This is the second article in a two part series highlighting and comparing various deal points reported in the American Bar Association's recently released edition of the Private Target M&A Deal Points Study (the US Study), which analyzes acquisition agreements for transactions completed in 2014 involving US private targets being acquired by US public companies, and the 2014 Canadian Private Target M&A Deal Points Study, which was released last year and analyzes acquisition agreements for transactions signed in 2012 and 2013 involving Canadian private targets being acquired or sold by Canadian public companies (the Canadian Study), as well as those reported by the prior editions of these Studies.1 The first article in this series focused on study samples and indemnification matters, while this article focuses on financial provisions, pervasive qualifiers, representations and warranties, covenants and closing conditions. The trends revealed by these Studies are enlightening but it is important to bear in mind that referring to deal point studies is not a substitute for reasoned negotiations.
Financial Provisions
Post-Closing Purchase Price Adjustments
The post-closing purchase price adjustments deal terms reported by the US Study are largely consistent with the Prior US Study. Post-closing purchase price adjustments are used in most US deals and working capital remains the most popular adjustment metric. Working capital quantifies the liquidity needed to maintain normal course operations and an adjustment based on working capital will compensate buyer or seller in the event that there is too little or too much operating liquidity. However, the majority of deals both use more than one adjustment metric and include a payment at closing based on the target's estimate. An initial adjustment at closing allows the parties to bring the purchase price paid at closing closer to the final purchase price as at the adjustment date. Furthermore, in most US deals, buyer prepares the first draft of the closing balance sheet. It is often easier for the buyer to prepare the closing balance sheet as it has control of the business and its books and records post-closing. The seller is typically provided with the right to object if it has issues with buyer's preparation of the balance sheet. A comparison of the US Study and the Canadian Study shows there are only a few significant differences with respect to purchase price adjustment deal terms, including the following: US deals are more likely to (i) use debt or cash as an adjustment metric, (ii) include a payment at closing based on the target's estimate, or (iii) exclude tax-related items from the working capital calculation.
| Prior US Study | US Study | Prior Canadian Study | Canadian Study | |
| Includes Adjustment Provision | 85% | 86% | 70% | 73% |
| If Includes Adjustment Provision, Working Capital used as an Adjustment Metric | 91% | 83% | 70% | 70% |
| If Includes Adjustment Provision, Adjustment based on more than One Metric | 59.5% | 51.5% | 22.5% | 55% |
| If Includes Adjustment Provision, Includes Payment at Closing Based on Target's Estimate | 88% | 89% | 41% | 48% |
| If Includes Adjustment Provision, Buyer Prepares Closing Balance Sheet | 90% | 85% | 52% | 61% |
| If Adjustment based on Working Capital, Tax Related Items are Excluded | 39% | 44% | 16% | 10% |
| If Includes Adjustment Provision, Debt used as an Adjustment Metric | 44% | 33% | 11% | 11% |
| If Includes Adjustment Provision, Cash used as an Adjustment Metric | 35% | 38% | 11% | 7% |
Earnouts
Earnouts allow the parties to an M&A transaction to bridge a valuation gap relating to the future performance of the target by providing for additional payments upon the attainment of certain performance milestones by the target during a specified post-closing period. The earnout related deal terms reported by the US Study are largely consistent with the Prior US Study. Slightly more than a quarter of all deals use an earnout. Most deals using an earnout do not include (i) a covenant to run the business consistent with past practice, or (ii) a provision accelerating the earnout on change of control (only 3% compared to 18% in the Prior US Study). None of the agreements in the US Study include a covenant to run the business to maximize earnout. Also, for the first time, the US Study reports on whether the agreement provides that buyer may operate post-closing in buyer's discretion. Thirty-two percent of deals include such a provision. Although it is important to define the parties' rights and obligations relating to the future conduct of the business as the degree to which earnout milestones are attained can potentially be manipulated by the way the target business is run after the closing of the transaction, parties often find it difficult to agree on such covenants and instead choose to be silent. It should also be noted that for the first time, the US Study does not report on the duration of the earnout period. A comparison of the US Study and Canadian Study shows no significant differences on earnout deal terms except with respect to buyer's ability to offset indemnity payments owed to it by seller against an earnout payment that it owes to seller: unlike US practice, Canadian agreements are equally likely to either expressly permit offsets or be silent on the point and in the latter case, the ability to set-off is determined by applicable law.
| Prior US Study | US Study | Prior Canadian Study | Canadian Study | |
| Deals Using an Earnout | 25% | 26% | 21% | 25% |
| If Includes Earnout, Includes Covenant to Run Business Consistent with Past Practice | 18% | 3% | 23% | 20% |
| If Includes Earnout, Includes Covenant to Run Business to Maximize Earnout | 6% | 0% | 8% | 0% |
| If Includes Earnout, Includes Provision Accelerating Earnout on Change of Control | 21% | 23% | n/a | 7% |
| If Includes Earnout, Buyer can Offset Indemnity Payments Against Earnout Payments | 68% | 81% | n/a | 40% |
| If Includes Earnout, Silence as to whether Buyer can Offset Indemnity Payments Against Earnout Payments | 27% | 13% | n/a | 40% |
Pervasive Qualifiers
Pervasive qualifiers, such as knowledge and material adverse effect (MAE), serve as a risk allocation tool. These deal terms are largely consistent with the Prior US Study. In most deals, MAE is defined, forward looking and does not include prospects but does include carve outs. When comparing the US Study and Canadian Study, some of the key differences are (i) the inclusion of prospects in the definition of MAE, which is higher in Canadian deals, (ii) the inclusion of carve outs being qualified by disproportionate effect, which is higher in US deals, (iii) the use of certain carve outs to MAE including, war or terrorism and change in accounting, which are higher in US deals. According to these studies, in most US and Canadian deals, knowledge is defined as constructive knowledge requiring express investigation and imputing the knowledge of identified persons to the target.
| Prior US Study | US Study | Prior Canadian Study | Canadian Study | |
| MAE Defined | 96% | 99% | 83% | 88% |
| MAE is Forward Looking | 93% | 91% | 62% | 77% |
| Prospects Not Included | 83% | 88% | 65% | 60% |
| MAE Definition Includes Carve Outs | 91% | 91% | 70% | 83% |
| If MAE Defined and Includes Carve Outs, At Least One Carve Out Qualified by Disproportionate Effect | 91% | 86% | 52% | 53% |
| If MAE Defined and Includes Carve Out: | ||||
|
88% | 85% | 57% | 55% |
|
77% | 79% | 48% | 48% |
| Knowledge Standard is Constructive Knowledge | 80% | 73% | 69% | 72% |
| If Standard is Constructive Knowledge, Requires Express Investigation Reasonable of Due Inquiry | 71% | 81% | 67% | 89% |
| If Knowledge Defined, Identified Persons Included | 96% | 97% | 78% | 82% |
Target's Representations and Warranties
The target's representations and warranties are important as they serve the basis upon which buyer can obtain disclosure, terminate the transaction, or obtain an indemnity. These deal terms are largely consistent with the Prior US Study and the Canadian Study, some of which are summarized below. Most deals include a "fair presentation" representation on the target's financial statements that is not GAAP qualified. Most deals also include a representation regarding no undisclosed liabilities that is not qualified by knowledge: however there is a change with respect to this deal term. The US Study shows a remarkable shift towards limiting this representation to GAAP liabilities (up from 22% to 41%). In general, GAAP requires the accrual of a contingent liability if it is probable that the liability will be incurred and the amount of the loss can be reasonably estimated. As such, where the undisclosed liabilities representation is limited to GAAP liabilities, the representation is limited. This is a clear shift in favour of sellers and differs from Canadian practice. The US Study and the Canadian Study also show that most deals include a representation on compliance with laws that is not qualified by knowledge. According to the US Study and the Canadian Study, there remains some differences in practice regarding the representation on compliance with laws: Canadian deals are more likely to cover present and past compliance, but less likely to include a notice of violation. Another key difference is that US deals are less likely to include a 10b-5 representation full disclosure representation than Canadian deals.
| Prior US Study | US Study | Prior Canadian Study | Canadian Study | |
| Includes Fair Presentation Representation on Financial Statements | 99% | 99% | 93% | 96% |
| If Includes Fair Presentation Representation, not GAAP Qualified | 78% | 83% | 78% | 87% |
| Includes No Undisclosed Liabilities Representation | 94% | 93% | 78% | 90% |
| If Includes No Undisclosed Liabilities Representation, Applied to GAAP Liabilities | 22% | 41% | n/a | 21% |
| If Includes No Undisclosed Liabilities Representation, Applies to all Liabilities | 78% | 59% | n/a | 79% |
| Includes Compliance with Law Representation | 99% | 98% | 89% | 95% |
| Includes Compliance with Law Representation, Knowledge Qualified | 5% | 4% | 23% | 5% |
| If Includes Compliance with Laws Representation, Covers Present and Past Compliance | 33% | 37% | 55% | 62% |
| If Includes Compliance with Laws Representation, Covers Notice of Violation | 73% | 77% | 21% | 36% |
| 10B-5/ Full Disclosure Representation not Included | 64% | 75% | 48% | 55% |
Target's Covenants
The parties to an M&A transaction typically negotiate covenants with respect to how the target may be operated during the period between the signing and closing of transaction and what each party will do to ensure that the transaction is completed. These deal terms are largely consistent with the Prior US Study, some of which are summarized as follows. With respect to the covenant to update disclosure schedules prior to closing, most US deals are equally likely to be silent or to expressly permit or require such updates. There is one major shift related to this deal point, where disclosure schedule updates are permitted or required, buyer's right to indemnification for updated matters is now limited. According to the Canadian Study, Canadian practice is quite difference on these deal points. Most Canadian deals are silent with respect to the covenant to update disclosure schedules prior to closing and where updates are permitted or required, they are also silent with respect to buyer's right to indemnification for updated matters. Most US deals include a covenant by the target to conduct business in ordinary course consistent with past practices. According to the Canadian Study, what differs between US and Canadian practice with respect to this covenant is that, in a Canadian deal, the covenant is more likely to include an efforts standard.
| Prior US Study | US Study | Prior Canadian Study | Canadian Study | |
| Silence on Updating Disclosure Schedules Before Closing | 55% | 43% | 80% | 83% |
| Pre-Closing Updates to Disclosure Schedules Permitted or Required | 31% | 42% | 20% | 17% |
| If Updates Permitted or Required, Buyer's Right to Indemnification Limited for Updated Matters | 39% | 63% | 36% | 11% |
| Includes Covenant of Conduct Business in the Ordinary Course | 95% | 99% | n/a | 93% |
| If Includes Covenant to Conduct Business in the Ordinary Course, Qualified by Consistent with Past Practices | 89% | 88% | n/a | 78% |
| If Includes Covenant to Conduct Business in the Ordinary Course, Qualified by Efforts Standard | 16% | 15% | n/a | 41% |
Conditions to Closing
A purchase agreement will include conditions to closing when the transaction does not simultaneously sign and close. If the conditions in favour of a party are not met, that party will typically have the right to refuse to close the transaction. These Studies report on a number of closing conditions. The terms reported by the US Study are mostly consistent with the Prior US Study, some of which are summarized as follows. Most US deals include a condition that there has not been a material adverse change (MAC) with respect to the target, whether that condition comes in the form of a stand-alone condition or through a representation on MAC that is brought down in the condition to closing regarding the accuracy of representations and warranties. Another common condition to closing is that there be no legal proceedings challenging the transaction. The US Study shows a rise in the percentage of deals that include a no legal proceedings challenging the transaction condition and a shift in the type of legal proceedings covered from "pending and threatened proceeding" towards "pending proceedings only". The Canadian Study shows that most Canadian deals also include such a condition, and that even if there an increase in the percentage of Canadian deals that tie the condition to "pending proceedings only", in the majority of Canadian deals the type of legal proceedings covered by the condition is "pending and threatened proceedings".
| Prior US Study | US Study | Prior Canadian Study | Canadian Study | |
| No MAC Condition | 6% | 9% | 18% | 5% |
| Includes No Legal Proceeding Challenging the Transaction Condition | 67% | 86% | 86% | 93% |
| If Includes No Legal Proceeding Challenging the Transaction Condition, Pending and Threatened Proceedings | 66% | 43% | 82% | 74% |
| If Includes No Legal Proceeding Challenging the Transaction Condition, Pending Proceedings Only | 30% | 55% | 18% | 26% |
Footnotes
The authors would like to thank Kim Ton-That for her contribution to this article.
1 The Prior US Study analyzes acquisition agreements for transactions completed in 2012 involving US private targets being acquired by US public companies and the Prior Canadian Study analyzes acquisition agreements for transactions completed in 2010 and 2011 involving Canadian private targets being acquired by Canadian public companies.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
