Welcome to MJ Hudson’s monthly On Target, where you’ll find useful tips and insights to ease you through your M&A transactions. This month we focus on 10 of the key issues to consider if you are the seller of a UK business with a US buyer at the negotiating table.
For the purpose of this article, we have assumed that 100% of the share capital of a UK private limited company is proposed to be sold under a sale and purchase agreement (“SPA”) governed by English law.
In UK M&A, the purchase price of a target company is typically determined based on completion accounts or the locked box approach.
Completion accounts allow for a post-completion price adjustment if the target’s financial position (usually based on working capital, net debt and cash) is different to that at completion. Completion accounts are often seen as the ultimate protection for a buyer given the ability to adjust the purchase price after completion, and they are almost always used in US M&A (and are referred to as a “working capital adjustment”).
Under the locked box approach, the purchase price is fixed based on the target’s equity value as derived from a historical (pre-signing) balance sheet with no opportunity for adjustment. The buyer bears all trading risk in, and all profits of, the target from the date of the historical balance sheet date until completion, supported by an indemnity from the seller for any “leakage” of value (e.g. dividends and other agreed payments) that occurs between from the date of the locked box accounts until completion.
The locked box approach is commonly used by UK private equity sellers and in UK auction sales, but is rare in US M&A. Given the relative lack of familiarity of US buyers with the locked box approach, the seller of a UK business may wish to consider using completion accounts to generate interest from US buyers in the target business.
Antitrust and/or regulatory clearances are often required for an M&A transaction to complete, which can mean a split signing and completion under an SPA. In this instance, a US buyer may be more likely than a UK buyer to require additional non-regulatory conditions to be included in the SPA to cover this “risk period” between signing and completion.
These conditions often include:
(a) the accuracy (i.e. repetition) or “bring down” of all or substantially all of the seller’s warranties at completion, often measured against a materiality standard;
(b) no material breach of pre-completion covenants (these specify how the target business should be operated between signing and completion to preserve its condition); and
(c) a material adverse change (MAC) clause (as discussed below).
The inclusion of additional conditions erodes the seller’s deal certainty, as they give the buyer a termination right.
A MAC clause permits a buyer to elect not to complete a transaction if the financial position of the target business (or, sometimes, its prospects as a result of macro events) has materially and adversely deteriorated in the period between signing (or the date of a set of historical audited accounts) and completion.
MAC clauses are far more usual in US M&A than in UK M&A and are generally more broadly defined, and therefore more buyer friendly, than MAC clauses in UK deals. However, MAC clauses are difficult to enforce in both the UK and the US and are often requested by a buyer as a potential means to renegotiate the purchase price before completion if it can find a reason to do so. As indicated above, a MAC clause is best avoided by a seller. In UK and US M&A, if a seller agrees to a MAC clause it will usually seek to exclude from the definition of MAC adverse changes resulting from macro events, changes in law or accounting rules, and any change caused by the seller’s compliance with the terms of the SPA or the announcement of the transaction.
A third party escrow account which holds part of the purchase price to satisfy a buyer’s potential claims (including, if agreed, any post-completion purchase price adjustment) is very common in US M&A, particularly with US private equity sellers. An escrow account is less common in UK M&A, and often fiercely resisted by private equity sellers.
In US deals a buyer’s sole recourse for all claims is sometimes limited to the escrow account to ring-fence the seller’s potential liability. This is often the case where the target company has a large shareholder base or where the seller is a private equity fund. In UK M&A, it is unusual for a buyer to have recourse solely against the escrow account, instead it is used to provide security for part payment of potential claims against the seller.
An online data room is now common place in M&A transactions (it is rare not to see one). In UK M&A, it is extremely common for the entire data room to be disclosed against the seller’s warranties, subject to a standard of, at least, “fair” disclosure under English law.
General disclosure of the data room is not market practice in the US. Rather, disclosure is usually only specific against the relevant warranties as set out in the disclosure letter. However a US buyer should be able to accept full disclosure of a data room if it is well-organised and of a manageable size.
US buyers will typically require a seller to indemnify them for all losses arising from breaches of warranties, subject to express limitations. In contrast, in the UK a breach of warranty is usually calculated with reference to contractual damages, being the decrease in the value of the target’s shares due to the warranty breach, rather than on a more generous indemnity basis. Although the technical differences between recovery on an indemnity vs. contractual basis can largely be removed with legal drafting, this is another request that a UK seller should strongly resist.
In the UK, the financial limitations that apply to warranty claims focus on three metrics – an aggregate cap, a ‘de minimis’ amount (i.e. minimum size of claim; only claims in excess of this value can be actioned), and a threshold amount (i.e. the total value of all actionable claims must exceed this amount before a claim can be brought). The purpose of the ‘de minimis’ concept is to weed out immaterial or nuisance claims, and it is a standard feature of UK M&A deals. By contrast, US M&A practice is mixed, so a US buyer may, initially, be surprised if a seller proposes a ‘de minimis’ for warranty claims. Practice also differs in respect of the type of threshold, discussed below.
In UK M&A, the whole amount of all aggregated warranty claims is usually recoverable once the threshold (referred to as a hurdle or tipping basket) is reached. This is a buyer-friendly position and a principle that is rarely negotiated in UK deals. In US M&A, once the claims threshold is reached the buyer is often only entitled to the excess amount over that threshold (referred to as the excess or deductible), which favours the seller. This is a key difference and a well advised US buyer is likely to insist on adopting the UK approach of a hurdle/tipping basket. A seller in a UK deal should mitigate this by arguing for a higher threshold amount than might be ordinarily seen in US M&A (which is often a lower proportion of the purchase price given it may work as a deductible).
A US buyer may seek to expressly preserve their right to bring a warranty claim against a seller even if they have actual knowledge of a potential claim (e.g. through the seller’s disclosure process or the buyer’s own due diligence). This is often referred to as a “pro sandbagging clause”. In the UK, it is highly questionable whether this clause would be enforceable at law; the general view is that if a buyer has actual knowledge of a matter that leads to a successful warranty claim, it may only be awarded nominal damages by an English court. A pro sandbagging clause is rare in UK M&A and although it arguably poses less risk to a UK seller (due to enforceability doubts), it should still be avoided if proposed.
A UK seller may seek a clean break from SPA claims by requiring a buyer to take out warranty and indemnity (W&I) insurance. W&I insurance is also commonly proposed by UK buyers. However, W&I insurance is not as commonly used in US deals, so the suggestion may be received with scepticism. This is even more likely to be the case if the buyer is a US corporate, rather than a private equity or other institutional investor.
With special thanks to Jonathan Silverblatt, a partner at Reitler Kailas & Rosenblatt LLC, who provided input on New York law and US M&A market practice for this article.
Is this brief too brief? Want to know more about issues to consider if you are approached by a US buyer? (of course you do) Expert legal advice is on hand from MJ Hudson’s M&A team. Just contact any of the On Target team (details below) or your usual MJ Hudson M&A contact, and we’ll gladly help.
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