Trends in Mergers and Acquisitions“What’s market?” is an important question for the buyer and seller to ask in a merger and acquisition (M&A). Along with counsel from a skilled M&A attorney, having a basic understanding of what terms are typical in the current M&A market will help businesses that are in the market to buy or sell a business (1) better analyze the reasonableness of specific terms offered by the other side and, if an offered term is not typical, have the necessary insight to (2) counter with better terms or to (3) take a more aggressive stance on another term. Businesses whose management teams are equipped with a basic understanding of M&A deal terms can easily work with M&A counsel to more effectively and efficiently identify deal terms and strategies that are ideal for their business needs.
SRSAcquiom recently released its 2019 M&A Deal Terms Study, which analyzes hundreds of transactions annually and provides extensive information regarding common deal terms and how those terms have changed over time. For transactions in the low mid-market range (for the purposes of this blog, only deals with a transaction value under $50 million and a buyer market cap under $5 billion were included), the following recent trends can be seen in deal terms:
Fewer Deals Include Equity as Consideration
Often, a seller’s main concern is how much money it will receive when it consummates a transaction. A buyer, on the other hand, might consider alternative ways to offer value in transactions, including rollover equity, promissory notes, and earnout payments, while limiting the amount of cash paid at closing. Cash has been the most common form of deal consideration for several years, although many deals have included a combination of stock and cash as consideration. In 2018, all cash consideration accounted for 86% of transactions. While equity as consideration is becoming less frequent, it remains an attractive option for buyers who want to reduce cash payments and to sellers who want to retain some ownership in the company following the transaction.
Earnouts Are Less Common
An earnout is compensation that the seller can receive after closing that is linked to the future performance of the company and its ability to meet and exceed specified targets. In 2018, 14% of transactions included an earnout as compensation, a decrease from 2017 when 32% of transactions included an earnout. While earnouts are less common, they provide the buyer with an opportunity to reduce closing payments, especially for companies that are younger and still growing. On the other side, an earnout can permit the seller to benefit from the future growth of the company. Earnouts can help bridge a valuation gap between the buyer and seller, lowering the closing purchase price while simultaneously providing compensation to the seller should the company’s growth continue.
Shifts in Indemnification Baskets
Most purchase agreements include indemnification provisions that allocate the risk and expense of a breach or default, including claims from third-parties, from the buyer to the seller. However, the seller is often not responsible for each and every dollar of damages that the buyer incurs. Instead, the transaction often includes an indemnification basket which limits indemnification until the losses exceed the basket threshold. There are two main types of baskets: first-dollar and deductible. In a first-dollar basket, once the losses exceed the threshold, the seller is liable for all losses, including those below the threshold. In a deductible basket, the seller is only liable for losses that exceed the threshold. Many purchase agreements tailor the baskets further to carve out certain specific representations, warranties, and covenants, so they are not subject to the threshold or any deductible.
In 2018, deductible baskets have become much more common. In 2017, first-dollar baskets accounted for over half of transactions, but in 2018, first-dollar baskets only accounted for 41% of transactions. On the other hand, deductible baskets have increased to nearly half of all transactions. The average basket size has increased slightly and is approximately 1% of the total transaction value. The vast majority of baskets range from 0.5% to 1% of total transaction value, and the number of transactions with baskets over 1% of transaction value has decreased from 21% of transactions to 12% of transactions. While basket carveouts for many representations, including capitalization, due authority, ownership of shares, and fraud, remain common, their frequency has decreased since 2017.
Capping Indemnification Amounts
Most purchase agreements also include caps on total indemnification amounts. The cap acts as a ceiling on the maximum amount that the buyer can recover from the seller for its losses.
Most indemnification caps range from 10% to 15% of total transaction value. However, transactions in 2018 reflect two interesting changes in the size of indemnification caps. First, the median cap size has shifted from 10.2% to 12.5%. While a modest increase, this change reflects that the most common cap size (present in approximately 25% of all transactions) shifted from 10% of transaction value in 2017 to 15% in 2018. Second, the number of transactions with an indemnification cap below 5% of transaction value doubled from 8% to 16%. This increase reflects that many buyers, particularly private equity investors, obtain representations and warranties insurance, which provides additional protection for damages above the indemnification cap.
Lengthening Survival Periods
A seller’s potential indemnification obligations do not persist indefinitely. Instead, purchase agreements often include survival periods, which limit the amount of time during which the buyer can seek indemnification for its losses. Survival periods are often tailored and lengthened for certain claims that may lead to significant losses or for issues that are of particular concern for the buyer.
The average survival period for representations and warranties has increased slightly from 15 months to 16 months. Twelve-month survival periods still account for approximately 40% of transactions, but 18-month survival periods have increased to nearly 40% of transactions.
However, as longer survival periods have become more common, some carveouts have decreased in frequency. For example, in 2017, breaches of seller’s covenants were carved out from the survival period in 87% of transactions; in 2018, that frequency fell to approximately 59% of transactions. Other carveouts, including ownership of shares and broker’s fees representations, decreased but at more modest rates. Survival periods for fundamental representations have shifted to the statute of limitations in 57% of transactions, and survival periods for fraud and intentional misrepresentation have shifted to indefinite survival in over 70% of transactions, as purchase agreements are no longer silent on this issue.
Conclusion
While market terms have shifted, every transaction is unique, and individual market terms may not suit a buyer or seller’s strategies and goals in the transaction. Please contact a member of PilieroMazza’s Business & Transactions Group to help you identify the deal terms and strategies that are ideal for your needs.
Francis Massaro, the author of this blog, is an Associate in the Firm’s Business & Transactions Group.