Lecture 3:

Structuring and Paying

for the Deal
Corporate Finance
Professor Joseph McCahery
Road Map
• Payment Methods in M&A
• Due Diligence
• Acquisition Finance – Loan Documentation
• Types of Acquisition Finance
• Types of Acquisition Structures
• Contract Design
• Acquisition Agreement

2
Payment Methods in M&A
• Cash in Exchange for Shares
Cash • Requires Higher Premium Paid due to Tax Rules
• Takes Shorter Term to Complete Transaction

• Specified Number of Bidder’s Shares for Each Target’s Share

Share Exchange • Dominate When Stock Market is High
• Increases Number of Shares and Dilutes Reported Earnings

Cash Underwritten • Offers Stock to Target Shareholders that can Sell for Cash
• More Flexible that Underwriting and can be Conditional
Share Offer • Suffer Less Post Bid Completion Price Decline

Convertible Loan • Loan Stock or Preferred Shares Convertible into Shares

• Cheaper Financing than Straight Debt (but need rating)
or Preferred Shares • High Speed of Execution

• Part of Consideration After a Specified Period

Deferred Payment • Subject to Performance Criteria (future profit levels)
• Valuation Risk Reduction, but subject to conflicts 3
Payment Methods: Theories
§ Relative Size (of target determines cash vs. shares)
§ Managerial Ownership
• Cash bid associated with high managerial ownership
• Target (with high managerial ownership) prefer shares

§ Free Cash Flow

• Higher amount of FCF associated by acquirer associated with cash offers

§ Corporate Performance and Growth Opportunities

• Firms with higher growth (or higher Tobin’s Q values) more likely to use
shares than cash; shower growing firms use cash

§ Stock Market Performance

• Better share price performance of acquirer’s stock makes share offer
more likely
4
Payment Methods in M&A
§ Total Value of M&A in EU by payment method, 1984 – 2001

All-equity bid All-cash bid Mixed Cash/Equity/Debt bid

5
Payment Methods in M&A
§ Bid premium European M&A (1995 – 2003)
40%

35%

30%

25%

20%

15%

10%

5%

0%

Pure Cash Cash and shares Pure Shares

Cross Border Domestic 6
Payment Methods in M&A
§ Consideration paid in Stock, Cash and Mixed in US, 2000 – 2014

7
Payment Methods in M&A
§ Medium Premium US M&A (2002 – 2014)

8
Payment Methods in M&A
§ Total Value of M&A in EU by payment method, 1990 –2007

9
Payment Methods in M&A
§ Total Value of UK M&A by payment method, 1990 –2007

10
Payment Methods in M&A
§ Total Value of US M&A by payment method, 1990 - 2007

11
Payment Methods in M&A
§ Summary of Payment Methods: EU vs. US
EU Deals
• 1995-99: shares and mixed payment •
dominate cash offers
• 2000: mixed offers and cash
dominate
• 2005 - 2007: mixed and pure equity
dominate due to rise of stock
markets during period
US Deals
1995-99: shares and mixed offer
dominate
• 2000: cash deals
• 2004 - 2007: cash dominates despite
rise of US stock market (increase in
private equity in M&A market)
• 2008 - 2014: mixed offers increased,
but cash still prevails
12
Payment Methods in M&A
§ Questions
• What are the strategic reasons for using cash in an offering?
• How do stock market conditions influence the method of
payment?
• What impact does deal size have on methods of payment?
• Cash v. stock: what are the trade-offs?

13
Payment Methods in M&A
§ EU Tax aspects of M&A financing
• Transfer tax and value added tax
Transfer tax depends on types of assets (e.g. real estate or intangibles)
In the Netherlands there is no tax on shares, but 6% on real estate company
share transfers or transfer of real estate

• Depreciation and amortization of assets

Cost of goodwill (and other intangibles) may be tax deductible in some EU
countries (e.g. UK, Germany, the Netherlands, Belgium)
In some countries, asset acquisition (unlike share acquisitions) can result in
asset revaluation and a higher tax allowance
Tax relief may be available for higher depreciation as a result of asset step-up
(but not in UK)
14
Payment Methods in M&A
§ EU Tax aspects of M&A financing
• Tax efficient financing structure
• It may be tax-efficient to “push down” debt from the country with low tax
rate to the country with higher tax rates (to exploit tax deductibility of
interest or deductibility at a higher corporate tax rate)
• Example: UK corp. tax 28%, US – 42% (federal + state); debt should be
raised by a US-based entity
• Tax anti-avoidance rules impose limits on the level of debt financing be
related parties
• Tax treatment of intragroup loans is based on transfer pricing rules and
comparison terms in arm’s length loans (e.g. the UK)

15
Payment Methods in M&A
§ US Tax aspects of M&A financing
• Under the IRS Code, tax-free merger must satisfy the “continuity
of interest” condition:
• At least 50% of target’s shares must be exchanged for stock (otherwise,
all compensation is fully taxable)
• Consideration other than the acquirer’s stock, e.g. cash, may be taxable
• Amortized goodwill is tax deductible (now)
• In taxable mergers asset basis step-up increases the tax relief
• Asset acquisitions can result in asset basis step-up and a higher tax
allowance
• Acquirers and vendors can elect share acquisitions to be treated as asset
acquisitions, to benefit from the basis step-up
16
Payment Methods in M&A
§ Impact of price-earnings ratio (PER) and exchange ration (ER) on the wealth
gains of Bidder and Target shareholders

31%

14% 50%

5%

17
Payment Methods in M&A
§ Abnormal returns to targets in European acquisitions

18
Payment Methods in M&A
§ Abnormal returns to bidders in European acquisitions

19
Payment Methods in M&A
§ Shareholder value effects of different sources of cash in all cash European acquisitions

20
Payment Methods in M&A
§ Earn-outs
— The way of mitigating the (mis-)valuation risk, which suppose to make the
consideration payable to the vendors contingent upon the future
performance of the target under their own management

§ In an earn-out, consideration to the vendor is made up of the following:

• An immediate payment in cash or shares of the acquirer
• A deferred payment contingent upon the target-turned-subsidiary achieving
certain predetermined performance levels
§ This payment method is usually used to finance acquisitions of private companies
operating in the service or high-technology sectors, such as advertising agencies or
software development businesses (or other industries, where the value of the
company often depends on the intangible asset of human creativity and/or the flair of
one or two individuals) 21
Torex offers earn-out deal to McKeown

22
Payment Methods in M&A
§ Advantages and disadvantages of earn-out

23
Payment Methods in M&A
§ Factors influencing choice among acquisition financing methods

24
Payment Methods in M&A
§ Factors influencing choice among acquisition financing methods

25
Road Map
• Payment Methods in M&A
• Due Diligence
• Acquisition Finance – Loan Documentation
• Types of Acquisition Finance
• Types of Acquisition Structures
• Contract Design
• Acquisition Agreement

26
Due Diligence: Legal Basis
• Contractual: where a bidder has arranged, pursuant to a purchase agreement,
a private placement, then bidder is responsible to the other party some level
of due diligence
• Statutory: no affirmative requirement in Securities Act or Exchange Act, but
due diligence is widely seen as a defense against negligence
• Statutory protection against material misrepresentations or omissions in
securities registrations (§ 11(b)(3)) of 33 Act – requires reasonable
investigation and reasonable ground for belief of a prudent man in
management of his own property
• Escott v. Bar Chris Construction Co, 283 F.Supp. 643 (1968): requires that party
not only ask questions to seek truth, but should consult records where
possible to ensure accurate and true answers

27
Due Diligence
§ How to defend against securities violation for failure to investigate
• Rule 176 (Securities Act 1933) states that a reasonable amount of attention
depends on a number of factors:
• Type of company,
• Type of security,
• Type of person,
• Office held by person,
• A related party transaction at the time (between director and affiliate, for example),
• Level of reliance on officers and directors knowledge—was it reasonable in light of
the facts and their particular function?
NB: due diligence means absence of negligence, so parties must make sufficient
inquiries to avoid liability
What about fraud? Due diligence is not a defense unless plaintiff alleges fraud is the
result of total recklessness or breakdown in due diligence process.
28
Due Diligence
§ Confidentiality Agreement
• Agreements for publicly held company typically include:
• Financial information about assets, IPR, etc.
• Information used for evaluation purposes only by company & advisers
• Take reasonable measures to avoid disclosures (including notification
about potential securities law violations for insider trading)
• Restricted communication
• Anti-competition agreement (3 years)
• No representation or warranty as to the accuracy or completeness of
information
• Quick return of all information
• Equitable relief in case of breach
• Choice of law provision 29
Due Diligence
§ Due Diligence Check List: 5 areas:
• Corporate documents – articles of incorporation, by laws, minutes and
materials, stock books, ledgers, list of jurisdictions where firm does business, all
agreements between company and management (right of first refusal,
preemptive rights, registration rights)
• Financial information – annual, quarterly, proxy, private placement, 13D/G,
internal budget, operating & financial plan, audited statements, list of returns
• Material corporate agreements – all agreements, proposed transactions,
borrowings, securities, mortgages, and other financial arrangements
• Government regulation – all regulatory filings, correspondence with regulators,
list of permits, etc.
• Legal Matters – litigation, pending actions, judgments, decrees, settlements,
correspondence and other material information 30
Due Diligence
§ Due Diligence: Problem areas:
• Early recognition of expenses – shipping goods before sale is complete and
booking revenue
• Recording revenues that are not genuine – recording exchange of similar
assets, using unfunded estimates for interim reporting
• Increasing income through one-time gain – selling undervalued assets, retiring
debt, non-recurring items, etc.
• Shifting expenses to later period – improper capitalizing of current costs,
prolonged depreciation
• Failing to disclose all liabilities – recording revenue on unearned cash receipts,
failing to show accrual of expected liabilities, creating transactions to be kept
off balance sheet (in orphan structure or sub)
• Shifting income to future period – creating reserves to shift sales revenue 31
Due Diligence
§ Management Discussion and Analysis of Financial Condition
and Results of Operation (MD&A)
• MD&A checklist:
• Events or demands that may decrease company’s value
• Material commitments to capital expenditure
• Trends in capital resources
• Significant economic changes that may affect reporting income
• Source of higher profits (increases in volume)
• Inflation effect
• Overall material changes in operation

32
Due Diligence
§ Creating a Data Room for due diligence documents
• Investigator will look at:
• Brand — reputation, logo, license, trademark, etc.
• Cash — positive cash flow, retained earnings
• Culture — code of conduct, standards
• Global reach — operations in how many time zones
• Market position — market share, industry leadership
• Operations — performance standards, process integrity
• People — key employees, etc.
• Intellectual property – proprietary
• Scale — number of offices, location, etc.

33
Due Diligence
§ Creating a Data Room for due diligence documents
• Example: Intellectual Property Rights
• Risk exposure
• Are all copyrights, patents and trademarks properly registered?
• Have all fees been paid up and is the target company the legal and active
owner of the intellectual property rights?
• Have there been any infringements by the target company on other
firm’s IPR?

34
Due Diligence
§ Copyright
• Copyrights are protected by Title 17 USC: any type of work can be
copyrighted so long as its original and in a concrete medium of expression
• Copyrights last 70 years
Owner has rights to work including the:
• Display
• Distribution
• Licensing
• Performance
• Reproduction

35
Due Diligence
§ Due diligence review for copyright
• All registered copyrights and applications for copyright registrations
• All material unregistered copyrights, including software
• Documentation relating to chain of title
• Copyright clearance letters evaluating possible infringements
• Documentation concerning recordation of copyrights
• Files concerning review of software usage for unlicensed copies of
copyright software
• Files relating to copyright assignments, licences etc
• Files regarding threatening or pending litigation

36
Road Map
• Payment Methods in M&A
• Due Diligence
• Acquisition Finance – Loan Documentation
• Types of Acquisition Finance
• Types of Acquisition Structures
• Contract Design
• Acquisition Agreement

37
Acquisition Finance – Loan Documentation
§ Loan Syndication and Trading Association (LSTA) & Loan Market
Association (LMA)
• Aim to create standard terms and conditions (LMA conditions)
• Subject them to warranties and representations
(LMA representations)
• Establish market best practices (core areas)
Flexibility for representations, financial arrangements and undertakings

38
Acquisition Finance – Loan Documentation
§ Elements of facility agreement:
• Conditions Precedent (DD reports, reliance letters, AA and
amendments, regulatory clearances)
• Utilization and disbursement of loan
• Repayment
• Early repayment :
• Voluntary
• Mandatory (e.g.: IPO, change of control, proceeds disposals)

• Interest:
• Fixed / variable (EURIBOR)
• Market disruption
• Break costs (“match funding”) 39
Acquisition Finance – Loan Documentation
§ Especially important for syndicated loans:
• Representations and undertakings (negative pledge / disposals)
• Events of default (cross default / material adverse change)
• Change of parties
• Transfer mechanism
• Group of new lenders (securitization)
• Borrower’s consent

• Role of the (security) agent

• Individual lenders versus majority lenders

40
Acquisition Finance – Loan Documentation
§ Acquisition Finance – Parties:
• Target
• Buyer
• Vendor
• Bank
• Works Council

41
Acquisition Finance – Loan Documentation
§ Acquisition financing - documentation
• (Senior) Facility Agreement
• Mezzanine Facility Agreement
• Intercreditor Agreement
• Intercompany Loan Agreement
• Security Documents
• Hedging Agreement
• Corporate Documents

42
Acquisition Finance – Loan Documentation
§ Sequence of Acquisition Finance

Mandate from General

Acquirer to Arranger Signing Drawdown Syndication

Term Sheet Invitation

Mandate Letter
Senior Facility Agreement
(signed by arrangers only)
Fee Letters
Conditions Precedent to
signing
Completion of CPs Information Memorandum
Allocation of participants
Global individual transfer
Syndication agreement
Conditions Precedent to
initial utilization to
provide senior funding for
completion of the
acquisition
43
Road Map
• Payment Methods in M&A
• Due Diligence
• Acquisition Finance – Loan Documentation
• Types of Acquisition Finance
• Types of Acquisition Structures
• Contract Design
• Acquisition Agreement

44
Types of Acquisition Finance

Investment Type

Senior Secured Loans

Second Lien Secured Loans

High Yield Corporate Bonds

Mezzanine Loans

Preferred Equity

Common Equity

45
Types of Acquisition Finance
§ Senior/Junior Types of Loan:
• Financing of large deals includes both senior and junior debt:
• Senior: includes bank loan facility (e.g. revolver) which is secured & some
senior securities (unsecured)
1. Unsecured securities are subordinated to bank loan facility, but
collateralized by the assets of the borrowing company (paid only
after bank facility has been paid out)
2. Senior debt: secured at the operating company level in order to
ensure that creditors have claims on the operating assets of the firm
• Junior: unsecured and subordinate securities

46
Types of Acquisition Finance
§ Revolving Credit Facility
• Main financing types (bank or bond):
• Revolving credit: drawdown, repay and reborrow (annual fee)
• Swingline: small overnight borrowing
• Multicurrency borrowing
• Term loan: allows borrowings to term loan

47
Types of Acquisition Finance
§ Working Capital Facilities
• Depend on credit quality of borrower & nature of combined business
• Typical borrower: non-investment grade and subject to stricter credit conditions
• Facility allows: borrowings and repayments up to certain amount and secured by
same collateral securing acquisition
• Asset based facility: inventory and accounts receivable may be used to structure
the facility
• Allows borrower to borrow to the extent of availability (borrowing base calculated
on advanced rates based on extent of collateral)
• Can be more flexible and larger than traditional revolving facilities since banks look
at the liquidation value of the collateral rather than cash flow of the borrower
• Downside: availability is based on specific assets, reducing levels of funding if there
is deterioration in collateral supporting facility
48
Types of Acquisition Finance
§ Term Loans
Term Loan A
• Marketed to banks
(with Revolver—draw down)
• Amortization tied to borrower’s free
cash flow (progressive repayment
schedule typically runs to 6 years or
less)
Term Loan B
• Marketed to institutions (CDOs, etc.)
• Minimal amortization (1-5% per
year; prime rate for mutual funds)
• Longer maturity (directed to
institutional market)
49
Types of Acquisition Finance
§ Second Lien loans:
• Claims on collateral (all tangible and intangible assets of the borrower) of
second lien loans
• Claims on second lien loans stand behind those of the first lien loans but
ahead of bonds and mezzanine Second-lien activity, 1997 – 2011
$B
• Second lien loans typically come
30
with restrictive covenant levels
20
that are wider than first lien loans
10

50
Road Map
• Payment Methods in M&A
• Due Diligence
• Acquisition Finance – Loan Documentation
• Types of Acquisition Finance
• Types of Acquisition Structures
• Contract Design
• Acquisition Agreement

51
Types of Acquisition Structures
§ Acquisition structure
• Typically determined by tax consequences and limitations of
liability of the acquisition structure
• Example: sale of shares to acquisition vehicle, followed by merger of
target in acquisition vehicle with proceeds of acquisition used to pay
target shareholders
• Post acquisition structure: group of companies, with one company
(operating company) being the main borrower with possibly a group
member that is suited to secure a separate facility
• Example: packaged debt – senior securities (group holding company)
subordinated to acquisition vehicle

52
Types of Acquisition Structures
§ Share Exchange:
• B corporation merges into A corporation: A corporation is
survivor and B corporation ceases to exist
• B corporate stock is cancelled and B’s shareholders receive as
consideration A’s shares (stock for stock merger)
• Alternatively, A corporation and B corporation could merger into
new firm C (consolidation)

53
Types of Acquisition Structures
§ Example Share Exchange

54
Types of Acquisition Structures
§ Cash-out merger:
• Purchasing firm pays cash (or non-voting investments in purchasing
firm) to target firm’s shareholders
• Majority vote required (i.e., up or down ratifying vote on the offer)
• No voting required

• Law allows for merger of parent corporation and subsidiary when

parent owns 90% of subsidiary's stock (i.e., upstream merger) or
• Reorganizations of holding company structure is permitted

55
Types of Acquisition Structures
§ Asset Acquisition
• Two step transaction:
First Step: cash for assets
• A corporation pays B corporation cash for B’s assets & (some or all of B’s
liabilities)
Legal effect: No change in shares or constitution of A corporation or B corporation

Second Step:
• B corporation is dissolved (charter is cancelled and shares are extinguished)
• A corporation pays off residual liabilities of B corporation
• Cash and assets of B corporation are then transferred to A corporation
• Post acquisition – B corporation shareholders hold cash and no shares

56
Types of Acquisition Structures
§ Stock for Asset Acquisition
• Method: Stock for Stock, which entails that A corporation buys
with common stock all of B corporation’s assets and assumes all
its liabilities
B corporation’s authority to sell assets and liabilities is based on ratifying
shareholder vote to sell ‘all or substantially all’ of B corporation’s assets
(quantitatively vital to corp.)

• Majority of shareholders’ approval (51%)

• B corporation dissolves and B corporation’s shares extinguished

57
Types of Acquisition Structures
§ Stock for Stock Acquisition
• A corporation purchases B corporation’s assets (and assumes
liabilities) with A corporation’s common stock as consideration
• Neither A corporation nor B corporation’s shareholders have no right to
vote on the stock acquisition
• B corporation’s shareholders do not need the right to vote, because each
shareholder individually decides whether or not to accept offer by A
corporation for their shares (refusal is substitute for right to vote)
• A shareholder’s do not have right to vote on transaction nor claim appraisal
rights
Anti-takeover protection: give target firm’s shareholders’ voting rights (not on
acquisition, but on effect—if target board disapproves, shareholders can vote)
58
Types of Acquisition Structures
§ Two Stage Stock acquisitions: stock acquisition followed by back
end merger
• Second or Freeze out stage — purchasing corporation holding
shares in partially owned sub drops down a new wholly owned
sub and then merges the partially owned sub into wholly owned
sub
• Firm gives minority SHs in partially owned sub cash or debt
securities in A corporation for cancelled shares
Advantage: speed and conversion of subsidiary

59
Types of Acquisition Structures
§ Triangular Acquisition
• Typical US structure: purchasing firm drops down a wholly owned
sub and selling firm merges with the sub
• SHs of parent do not vote on the acquisition since sub is party to
acquisition and parent is not
• Only SHs of sub is parent of itself; board of directors of parent
votes the stock in favor of merger by simple board resolution
• Benefit: triangular merger limits voting (and appraisal) rights for
SHs of acquirer and isolates the newly absorbed selling company
liabilities in a sub, free from purchasing company’s assets

60
Types of Acquisition Structures
§ Triangular Acquisition
• Variations:
• Forward triangular — when target corporation merges into shell sub of the
acquirer with the former Target shareholders receiving the merger
consideration in exchange for their Target stock
• Target shareholders can receive Acquiring stock as long as acquiring is in
control of Sub and target shareholders receive no shares of Sub stock.
• Reverse triangular — purchaser drops down a shell sub that purchases the
asset of the target and the target dissolves

61
Types of Acquisition Structures
§ Forward Triangular Merger

Target Shareholders Acquiring Stock

Acquirer

Target Merger
Sub

62
Types of Acquisition Structures
§ Reverse Triangular Merger

Target Shareholders Stock + Cash

Acquirer

Target Reverse
Sub
Merger

63
Types of Acquisition Structures
§ Squeeze Out Mergers (recapitalization)
• Corporation — drops down a wholly owned shell sub and
merges itself into the new sub
• Stock — all stock of the corporation is cancelled
• Majority SHs — receive stock of the surviving firm
• Minority SHs — receive cash or debt securities
• Preferred SHs — do not vote on restructuring unless stated in
certificate of incorporation

64
Types of Acquisition Structures
§ Leveraged buyout (LBO)
— private equity firm creates shell corporation and funds the
entity with cash

• Acquisition vehicle raises cash by selling debt to banks and institutional

investors
• Cash is used to purchase legal control of public corporation and the
acquisition vehicle merges into the target
• Remaining voting shares—are exchanged for debt or non-voting preferred
shares and owners of vehicle take only outstanding stock of target
Surviving target corporation — assumes the debt of the acquisition vehicle in second
stage merger
65
Road Map
• Payment Methods in M&A
• Due Diligence
• Acquisition Finance – Loan Documentation
• Types of Acquisition Finance
• Types of Acquisition Structures
• Contract Design and Commitment Letter
• Acquisition Agreement

66
Contract Design
§ Acquisition Agreements
— designed to limit risks and uncertainties associated with
corporate combination
• Agreement specifies: amount & form of consideration, structure of
transaction, R&Ws, covenants and closing conditions

§ Key contracting assumptions:

• A and B have some private information
• Each party knows its vulnerability to information advantage of the other
• Enforcer of contracts less informed than either party and courts may not
be able to accurately interpret claims of parties

Information problems are barriers to completing acquisitions

67
Contract Design
§ Contract Design Implications:
• Information asymmetry limited by screens/signals
• Incentive needed for seller to make necessary investment
that increases value of the good to buyer
• Contract design complicated by uncertainty in exogenous
conditions (addressed by MAE/MAC clauses)

68
Contract Design
§ Contract Design Implications:
• Acquisition agreements are evolving to deal with information
problems
• Movement away from simple choice between conditions and
termination rights
• Financial and strategic transaction structures are converging
New pattern of embedded options within acquisition agreement based on
different contingencies and exercise prices (buyer vs. seller friendly terms)

69
Contract Design: Commitment Letter
§ Commitment Letter
— designed to limit seller’s concerns over financing

§ Types:
• Underwritten deal: banks agree (through commitment letter
which includes: pricing, terms, tenors, covenants and
collateral requirements) to fund the entire commitment
• If not fully committed: lead bank arranger will absorb
difference and later try to re-sell portion of commitment
• Includes: conditions that limit bank’s obligation to fund
(e.g. due diligence) 70
Contract Design: Commitment Letter
§ Underwritten deal:
— based on continuation of current market conditions (market out) requires
the absence of any adverse market conditions that impact the banks’
ability to syndicate loan
• Restricts acquirer from seeking any other financing while commitment is in effect
(market flex provision)
• Commitment letter allows bank to modify terms of bank loan facility (interest rate,
maturity, allocations to other banks etc.)
• Key condition: reimbursement clause (costs and expenses) whether deal closes or not

§ Lower level of Commitment:

• Best efforts: syndication in which the arranger group agrees to underwrite less
than entire amount (leaving credit line to market movements)
• Club deal: smaller loan (150$M) that is pre-marketed to group of relationship
71
lenders (common in Europe after credit crunch)
Road Map
• Payment Methods in M&A
• Due Diligence
• Acquisition Finance – Loan Documentation
• Types of Acquisition Finance
• Types of Acquisition Structures
• Contract Design and Commitment Letter
• Acquisition Agreement

72
Acquisition Agreement
§ Acquisition Agreement
— not binding unless closing conditions satisfied or waived
§ Closing conditions:
• Representations and Warranties (R&W) – close the gap between buyer and
seller’s knowledge, representations made at time of agreement and closing
• Material Adverse Change (MAC) clause – remove systemic or industry risk
at time of agreement; where seller has little control and insufficient private
information
• Covenants – a closing condition & violations may trigger buyer’s option to
terminate
• Exogenous conditions: outside R&Ws and covenants — financing and
regulatory approvals for sale
73
Acquisition Agreement
§ Types of Reps and Warranties

• Corporate organization and • No material adverse change

existence
• Litigation
• Good standing as a foreign
• Compliance with law
corporation
• Environmental issues
• Capitalization and title to stock
• Subsidiaries • Taxes

• Approvals, no violations • Employee benefits plans

• Financial statements • No misleading statements

• Undisclosed liabilities • Other representations

74
Acquisition Agreement
§ Core Components of Representations and Warranties
• Breach pre-signing:
• R&Ws are viewed as a reflection of acquired business made as
of signing date
• Buyer’s closing conditions: R&Ws are true when made and as
of closing date
• If there are new facts (i.e., major lawsuit occurs before closing,
but not disclosed), no obligation to close (without waiving
indemnification rights as to losses relating to the lawsuit)

75
Acquisition Agreement
§ Warranties
• Statements about target quality with commitment to repay if any
term violated.
• Serve as a signaling device for quality.
• More warranties reduce information gap.
• Provide insurance to buyer where seller is not certain on some
issues.
• Seller can limit effect (qualifier: with/ and w/out knowledge
qualifiers).
• Enforceability reduced by stating warranties only materially as
opposed to fully true.
• Enforcement period limited: 1.5 years (secured through escrow). 76
Acquisition Agreement
§ Risk Shifting
• Risk can shift to buyer if seller qualifies some or all of the
representations with materiality exceptions
• Very imprecise concept (depends on context employed)
• Buyer is responsible for risks and costs with regard to any
non-material terms

Example: “Except for those which do not have a material adverse effect upon
the Company, its financial condition or the transaction contemplated hereby”

77
Acquisition Agreement
§ Distribute Value
• Use of qualifications (based on bargaining of parties and other
circumstances surrounding transactions)
§ Problems:
• Double materiality — can occur if representation is qualified by
materiality and the corresponding indemnification provision is
conditioned upon the breaches resulting in a certain threshold
level of damages.
• Upshot: representation is not breached & hence economic loss will
not be counted toward the minimum threshold level unless there
exists a material obligation or liability which is not disclosed
78
Acquisition Agreement
§ Knowledge Qualifiers
• Knowledge limitations: ”best of seller’s knowledge”
• Person making statement: identify person (officer) that has the
knowledge (embedded in the representation) in order to make
clear if representation is based on constructive knowledge

Representations in SEC filings—despite parties’ representations made

about the accuracy of SEC filings, may not be sufficient with regard to
outsize liability issues (e.g., toxic tort liability)

79
Acquisition Agreement
§ Pre-closing covenants:
• Best efforts — if 3rd party consent is needed to close, seller could supply
“best efforts” covenant
• Not very useful in most contexts (hard to force third party consent)
• What is the alternative? Reasonable efforts
Question: What is the role of interim covenants for protecting the buyer and
seller interests?

• Affirmative covenants include:

• Preservation of corporate existence
• Only carrying on business in the ordinary course
• Maintaining plant, property and equipment
• Complying with all applicable laws and qualifications to do business
• Paying all taxes when due and avoid liens 80
Acquisition Agreement
§ Reporting Covenants:
• Designed to keep banks informed about financial
performance and business developments of borrower:
• Comprehensive financial reporting (annual audited financials,
quarterly statements, projections, etc.)
• Reporting of defaults
• Reporting of material lawsuits or other events that trigger
liabilities
• Delivery of compliance certificates with regard to financial
covenants

81
Acquisition Agreement
§ Negative covenants
— designed to restrict operations of the borrower and should be
reviewed so they do not interfere with intended operation of
combined business.
• Restrictions on new accounting method that is inconsistent with method used
earlier;
• Restrictions on material transactions;
• Restrictions on undertaking changes to constitution of the firm
(e.g., charter or by-laws amendments);
• Restrictions on changes in executive pay;
• Restrictions on new long-term contracts;
• Restrictions on changes in relations to 3rd parties.
Scope of covenants: apply to borrower and subsidiaries 82
Acquisition Agreement
§ Buyer vs. Seller Conflicts
• Typical conflicts between buyer and seller:
• Purchase price determination and adjustment
• Stock as acquisition consideration
• Addressing and allocating liabilities
• Indemnification — generally and limitations
• Indemnification — scope
• MAC clauses-scope limited by exemptions
• No Shop, fiduciary outs and break-up fees

83
Acquisition Agreement
§ Buyer vs. Seller Interests

R&Ws Narrow Broad

Indemnification Loose Tight
Closing Narrow / Few Broad / Many
Signing Gap Loose Tight
No Shop Loose / Broad Tight / Limited

84
Acquisition Agreement
§ Buyer vs. seller tensions – stock
• Seller – wants buyer shares equal to value of seller’s business
• Buyer – wants certainty as to number of its shares it will
issue: its dilution
• Seller versus Buyer tension: relates to the gap between
signing and closing—after the closing, seller shares the same
risk as any acquirer (subject to securities law restrictions)

85
Acquisition Agreement
§ Pricing Provisions
• A number of pricing provisions are typical for allocating the risk
that occurs between deal signing and closing:
1. Fixed price
2. Fixed exchange ratio
3. Caps, floors and collars
4. Walkaways
5. Contingent value rights

86
Acquisition Agreement
§ Fixed Exchange Offers

87
Acquisition Agreement
§ Fixed Price
— each target share converted into that number of buyer shareholders’
shares’ equal to $100 divided by the buyer shares 10 day moving
average closing price. At signing, that price is $25 and thus a 4:1
exchange ratio, but if the average goes up or down, then:
• Seller gets fewer (share price average up) or more (share price average
down) buyer’s shares, but always gets buyer’s shares equal to $100

• Benefits: protected against decreases in buyer’s shares’ value in the gap

• Does not share in any increase in the buyer’s value in the gap
• But generally fine, because gets fixed value of buyer’s stock

88
Acquisition Agreement
§ Fixed Exchange Ratio
— each target share converted into 4 shares of buyer’s shares
• Seller always get 4 buyer’s shares for each of its shares (opposite of
first alternative—that is, assume the same intended exchange ratio as
in alternative
No downside protection due to decease in buyer’s shares
• Does not share in increase in buyer’s shares
• Seller’s problem is with downside—since not getting $100 a share
bargained for buyer—always issues same number of shares regardless
of value
Is protected against decrease and does note get benefit of any increase
in value of shares 89
Acquisition Agreement
§ Collars incidence and Share in Global M&A Deals

90
Acquisition Agreement
§ Collar
— a method to mitigate the problem of alternatives 1 & 2
• Fixed price — 10 day average deemed not less than $22.50 (floor) or
more than $27.50 (the cap)
• Fixed exchange ratio:
Example: ”if 10 day average price is less than $22.50 (the floor), then each
target share is converted into right to receive number of buyer shares equal
to $100 divided by a deemed 10 day moving average closing price of $22.50;
and if 10 day moving average is more than average closing price of $27.50, the
each target share converted right to receive a number of buyer shares equal
to $100 divided by a deemed 10 day moving average closing price of $27.50”

91
Acquisition Agreement
§ Fixed Exchange Ratio Collar

92
Acquisition Agreement
§ Fixed Exchange Ratio Collar
• Benefits:
• Seller — gets value approximately bargained for
• Buyer — under either option, issues approximately 4 shares for every target
share regardless of their value

• Cap — in a fixed ratio deal, a cap sets a maximum amount of

consideration paid by the acquirer to target shareholders. In a fixed value
deal, a cap sets a maximum exchange ratio for target firms
• Floor — in a fixed ratio transaction, a floor sets a minimum amount of
consideration paid by the acquirer of the target shareholders. In a fixed
value deal, a floor sets a minimum exchange ratio for target shareholders
93
Acquisition Agreement
§ Fixed Price Collar

94
Acquisition Agreement
§ Additional consideration
• Buyer may pay most of purchase price at closing, but then can
make additional post-closing payments
• Additional consideration can be paid if the target meets certain
milestones post-closing
• Useful if parties disagree about anticipated financial performance of the
target, and the valuation
• Seller is asked to put more money on the table
• Key: what financial measure used to count performance (cash flow or
earnings) vs. (revenue, EBITDA); GAAP should be specified
• Payments — capitalize them as part of the tax basis of the assets acquired

95
Acquisition Agreement
§ Bidder and Target Natural Preferences

96
Acquisition Agreement
§ Break Up Fee
• Firms may pay a break-up fee to buyer if the deal is not closed by a certain date
• Viewed as indemnity and not prohibited by law or statute
• Serves to protect seller’s own negligence (reimburse an unsuccessful bidder,
based on board’s failure to meet its promises)
• Courts are unlikely to allow to sue for breach of contract as a consequence of
the break up fee (hold harmless provision tied to specific set of monies)
• Only considered unlawful if it reduces the net assets of the company to a
material extent ( not to exceed amount equal to 25% of the average of the
company’s profits for the last three financial years)
• Pfizer and IRS reached settlement about break-up fee paid to enable Warner-
Lambert to abandon a merger agreement (a portion of the fee may be tax
deductible). 97
Acquisition Agreement
§ Walkaway provision
• Triggered in case where the target board abandons deal in the event
that the value to be delivered via a fixed ratio deal drops to a defined
amount
• Acquirer walkaway — buyer has right to terminate transaction in the
event that the shares to be delivered via a fixed deal exceeds a defined
number (target is allowed to top up the deal in order to reset the value
to the walkway threshold)
• Double trigger walkaway — deals with problem where the acquirer’s
stock falls by a negotiated percentage greater than the decline either in
an index of publicly traded acquirer comparables or some broader index
98
Acquisition Agreement
§ Contingent value rights
• Designed: to protect target shareholders
• Technique: acquirer issues to the target stockholder a security (CVR)
along with each share of stock CVR entitles the holder to an amount of
cash equal to the difference between the acquirer’s projected stock
price at some future date after the close and the acquirer’s actual stock
price at that future date
• In sum: buyer can avoid excessive dilution at the time of close in case
arbitrage community has pushed down buyer’s sock

99
Acquisition Agreement
§ Indemnification Agreement: allocation of liabilities
• Minimum loss — threshold below which buyer cannot claim damage.
• Setting a threshold — buyer entitled to indemnification only if the
damages exceed a specified amount.
• Set a Deduction level — serves same purpose as setting threshold.
• Problem: minimum loss provision creates perverse incentive where
limitations on materiality are included in acquisition agreement.
• Provision typically inserted to target at opportunistic buyers (provides
that indemnification is sole remedy for breach of R&Ws).

100