M&A transactions can be anything but straightforward. Parties to the deal need to agree on a valuation, how the valuation will be arrived at and, crucially, how the buyer will pay for the acquisition. Disagreements of differences of opinion may lead to a breakdown in the deal process and mistakes can be very costly.
“There is no one-size-fits-all structure for a M&A deal,” says Eversheds Sutherland partner Mary Kiely. “Deal structures require careful consideration and will vary depending on the target’s business, the exit requirements of the seller and the type of buyer involved in the transaction.”
An upfront consideration in cash has obvious attractions for sellers. “If the seller wants a clean exit, obviously, the most favourable outcome is to receive 100 per cent of the purchase price on completion of the sale,” says Kiely. “This is probably the least favourable structure from a buyer’s perspective. If the entirety of the purchase price is paid upfront, the buyer has no collateral to set off against any warranty or indemnity claims, thereby increasing transaction risk for the buyer. It also places a greater burden on the buyer to lift the lid on the target during the due diligence process. Warranty and indemnity insurance should be considered by the buyer for this type of transaction structure as it may help address any gap on risk.”
While clearly not as attractive to the vendor, a deferred consideration or payment-by-instalments arrangement can be a useful way of bridging the gap between a seller’s valuation and that of the buyer.
“If the buyer believes that the seller’s valuation of the company is too high or the company’s projections are overly optimistic then the buyer may request and the seller may agree to accept a deferred consideration structure,” explains Adrian Benson, partner and head of Corporate and M&A at Dillon Eustace. “Typically, this involves the buyer paying part of the price on completion, with the balance being paid in instalments after completion.”
Accepting a deferred consideration structure exposes the seller to the risk that the buyer may not pay the deferred element on time or at all, he adds.
“The seller should therefore be reluctant to accept this type of consideration structure if it has any doubts concerning the strength of the buyer’s financial covenant,” Benson advises. “Sellers may seek a variety of additional contractual protections against the risk of non-payment, including, for example, a payment acceleration clause – where the buyer fails to pay an instalment on the due date or if the buyer suffers an insolvency event – default interest on late payments, security for the buyer’s obligations and contractual right of set off.”
Another structure often employed in M&A transactions is the earn out. “In times of economic uncertainty or where buyers and sellers cannot agree on a valuation, earn-out mechanisms are often used,” William Fry Corporate and M&A partner Ronan Shanahan points out.
“This structure means that a portion of the consideration is contingent on certain financial or other business milestones being achieved post-acquisition. The mechanism itself can be tailored by both parties to suit the target business. It is usually based on a financial performance metric, such as sales targets or EBITDA. It is also favoured by buyers as a way to incentivise sellers that remain with the target business after acquisition.”
Earn outs can appeal to sellers because, although there is a delay to payment of part of their purchase price, there is an opportunity to reap the rewards from a strong performance post-acquisition, Shanahan explains.
“This can appeal to sellers where the buyer does not have the same visibility of, or confidence in, the strength of the business. Sellers will sometimes look for ‘catch up payments’ where targets in earn-out periods are not met but are subsequently exceeded in later earn-out periods.”
Problems can arise post-transaction, as Taylor Wessing managing partner Adam Griffiths points out. “One of the difficulties with earn outs can arise when an owner-managed business is sold to larger trade buyer and becomes one of several divisions in the new parent. There are ways in which the buyer can manipulate the performance of a new division. There are ways that EBITDA performance can be depressed by putting more staff in or requiring the division to invest in new equipment and machinery. Lawyers can be left with the difficult task of coming up with a schedule of what is allowed and not allowed.”
Another common fear is that the new owner will levy excessive management charges or other fees.
“One of the critical parts of the earn out is achieving a balance between the buyer making changes to achieve efficiencies and the seller not being disadvantaged,” says Griffiths. “For example, if the new owner buys a competitor of the company it has just acquired it can route new business to it. It is very difficult to prevent a company from acquiring a business.”
A seller rollover allows the seller to take some chips off the table but also benefit from the continued growth in the company post-acquisition
— Deirdre Geraghty, A&L Goodbody
The risk is not all on the sell side, of course. “In some transactions the buyer may wish to retain part of the purchase price at completion, with amounts of between 5 per cent and 15 per cent of the total consideration not uncommon to secure certain seller’s post-completion obligations,” says Benson.
“If the purchase price is to be adjusted after completion on the basis of completion accounts, a retention arrangement may also be used to secure the parties’ post-completion payment or repayment obligations under the price adjustment mechanism.”
Sometimes a deal can be facilitated by the seller retaining a stake in the business.
“A seller rollover is typically seen in private equity transactions when a seller rolls over a portion of its equity into shares in the bid vehicle,” explains A&L Goodbody Corporate and M&A partner Deirdre Geraghty. “This structure allows the seller to take some chips off the table but also benefit from the continued growth in the company post-acquisition.”
Buyers benefit too. “On the buyer side, it reduces the cash outlay of the buyer and ensures the seller’s interests are aligned with the buyer and they are committed to the future growth of the business,” Geraghty points out.
“Ultimately, once financing conditions improve, the buyer may then look to acquire the rump of the shares. There is always a risk for the seller with rollovers that the business goes downhill post-acquisition and they lose out on the premium they expected. It is important, therefore, that sellers properly diligence proposed buyers and their capacity to run the business successfully.”
Partial exits are quite common in venture capital, private equity and management buyout transactions, according to Kiely.
“The transaction structure will suit a seller who wants to take some cash off the table to retire in stages or reinvest in the business to enable growth,” she says. “Partial sales will also suit a buyer who is risk averse, is merging into a new sector or does not have access to sufficient funding for an entire acquisition. A robust and detailed shareholders’ agreement, which sets out the parameters of the future operation of the business, the relationship between the parties as shareholders and the terms of any future exit, is a must for this type of transaction structure.”
Sometimes the seller has to step in to help the buyer to acquire the business. Vendor finance is another form of deferred consideration, according to Griffiths.
“If a business is worth €10 million, the buyer might pay €5 million in cash, with the other €5 million being covered by a loan note from the seller. To compensate the seller for the risk they are taking, the loan note attracts a superior interest rate to what they could get from a bank.”
Alan Kelly, managing director (M&A) at Focus Capital Partners, expects debt to play a more prominent role in transactions during the coming year.
“With a stabilisation in interest rates, we would expect debt financing to be more prevalent in 2024. One of the benefits for a buyer in using debt is that leverage enhances returns on equity. For a seller it can lead to a higher purchase price as the buyer may be able to pay a premium with borrowed funds. A downside for a seller is that sometimes involving debt can add time to a deal as the bankers need to review due diligence reports and so on.”