M&A Buyer Protection Provisions Beyond Indemnification for Breaches of Representations and Warranties

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A M&A Buyer Protection Provisions Beyond Indemnification for Breaches of Representations and Warranties Minimizing Buyer's Risk with Provisions Including Purchase Price Adjustments, Contingent Payments, Accounts Receivable Repurchase, Inventory Audit, Retained Liabilities and more THURSDAY, MAY 31, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: David J. Mack, Attorney, Dorsey & Whitney, New York John Marsalek, Partner, Dorsey & Whitney, Minneapolis Eric Rauch, Partner, Dorsey & Whitney, Minneapolis The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1.

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5 Buyer Protection Provisions in M&A Agreements John Marsalek Eric Rauch David Mack

6 Outline I. Purchase Price Adjustments II. Key Clauses A. Accounts Receivable Repurchase B. Setoff Rights III. Earnouts IV. Excluded Liabilities 6

7 I. Purchase Price Adjustments 1. Deals with Purchase Price Adjustments 2. Working Capital 3. Working Capital Mechanics 4. PPA & Indemnification Comparison 5. Alliant Techsystems Inc. v. MidOcean Bushnell Holdings LP 6. Chicago Bridge v. Westinghouse 7

8 I. Purchase Price Adjustments 1. Deals with Purchase Price Adjustments (PPA) Adjust for working capital changes in the target s value between signing and closing Adjustment seeks to prevent: - Seller from shortchanging Buyer - Buyer from receiving a windfall 86% of deals have a PPA mechanism* 89% of those deals have an adjustment for Working Capital* * Per 2017 ABA Deal Point Study (Private Deals) 8

9 I. Purchase Price Adjustments 2. Working Capital Working Capital (WC) = Current Assets Current Liabilities What is included in Working Capital? What accounting principles should be used when calculating the adjustment? - GAAP - Company s historical practices 9

10 I. Purchase Price Adjustments 3. Working Capital Mechanics Parties agree on target WC Before Closing, Seller prepares estimate of WC Following Closing, Buyer prepares final WC Seller reviews Buyer s calculation of final WC Independent Accountant resolves disputes 10

11 I. Purchase Price Adjustments 4. PPA & Indemnification Comparison PPA Indemnification Subject Matter Time Frame (following closing) Assets & Liabilities (potentially others such as debt and transaction exp.) Reps & Covenants days months Limitations Usually none Deductible & Cap Dispute Resolution Independent Accountant Court or Arbitration 11

12 I. Purchase Price Adjustments 5. Alliant Techsystems, Inc. v. MidOcean Bushnell Holdings, L.P. (Del. 2015) ATK purchased Bushnell in a stock deal for $985M, subject to post-closing PPA Post-closing, ATK argued that Seller s calculation of WC was not calculated in accordance with GAAP Dispute over approximately $22M Seller refuses to submit the disputed items to the accounting firm ATK sues, claiming that SPA required PPA disputes to be submitted to an independent accounting firm 12

13 I. Purchase Price Adjustments Seller argues: Claim based on whether certain items accounted for in accordance with GAAP so it is really about a breach of financial statement rep. Indemnification sole and exclusive remedy for those claims But if PPA used, accounting firm to determine whether WC calculations are correct based on accounting principles used by Seller in preparing its financial statements (which buyer ignored) Buyer responds: Requirement is compliance with GAAP and that falls within PPA procedure so within scope of independent accountant s review Exclusive Remedy provision gave priority to PPA procedure 13

14 I. Purchase Price Adjustments PPA Indemnification Dispute Resolution Accounting Firm Courts Deductible No Yes Cap $12.3M + Escrow $7.3M (Escrow) Seller: Indemnification Deductible & Lower Cap Buyer: PPA procedure No Deductible & Higher Cap 14

15 I. Purchase Price Adjustments Which Procedure Governs? Purchase Agreement Exclusive Remedy provision: Provided that the indemnification provisions are the sole and exclusive remedy, but nothing in this sentence shall operate to interfere with or impede the operation of the provisions of Section 2.4 [Purchase Price Adjustment section] Court: Where a dispute could be brought either as a PPA or indemnification claim, and the purchase agreement specifically provides for an exclusive remedy in the PPA procedure, then the PPA procedure trumps the exclusive remedy provision for indemnification claims. 15

16 I. Purchase Price Adjustments WC: GAAP or Historical Practices? Purchase Agreement: Working Capital to be calculated in accordance with GAAP and otherwise in a manner consistent with the practice and methodologies used in the preparation of certain financial statements of target Court: Had the parties intended to proscribe the Buyer from challenging Seller s GAAP compliance in the WC calculation, then they should have said so in the Agreement 16

17 I. Purchase Price Adjustments 6. Chicago Bridge & Iron Company N.V. v. Westinghouse Company LLC, No. 573, 2016 (Supr. Ct., June 27, 2017) CB&I Stone & Webster, Inc. ( Stone ), a subsidiary of Chicago Bridge, and Westinghouse had been working together on the construction of nuclear power plants Disputes arose and to resolve them, Chicago Bridge agreed to sell Stone to Westinghouse Transaction was unusual in a few respects: Purchase Price was $0, but subject to an adjustment Westinghouse s sole remedy for a breach of rep was to not close the transaction Chicago Bridge would have no liability for monetary damages post-closing (the Liability Bar ) 17

18 I. Purchase Price Adjustments Target Working Capital = $1.174 billion Chicago Bridge estimated WC = $1.6 billion Estimate had to be prepared and determined from the books and records of the Company and its Subsidiaries and in accordance with [GAAP] applied on a consistent basis throughout the periods indicated and with the Agreed Principles. The Agreed Principles provided: Working Capital... will be determined in a manner consistent with GAAP, consistently applied by [Stone] and based on the past practices and accounting principles, methodologies and policies applied by [Stone] in the Ordinary Course of Business... 18

19 I. Purchase Price Adjustments Following the Closing, Westinghouse delivered its calculation of WC: ($976.5M), i.e., negative $976.5M more than $2B less than the target of $1.174B! Not surprisingly a dispute arose Most of the discrepancies were the result of three changes that Westinghouse made to Chicago Bridge s calculations and applications of GAAP in its underlying financial statements that formed the basis for the agreement on a $1.174B target WC 19

20 I. Purchase Price Adjustments Chicago Bridge sought an order declaring that Westinghouse s claims over the WC amount were actually claims for breaches of Chicago Bridge s representations, which were extinguished under the purchase agreement following the closing Chicago Bridge argued that Westinghouse was circumventing the Liability Bar Chancery Court ruled in Westinghouse s favor: Purchase agreement was unambiguous that the financial statements were to be prepared in accordance with GAAP A dispute over GAAP compliance would rightly be brought to the independent accountant 20

21 I. Purchase Price Adjustments At the Delaware Supreme Court: Chicago Bridge argues: narrow interpretation of the true-up procedure changes in Stone s business during the period between signing and closing Westinghouse argues: process for resolving disagreements over the final purchase price was not limited to the working capital amount The fact that claims could also have been a breach of the financial statement representation is irrelevant 21

22 I. Purchase Price Adjustments Purpose of true-up is to account for changes in WC between signing and closing, and not to catch the seller for breaches of its representations regarding its compliance with GAAP Language did require the closing statement to comply with GAAP, but as applied on a consistent basis throughout the time period covered by the financial statements and based on Stone s past practices and accounting principles. This language did not create a standalone obligation that the financial statements comply with GAAP, but rather established a requirement of consistency Moreover, the approach to GAAP was set at what was already used by Chicago Bridge in the preparation of the financial statements of the Business As such, the true-up process was: not to aid Westinghouse s investigation of the business or to otherwise provide a historical picture of Stone s operations. Rather, they account for changes in Stone s business from the time when the Purchase Agreement was agreed on until the closing. 22

23 I. Purchase Price Adjustments Contrast this to the ATK case: In ATK, the true-up was to be calculated in accordance with GAAP and otherwise in a manner consistent with the practices and methodologies The phrase and otherwise created two separate tests, one of which was compliance with GAAP In Chicago Bridge, the GAAP test was qualified by a requirement of consistency with past practice, i.e., in accordance with [GAAP] applied on a consistent basis throughout the periods indicated 23

24 I. Purchase Price Adjustments Supreme Court states: The sum total of the logic of Westinghouse s claims is worth stating. Based on challenges to large items included in the financials that Chicago Bridge represented were GAAP compliant, which Westinghouse knew about before closing, and which it did not use as a basis not to close, Westinghouse now says that it should keep Stone, which it got for zero dollars, and be paid by Chicago Bridge over $2 billion for taking it! Delaware Supreme Court reversed the Chancery Court and required entry of a judgment on the pleadings for Chicago Bridge 24

25 I. Purchase Price Adjustments PPA Takeaways Narrow Interpretation Contractual language should not be generic Consider the components of working capital Consider deviations from GAAP & references to GAAP compliance Include an example computation? Scope of independent accountant s review 25

26 II. Key Clauses A. Accounts Receivable Repurchase B. Setoff Rights 26

27 II. Key Clauses A. Accounts Receivable Repurchase Sample Clauses: Buyer shall have the right, upon written notice to Seller at any time after 90 days following the Closing Date, to require Seller to repurchase for cash all of the accounts receivable on the books and records of Seller as of the Closing Date that have not been collected as of such notice date. To the extent Seller indemnifies any Buyer Indemnified Person with regard to any one or more Accounts Receivable, Buyer hereby agrees to assign all of its right, title and interest in and to such Accounts Receivable to Seller including all rights of recovery with regard to such Accounts Receivable. 27

28 II. Key Clauses A. Accounts Receivable Repurchase Variations - Types of accounts receivable to be repurchased - Timing of Buyer Notice Mechanics of Operation - Working Capital - Representation - Indemnification Effect on Customer Relationship 28

29 II. Key Clauses B. Setoff Rights Another Payment to Seller - Promissory Note - Contingent Payment or Earnout - Supply Agreement (or other commercial agreement) Mechanics of Operation - Additional Protection for Buyer 29

30 II. Key Clauses B. Setoff Rights - Sample Provision #1: Buyer shall have the right to offset from any Contingent Payment then due and payable to Seller for any indemnification claims for Losses pursuant to Article V of this Agreement. Also include: The offset rights of Buyer pursuant to this Section shall be in addition to any other rights of Buyer pursuant to this Agreement. 30

31 II. Key Clauses Beyond Indemnification and Escrows B. Setoff Rights - Sample Provision #2: Upon notice to Sellers Representative specifying in reasonable detail the basis thereof, Buyer may set off any amount to which it claims to be entitled from any Seller, including any amounts that may be owed under this Article or otherwise, against amount otherwise payable under the Promissory note or any provision of this Agreement. The exercise of such right of setoff by Buyer in good faith, whether or not ultimately determined to be justified, will not constitute a default under this Agreement, the Promissory Notes or any instrument securing any of the Promissory Notes, regardless of whether any Seller disputes such setoff claim or whether such setoff claim is for a contingent or an unliquidated amount. 31

32 II. Key Clauses Beyond Indemnification and Escrows B. Setoff Rights - Sample Provision #3: Buyer may offset any amounts to which it reasonably believes itself, in good faith, to be entitled under the terms of this Agreement against amounts otherwise payable by it under this Agreement; provided, however, that if the Securityholders Representative provides written notice to Buyer that the Securityholders Representative, in good faith, objects to the amount claimed by Buyer to be subject to any such exercise of offset rights, the amounts to which such objection notice relates shall be held in a separate account by Buyer pending resolution of such objection notice in accordance with the procedures set forth in Section 5.04 [Indemnification procedures]. 32

33 III. Earnouts 1. Overview of Earnouts 2. Benefits and Risks 3. Deals with Earnouts 4. Variations on Earnout Provisions 5. Operation of the Business 33

34 III. Earnouts 1. Overview of Earnouts Earnouts are financial mechanisms that potentially produce future payments to the seller, which are contingent upon the achievement of predefined financial or operating objectives following the closing Almost always used in addition to initial closing payments Earnout payments may consist of cash, stock, or other consideration agreeable to the seller 34

35 III. Earnouts 1. Overview of Earnouts The performance that will result in an earnout payment is typically based on the post-closing revenue, profits, sales or other performance metric of the acquired company or business Earnouts can have a single or multiple testing periods, and can provide for a single payout or multiple payments over time 35

36 III. Earnouts 1. Overview of Earnouts Earnouts can help to bridge the gap between differing valuations- providing upside to the Seller and protection against overpayment to the Buyer Can be very useful for transactions in volatile markets and with targets that have limited operational history 36

37 III. Earnouts 2. Benefits and Risks Benefits to Buyer Reduced risk of overpayment, as business will need to prove out before full value is transferred Buyer is deferring payment of part of the purchase price, requiring less cash up front Future earnout payment can sometimes be made in whole or in part from the target s own earnings Ensures seller/management stays motivated for future successful performance Can provide source for future indemnity enforcement 37

38 III. Earnouts 2. Benefits and Risks Benefits to Seller Increases probability of receiving full (or greater) value for the business being sold Could allow Seller to share in any post-closing growth 38

39 III. Earnouts 2. Benefits and Risks Risks to Buyer If milestones are achieved, the total purchase price may end up higher than if there was no earnout Separate operations for the earnout period (often needed to properly measure the earnout performance) can reduce potential cost savings and other possible synergies Operational restrictions (often required by Seller) can limit Buyer s achievement of long term objectives in favor of earnout achievement 39

40 III. Earnouts 2. Benefits and Risks Risks to Seller If milestones are not achieved, total purchase price may end up lower than could have been obtained with a fixed price Seller will likely have less authority/control over the post-closing operations and will be partly at the mercy of the Buyer to achieve the earnout goals 40

41 III. Earnouts 2. Benefits and Risks Overall Risks An earnout provision can be complicated to agree on and draft, adding time and cost to transaction overall Seller and Buyer have differing motivations (shortterm/long-term business performance) Significant potential for future disputes over milestone achievement, rights to operate the business and final determination of earnout payment 41

42 III. Earnouts 2. Benefits and Risks Valuation The parties can close a deal while maintaining a disagreement over the precise deal value an earnout reduces the risk that a Buyer overpays by requiring the business to prove out before full value is transferred Especially useful in instances where the target business has a seasonal aspect or is in market flux Can help in ensuring outcomes in the acquisition of service businesses, businesses with a limited number of key customers or where the Seller s future involvement will be needed for maximum success 42

43 III. Earnouts 3. Deals with Earnouts Earnouts are frequently used in life-science transactions (often pharma (71%) and medical device (68%) companies use earnouts based on clinical trials or government approvals) In non-life-science deals, earnouts are not frequently implemented (only 15% in deals from per SRS Acquiom) 43

44 III. Earnouts 3. Deals with Earnouts In the majority of transactions with earnouts, the primary testing metric is revenue (64% in 2016), followed by earnings/ebitda (24% in 2016) Between 2012 and 2016, the amount of the earnout as a percentage of the closing payment varied forma low of 25% to a high of 53% For deals in 2016, earnouts most commonly lasted for 1 to 2 years (34%), followed by 1 year or less (29%), 2 to 3 years (23%) and 3 to 5 years (14%) 44

45 III. Earnouts 3. Deals with Earnouts The vast majority (80% or more) of earnouts in 2016 had the following Buyer favorable terms: No obligation to run business consistent with Seller s past practice No obligation to maximize earnout payments No full or partial acceleration on change of control Express right to offset indemnity claims against future earnout payments 45

46 III. Earnouts 4. Variations on Earnout Provisions Earnouts should have easily determined testing metrics that can be audited by both Buyer and Seller Common testing metrics are: revenue, earnings, EBITDA (either cash flow or income), sales, profit (gross or net), occurrence of specific event (key customer renewal, government approval), or any variation or combination thereof 46

47 III. Earnouts 4. Variations on Earnout Provisions Metrics can be tested once or multiple times over the earnout period Payments can be made periodically with each testing instance (as Seller would prefer) or only upon the conclusion of the full earnout period A earnout test may incorporate hurdles, floors and ceilings, and can provide for pro-rata payments through an achievement range, or an all-or-nothing test 47

48 III. Earnouts 4. Variations on Earnout Provisions Earnouts can have a significant variety in levels of Seller insight or control over the post-close operations Buyers can agree to maintain an operational status quo, or be free to modify (or even close) the acquired business Earnout payments can be secured/guaranteed by the Buyer, the target or the subject assets 48

49 III. Earnouts 4. Variations on Earnout Provisions - Example Assume a two year earnout with two annual tests, with a total sales achievement metric: Annual payments may be made upon the achievement of each target, or one payment may be made at the end of the two years for the achievement of a single target (or only made if both targets are met an all-or-nothing scenario ) The two tests may be for the same or different sales targets, and if more than one payment, they can be for differing amounts for each test If one target is missed, but the other target is exceeded, the overage may be used to make up a deficiency The earnout payment amount(s) may be a flat amount, tiered for various sales numbers, or scaled pro-rata through a sales range 49

50 III. Earnouts 5. Operation of the Business As payment of an earnout depends on post-closing performance, the Seller generally wants to retain some control of the business during the earnout period If Seller management/shareholders will be part of the post-closing business, they may wish to be able to operate autonomously from Buyer during the earnout period If the Seller is not involved, they will look for restrictions on what actions the Buyer may take with the Business 50

51 III. Earnouts 5. Operation of the Business Frequent operational restrictions relate to: Operating the business consistent with past practice Hiring or firing key personnel Expanding or terminating the business overall or any business segment/market focus Terminating any key contracts, leases, customers or suppliers Overall, if the Seller is not directly in charge of operations, they will look to require the business to be run as it was the day of closing 51

52 III. Earnouts 5. Operation of the Business Buyer will want the ability to sacrifice short-term earnings for long-term goals, even at the cost of missing earnout targets Buyer will want to avoid being required to take actions to ensure a target is met or maximize an earnout payment Generally the parties can at least agree that the Buyer will not take any actions for the sole purpose of missing earnout targets or frustrating the earnout (such as deferring invoices on a collected revenue test) 52

53 III. Earnouts 5. Operation of the Business The acquired company or business line will often need to be segregated from Buyer s existing business in order to evaluate earnout achievements If this is not done, such as for a re-branding, to use economies of scale or correct overlapping contracts/employees, it will be more important to narrowly define earnout metrics that can be clearly determined despite the integration (such as revenue from a key customer of Seller) 53

54 III. Earnouts Overall, earnouts can be helpful to bridge a valuation gap, or to ensure a deal even if Buyer does not have sufficient current capital However, earnouts require significant detail, planning and agreements between Buyer and Seller on a number of detailed pre- and post-closing matters Earnouts can easily result in disputes, whether from the post-closing operation of the business to whether an earnout target was (or should have been) met 54

55 III. Excluded Liabilities 1. Overview of Excluded Liabilities 2. Interaction with Representations and Warranties 3. Indemnification 55

56 IV. Excluded Liabilities 1. Overview of Excluded Liabilities Excluded Liabilities are a defined set of liabilities of the target company that will not be transferred to the Buyer in the transaction Seller will be fully-responsible for satisfying any such liabilities, and the parties can agree on timelines or mechanics to ensure satisfaction/payment (including Buyer paying them on Seller s behalf, with appropriate set-off/recovery) 56

57 IV. Excluded Liabilities 1. Overview of Excluded Liabilities Excluded Liabilities are distinct from other forms of buyer protections, such as indemnification, as they operate not just between Buyer and Seller, but also limit Buyer s exposure to suits by third parties Note that it is possible for in some instances for successor liability to attach to Buyer, which may expose the Buyer to third party liability, although in such case the Seller would still be required to indemnify for any losses 57

58 IV. Excluded Liabilities 1. Overview of Excluded Liabilities Excluded Liabilities often cover all liabilities that are not covered in the list of expressly assumed Assumed Liabilities To protect the Buyer, the definition of Excluded Liabilities should also include an enumerated list of categories that will be the responsibility of Seller, with a clarification that when a liability could be argued to be both an Assumed Liability or an Excluded Liability, it will only be considered an Excluded Liability 58

59 IV. Excluded Liabilities 1. Overview of Excluded Liabilities For the greatest Buyer protection, the enumerated list of Excluded Liabilities should cover any liabilities arising from or relating to any event or occurrence first arising on or prior to the Closing (except to the extent explicitly constituting Assumed Liabilities), and liabilities arising from any Excluded Asset List should also include other items if appropriate in the transaction, such as transaction expenses of Seller, liabilities to Seller employees, directors or consultants, liabilities for indebtedness, taxes or contract breaches, or the failure of Seller to be compliant with law 59

60 IV. Excluded Liabilities 1. Overview of Excluded Liabilities - Example Excluded Liabilities include all Liabilities either: (A) arising from or relating to any Occurrence first arising on or prior to the Closing (except to the extent explicitly constituting Assumed Liabilities), or (B) arising from or relating to the following: (a) any Excluded Asset including any Employee Plan, (b) the employment or engagement by Seller or termination of employment or engagement by Seller any employee, consultant, independent contractor or other service provider, (c) Transaction Expenses, (d) any Liabilities to indemnify, reimburse or advance amounts to any present or former officer, director, employee or agent of Seller (including with respect to any breach of fiduciary obligations by same), (e) any Liabilities under any Excluded Contracts or any Acquired Contracts which are not validly and effectively assigned to Buyer pursuant to this Agreement, (f) any Liabilities associated with Indebtedness of Seller, (g) any Liabilities arising out of, in respect of or in connection with the failure by Seller to comply with any Law on or prior to the Closing Date, or (h) Taxes (1) relating to the Assets or the Assumed Liabilities with respect to a Tax period (or portion thereof) ending on or prior to the Closing Date (2) that arise out of the consummation of the transactions contemplated hereby or (3) of Seller, including Taxes that become a Liability of Buyer under any common law doctrine of de facto merger or transferee or successor liability or otherwise by operation of contract or Law. 60

61 IV. Excluded Liabilities 2. Interaction with Representations and Warranties To the extent the definition of Excluded Liabilities is comprehensive, it will effectively make most representations and warranties irrelevant (other than affirmative reps), as liabilities arising from breaches will likely also be covered as Excluded Liabilities For affirmative reps, such as representations that the assets are sufficient to operate the business, or as to top of the line financials, indemnification for rep breaches will still be the only recourse 61

62 IV. Excluded Liabilities 3. Indemnification In addition to standard indemnification coverage for breaches of representations, warranties and covenants, the purchase agreement should include a specific indemnification coverage for liabilities arising out of or relating to the Excluded Liabilities Claims for indemnification based on Excluded Liabilities should survive indefinitely 62

63 IV. Excluded Liabilities 3. Indemnification Indemnification for rep and warranty breaches are often subject to deductibles or baskets, usually between 0.5% to 1% of the deal size The are also subject to caps on damages, most often 10% - 15% of the deal size Reps and warranty survival periods often vary with general reps most often surviving between 12 and 36 months Indemnification protections for breaches of reps is often nuanced, and includes materiality thresholds and knowledge qualifiers, as well as limitations on lookback periods and their substantive scope 63

64 IV. Excluded Liabilities 3. Indemnification A Buyer s protection from Excluded Liabilities is typically uncapped, with no basket or deductible that must be met Coverage for Excluded Liabilities is often flat, without limited survival periods, qualifiers, or materiality determinations To the extent a liability is an Excluded Liability, the Seller retains full responsibility and the Buyer should not assume liability 64