ability to deliver post-closing returns to investors.
Average Deal Size on the Rise (but Limitation of Potential Damages) Purchase price is possibly the most critical negotiating point for most M&A transactions. If the market and negotiating leverage are shifting in a more sellerfavorable direction, one would expect average deal values to rise. Our analysis tends to confirm that prediction. According to Bloomberg Law data, between 2015 and 2017, average deal size has grown over 4 percent. This jump is a sign that sellers may be negotiating higher deal prices than they were a few years ago.
4
$108.00 2015
2016
2017
Source: Bloomberg Law
Median Multiple of Return
Year
2013
2015
2016
Median Multiple of Return
3.7x
3.9x
4.6x
Note: 2014 data is unavailable. Prior to 2015, this data was compiled on a biannual basis. Source: SRS Acquiom, private target transactions (publicly reported and non-public).
Several market factors may have facilitated the rise in average deal size and valuations, including: (1) the relative ease of obtaining financing for M&A deals; (2) the increased competitiveness of the M&A market; and (3) the participation of more private equity buyers, which tend to offer higher prices to compete with public strategic buyers in certain market segments. Although buyers have been willing and able to pay higher prices, they are increasingly negotiating for the express allowance of so-called “diminution in value” damages in M&A agreements. Diminution in
value damages provide the buyer a right to claim damages if a seller’s misrepresentation led the buyer to negotiate a different purchase price than it would have otherwise. In 2016, express inclusion of diminution in value damages increased to 23 percent, up from 18 percent the year before. Additionally, the express exclusion of such damages declined to 10 percent in 2016, down from 12 percent in 2015. The rise in the express inclusion of such damages is notable given that a New York federal court recently found that diminution in value damages are general in nature and therefore must be expressly excluded for a seller to avoid liability.5 Taken together, these two trends – the increase in average deal size and the inclusion of provisions expressly granting buyers the right to diminution in value damages – show that while sellers have been successful at obtaining higher prices, buyers are responding by seeking assurances that they are receiving the benefit of their bargain.
Increased Seller Negotiation of Earnout Parameters Earnouts are generally buyer-friendly provisions. They make payment of a portion of the purchase price contingent upon the achievement of postclosing financial milestones. Typically, parties actively negotiate the specific milestones (e.g., revenue or income level targets) and standards for operating the business, and they often prove to be significant points of contention. Sellers worry that the buyer may intentionally operate the target business in a manner that causes the target to miss the milestones in order to avoid paying an earnout.
business were essentially nonexistent in our analysis of 2015 deals, appearing in just 5 percent of agreements. In 2016, the number of agreements containing such covenants jumped to 20 percent. This is a win for sellers that agree to earnouts, as it provides some comfort that the full purchase price will eventually be paid. One reason for the jump in the post-closing operation covenants may relate to the larger number of private equity buyers currently in the market. After closing, private equity buyers typically do not combine the target business with a pre-existing business. In contrast, public and private strategic buyers combine the target’s operations with their existing business, eliminating redundancies and duplicative roles, which allows them to reduce overall costs while growing revenue. Thus, private equity buyers may be more likely to agree to such a covenant, as they do not face the same integration issues that strategic acquirers often face. A major concern for buyers regarding the earnout provision is that a buyer may be obligated to make earnout payments while simultaneously being forced to engage in arbitration or litigation to recover for a seller’s breach. To address this mismatch, buyers have increasingly sought to offset any outstanding indemnity claims against amounts due under an earnout. In 2016, the use of these offsetting provisions jumped over 10 percent from the previous year, appearing in 88 percent of agreements in 2016 compared with 76 percent in 2015. With the jump in covenants limiting the buyer’s post-closing operation of the business and the tightening of escrow terms (discussed below), it is likely that buyers will continue to push for such offsetting provisions in the future.
Sellers appear to have taken a two-pronged approach to addressing their concerns. First, they have had some success at excluding this obligation altogether: earnouts appeared in 20 percent of deals in 2016 compared with 23 percent during the prior year. Additionally, sellers have increasingly negotiated covenants to ensure that the buyer does not try to avoid making earnout payments. This type of covenant might obligate the buyer to operate the business consistently with the seller’s past practice or it might require the buyer to operate the business so as to maximize the earnout payments, for example. Buyers’ covenants regarding operation of the post-closing
© 2018 by The Bureau of National Affairs, Inc.
5
Earnouts (Non-Life Sciences Deals*): Covenants, Acceleration, and Offsets Subset: 2015 & 2016 deals with earnouts, excluding life sciences deals
Subset: 2015 & 2016 deals with earnouts, excluding life sciences deals
8% 18% 100%
84%
95%
80%
76%
80%
6%
16%
76%
5%
24%
20%
2015
2016
Covenant to run business in accordance with seller’s past practices
4%
2015
2016
Covenant to run business to maximize earnout payments
88%
20%
2015
2016
Earnout accelerates (fully or partially) on change in control of earnout assets
2015
2016
Buyer can offset indemnity claims against future earnout payments
Included
Express yes
Not included
Express no
Silent
* For a more detailed analysis of SRS Acquiom’s life sciences deals, please see the 2016 SRS Acquiom Life Sciences M&A Update. ** Generally subject to exceptions, such as if the subsequent buyer assumes the earnout obligations. Source: SRS Acquiom, private target transactions (publicly reported and non-public).
Limiting the Duration of Escrows Unlike earnout provisions, escrow provisions are included in most M&A agreements, appearing in 86 percent of 2016 agreements. Sellers are increasingly focused on reducing the time that funds are held in escrow. Our analysis showed that the median duration for general escrows declined from 18 months in 2014 and 2015 to 16 months in 2016. Of course, the seller
6
is without full benefit of the consideration for as long as the purchase price remains in escrow. This decline is also significant because the longer funds remain in escrow, the more likely they may be used to satisfy indemnification claims. In addition to being able to reduce escrow durations, sellers have also been able to avoid an increase in the size of escrows. Over the past four years, the median size of general escrows has remained flat at roughly 10 percent.
Subset: Deals with escrows/holdbacks and/or expense funds Median indemnification escrow/holdback size
Median post-closing expense fund recently, however, buyers appear willing tosize* give some ground when negotiating general escrows. Two major 0.35% factors have contributed to this trend: (i) the increase in0.30% specialty escrows; and (ii) an increase in the use of representation and warranty insurance.
14%
12% 10.0
10.0
10.0
0.25%
10.0
10%
0.25%
0.23%
0.22% The use of 0.20% a specialty, or separate, escrow for purchase price adjustments jumped to 39 percent in 2016, up 0.20% from only 27 percent the previous year. This trend 0,15% indicates that while buyers may be willing to give ground on terms relating to general indemnification 0,10% escrows, they still seek protection for areas of special concern (e.g., purchase price adjustments).
8%
6%
4%
2%
0.05%
0% 2013
2014
2015
2016
As % of transaction value
Source: SRS Acquiom, private target transactions (publicly reported and non-public).
Many buyers consider escrows important because they provide protection against the risk that they are dealing with sellers that may not have the funds available to indemnify the buyer if a breach occurred. More
The second key factor impacting escrow negotiations 0% is the rise of representation insurance. 2013 2014 and warranty 2015 2016 According to data from insurer, value the number of As one % of transaction representation and warranty policies underwritten *Funds established at closing to fund post-closing between 2013 and 2016 jumped over 200expenses. percent.6 If this trend continues, we may see the size and duration of general indemnification escrows continue to decline. In fact, there has already been a significant impact: some M&A parties skip a general indemnity escrow, and the buyer instead relies on the insurance policy as its sole recourse.
Post-Closing Purchase Price Adjustments: Thresholds and Separate Escrows Subset: 2015 & 2016 deals with post-closing purchase price adjustments in the consideration mechanics section of the acquisition agreement (as opposed to the indemnification section only)
Adjustment only if threshold exceeded Yes 13%
Inner circle = 2015 Outer circle = 2016
Source of payment if buyer-favorable adjustment 2016
Separate escrow 39%
Yes 13%
Payment not from indemnity escrow 7% No separate escrow 61%
Payment from indemnity escrow 93%
No 87%
2015 No 87%
Separate escrow 27%
Generally, payment out-of-pocket from securityholders.
Payment not from indemnity escrow 7% No separate escrow 73%
Payment from indemnity escrow 93%
Source: SRS Acquiom, private target transactions (publicly reported and non-public).
© 2018 by The Bureau of National Affairs, Inc.
7
Increase in Deductible Baskets but More Limitations on Material Breaches Sellers are also succeeding at negotiating the inclusion of limiting payments of buyer claims through the use of “deductible baskets.” Under a deductible basket, which is considered a seller-friendly term, the buyer receives payment for only those claims above the negotiated threshold; the threshold thus operates as a “deductible.” From the seller’s point of view, a deductible basket prevents the buyer from “nickel-anddiming” the seller for every insignificant breach. In 2016, the use of deductible baskets jumped to 42 percent, up from 30 percent the previous year.
Number of RWI Policies Number of RWI Policies 350
300 250
200
150
100
50
0 2013
2014
2015
2016
Source: Aon and Winston & Strawn
In addition to successfully pushing for the use of deductible baskets, sellers have also successfully negotiated increases in the average size of both deductible and tipping baskets. With a “tipping” or “first dollar” basket, the buyer receives payment for all claims, not just those in excess of the threshold, but only once the value of claims exceeds the threshold amount. In 2016, the average threshold for deductible baskets increased to 1.21 percent of the transaction value, up from 0.73 percent in 2015. During the same time period, the average threshold for tipping baskets increased to 0.70 percent from 0.64 percent. This combination means that buyers are receiving smaller payouts for indemnification claims while also needing to incur greater damages to be eligible for reimbursement. As sellers squeeze indemnification rights, buyers agreeing to deductible baskets have increasingly negotiated for the inclusion of a “double materiality” scrape. Materiality scrapes instruct the reader when to ignore materiality qualifiers found in the representations and warranties (e.g., for determining whether a breach has occurred, in the calculation of damages or in both instances). If the agreement instructs the reader to ignore materiality qualifiers
8
in both the determination of breach and for the calculation of damages, it is commonly referred to as a “double materiality scrape.” Buyers agreeing to a deductible basket often prefer inclusion of a double materiality scrape because, from its perspective, the seller already has protection from immaterial claims through the use of baskets, and it can eliminate postclosing disputes over what is and is not material. Our analysis indicates that agreements containing a double materiality scrape nearly doubled from 2015 to 2016 (increasing from 19 percent to 34 percent).
Baskets as a Percentage of Transaction Value Subset: 2015 & 2016 deals with baskets
Basket type
2015 Average
2016 Average
2015 Median
2016 Median
Deductible
0.74%
1.21%
0.71%
0.75%
First dollar
0.64%
0.70%
0.54%
0.54%
Source: SRS Acquiom, private target transactions (publicly reported and non-public).
“Materiality Scrape” Inclusion 2016 Deals 2016 Deals
Materiality qualifiers not Materiality disregarded qualifiers not 16% disregarded 16%
Materiality qualifiers Materiality disregarded qualifiers 84% disregarded 84%
For determining data breach only 20% For determining data breach only 20% For determining damages only 46% For determining damages only 46% For determining breach and damages 34% For determining breach and damages 34%
Materiality qualifiers Materiality disregarded qualifiers 84% disregarded 84%
For determining data breach only 23% For determining data breach only 23% For determining damages only 58% For determining damages only 58% For determining breach and damages 19% For determining breach and damages 19%
2015 Deals 2015 Deals
Materiality qualifiers not Materiality disregarded qualifiers not 16% disregarded 16%
Source: SRS Acquiom, private target transactions (publicly reported and non-public).
With increasing use of deductible baskets, coupled with rising basket thresholds, we expect buyers to continue to negotiate materiality scrapes or pursue other methods (e.g., representation and warranty insurance) that ensure they have recourse in the event of seller breaches.
Accuracy of Representations at Closing Becoming More Seller Friendly Another shift in favor of sellers is a rise in the inclusion of a material adverse effect (“MAE”) standard in the requirement that representations and warranties be accurate as of the closing date
© 2018 by The Bureau of National Affairs, Inc.
in order for the closing to occur. This provision is a closing condition often referred to as an “accuracy of representations” condition. The use of such MAE qualifications jumped 12 percent to 43 percent in 2016 (compared to 31 percent in 2015 agreements). The change is significant. We are unaware of any court that has found that a buyer has established an MAE, essentially prohibiting the buyer from walking away from the transaction even if the seller’s representations and warranties are inaccurate.7
9
Accuracy: Materiality (2015/2016 deals) 9%
9%
11%
5%
11%
5%
63%
63%
64%
52%
64%
52%
With 5%the increased use of MAE in this closing condition, buyers are responding by seeking the inclusion of a sandbagging provision. Sandbagging provisions permit buyers to seek post-closing indemnifications for 52% breaches that it was aware of at or prior to closing. In 2016, pro-sandbagging provisions appeared in 58 percent of the agreements analyzed, up from 52 percent the prior year.
5%
52%
Buyers seeking sandbagging provisions would likely argue that if they are being 28% 37% 31% 43% to close their transaction despite forced known seller breaches, that decision should not prejudice their right to seek post28% 37% 31% 43% closing indemnification for those breaches. 2015 2016 2015 2016 not familiar with M&A agreements At signing At signing At closingThose At closing may consider sandbagging provisions a 2015 2016 2015 2016 MAE “gotcha” game in which buyers knowingly At signing At signing At closing At closing “In all material respects” bait sellers into breaches and then elect to “In all respects” MAE close over them so as to clawback a portion “In all material respects” of the purchase price. However, until courts Year-Over-Year Trend Source: private target transactions (publicly reported and non-public). “InSRS allAcquiom, respects” change their views on what constitutes an MAE, sandbagging provisions may be the Year-Over-Year Trend only effective method for buyers to counter Year-Over-Year Trend the inclusion of an MAE in the accuracy of representations closing condition. 54%
54%
1%
1%
1%
52%
1%
3% 0%
3% 0%
45%
47%
45%
2014
42%
42%
2013 2013
45%
47%
45%
2015
Pro-sandbagging provision included
2014
2015
Pro-sandbagging provision included 2016
Anti-sandbagging provision included Silent
Anti-sandbagging provision included Source: SRS Acquiom, private target transactions (publicly reported and non-public). Silent
10
58%
58%
52%
52%
52%
2016
Conclusion Our analysis has shown that sellers have succeeded in leveraging a favorable market environment to push certain terms in their favor. In other words, perception is, to some extent, reality. However, M&A negotiations have not become one-sided, and buyers still exercise significant power. For each shift in sellers’ favor, buyers have pushed back, with some effect. Unless general market trends change, we would expect sellers and buyers to engage in a continuing game of whack-a-mole, with buyers continuing to search for ways to limit sellerfavorable provisions as they pop up.
About the authors Sean Arend is Managing Director, Corporate Development and General Counsel, for SRS Acquiom. He manages all company legal, risk, and compliance matters and assists with strategic alliances and early stage product development. Prior to SRS Acquiom, Sean served as General Counsel in a venture-backed technology company, Senior Counsel in an industry-leading public company, and an attorney at Cooley LLP. Andrew Hubley is a Senior Legal Editor at Bloomberg Law focused on M&A and private equity. Prior to Bloomberg Law, Andrew was a Corporate Associate with an Am Law 100 law firm. Prior to practicing law, Andrew was a strategy consultant advising Fortune 500 clients on business and strategic decisions.
See William Blair, Merger Tracker – Q1 2017 (noting that sellers are seeking to take advantage of the seller-friendly M&A market by accelerating the sale process); see also, Oliver Brahmst & Carolyn J. Vardi, Private Equity Adapts in a Seller’s Market, White & Case Jul. 31, 2017 (noting that “PE firms are under pressure to deploy capital in a market that has favored sellers in recent years”); Gibson Dunn, M&A Report – How Representations and Warranties Insurance is Transforming Risk Allocation in M&A transactions, Nov. 27, 2017 (stating that buyers are relying on rep & warranty insurance more frequently due to, among other things, “an increasingly competitive, sellerfriendly deal climate . . .”). 2 SRS Acquiom maintains a proprietary database of M&A agreements, most of which are not publicly available. The database includes statistics on drafting points for selected provisions in the agreements. As part of our analysis, we analyzed drafting trends in the 795 M&A agreements included in the SRS Acquiom database for deals occurring between 2013 and 2016. 3 We reviewed data concerning the approximately 42,561 M&A deals announced between January 2013 and October 2017, valued at less than $1 billion U.S., involving a U.S. private target company and contained in the Bloomberg Law Deal Analytics database. 1
© 2018 by The Bureau of National Affairs, Inc.
See, e.g., How to Navigate and be Successful During the Investment Banker-Led Auction Process, Pepper Hamilton LLP (Nov. 3, 2017), http://www.pepperlaw.com/ podcasts/how-to-navigate-and-be-successful-during-the-investment-banker-led-auctionprocess-2017-11-03/. 5 Powers v. Stanley Black & Decker, Inc., 137 F. Supp. 3d (S.D.N.Y. 2015) (“Where, as here, a party purchased a company on the basis of inaccurate warranties, the injured party is normally entitled to the benefit of its bargain . . . That is sensible because general damages include those damages that are the natural and probable consequence of the breach. Therefore, where the seller makes representations about the business he is selling, the natural and probable result is that the business is actually worth less than the buyer paid, and diminution in value damages therefore compensate the buyer for the value of the promised performance.”). 6 See, Oscar A. David, et al., The Real Deal Webinar Series: Negotiating Favorable Representation and Warranty Insurance Policies – Lessons Learned from Litigating Claims at *5, WINSTON & STRAWN LLP, (May 11, 2017), https://www.winston.com/images/ content/1/2/v2/123093/Real-Deal-Webinar-5.11.17.pdf (listing market statistics from Aon for the years of 2013 through 2016). 7 Although we are unaware of any cases finding an MAE, it is possible (and indeed likely) that buyers have used seller breaches that may rise to the level of an MAE to negotiate favorable revisions to the agreement in lieu of seeking litigation. 4
11
© 2018 The Bureau of National Affairs, Inc. 0118-JO25009 04-1363
