The Anatomy of a Deal Newsletter November 25, 2020
- Exclusivity provisions in the LOI are legally binding, but savvy sellers can structure them to allow for flexibility if the buyers try to change deal terms during that period.
- Delayed-close deals outline specific closing conditions, but can get tricky (and litigious) when the conditions are met, but one side still refuses to consummate the transaction.
- A reverse termination fee provision, often a few percent of the purchase price, can be a helpful tool for sellers wary that a buyer may back out of the deal.
This month, we talk about the concept of deal protection, but specifically as it relates to private company transactions. Deal protection simply refers to the various mechanisms used by buyers and sellers to help ensure that the deal they strike in principle ultimately comes to fruition. For example, a buyer wants to avoid a situation where another bidder (sometimes called an “interloper”) waltzes in and tries to steal the deal away from the buyer after it has invested significant time and expense pursuing the deal. Fun challenge: try using the word “interloper” in a sentence sometime today.
Private Deal Protection vs. Public Deal Protection
There’s a ton of riveting literature about deal protection in public company transactions. Concepts such as the “fiduciary out,” the “no-shop,” the “go-shop,” the “lock-up,” “the break-up fee,” and others are common. While these concepts aren’t entirely foreign to private deals, they’re much less prevalent, for a few reasons.
First, a large percentage of private company deals are structured as “simultaneous-sign-and-close” deals, meaning that the deal closes as soon as the purchase agreement is signed. In those cases, there aren’t many ways to practically implement deal protections, except in the letter of intent (LOI), which we’ll describe further below.
Second, in many private deals, the seller group is pretty small. Maybe there’s a single shareholder or a small group of shareholders, but there often aren’t huge groups of shareholders, each owning a very small piece of the company as is the case in public company deals. So fiduciary duties—while still applicable—tend to be easier to manage in private deals because the shareholders tend to be more directly involved in the process.
However, deal protection still matters in private deals, even though the deal protection mechanisms may take a different form. And, in many private deals, some of the same circumstances may exist as in a public deal, such as in cases where there is a large and dispersed shareholder group.
Deal Protection Mechanisms
Deal protection often focuses on the buyer. And that makes sense because buyers want to make sure that they don’t spend a bunch of money pursuing a deal only to have it snatched away. But sellers also have an interest in deal protection so that they can hold the buyer to the deal struck in the LOI. So, let’s look at some of the more common deal protection mechanisms that might arise in private transactions.
1. Letter of Intent
Deal protection for private deals begins—and often ends—with the LOI. For both buyers and sellers, the LOI represents a key inflection point in the deal lifecycle. A detailed LOI will ensure that the buyer and the seller have alignment on the key components and expectations of a transaction before going too far down the path. When everyone enters into the deal with a common understanding, the odds of success obviously increase.
In addition to the general purpose of aligning the buyer and the seller on the key terms, the LOI is also where we often find the exclusivity provision. Simply stated, the exclusivity provision requires the seller to deal exclusively with the buyer for some period of time—often somewhere between 30 and 90 days. The seller must agree to refrain from “shopping” the deal to other potential buyers during this period. And even though the exclusivity provision appears in the LOI, it’s one of the few LOI provisions that is legally binding.
Exclusivity helps the buyer, not the seller. It gives the buyer some additional leverage in negotiations, knowing that the seller can’t simply turn to another bidder at any time. However, all it does is force the seller to sit on its hands for a period of time. It doesn’t force the seller to do a deal with the buyer on the terms stated in the LOI. It doesn’t stop the seller from deciding to do a different deal after the exclusivity period expires—assuming the seller wasn’t shopping the deal during the exclusivity period and assuming the seller was somehow successful in keeping another potential buyer waiting patiently in the wings.
Savvy sellers also know how to negotiate an exclusivity provision that gives them free ability to engage with another potential buyer if the first buyer tries to change the deal terms. While the deal terms in the LOI aren’t binding, the seller can oftentimes use the buyer’s proposal to change those key deal terms as a way to terminate the exclusivity period early and walk away without any strings attached. Similarly, if the buyer can’t get the necessary financing or deal approvals, the seller can often negotiate a provision that allows for early termination of the exclusivity period in those limited circumstances. So, in a way, the seller can use the exclusivity provision as a back-door deal protection mechanism to discourage the buyer from re-trading on the deal.
2. Closing Conditions + Remedies
The remaining deal protection mechanisms we’ll talk about generally only apply in the “delayed-close” purchase I mentioned above. First, we look at closing conditions and related remedies, which can help sellers protect their deal from a buyer that gets cold feet before closing.
In a delayed-close deal, the buyer and seller enter into a purchase contract that specifies a number of actions that must be taken and circumstances that must exist (or not exist) for the closing to occur. Think of a contract used to buy or sell a home. The contract gets signed, and then the closing occurs a few weeks later after various things have occurred, such as the buyer getting financing, completion of a satisfactory property inspection, title search, etc.
In a delayed-close deal, sellers are rightly hyper-focused on what things must happen, or not happen, to trigger the closing—these are the closing conditions. Not surprisingly, sellers want closing conditions that are easily achieved, and buyers prefer to retain as much flexibility as possible. A lot can happen—good and bad—between signing the agreement and closing. The buyer doesn’t want to be on the hook to close a deal if something bad happens that makes the deal less appealing.
Sellers who are successful in negotiating closing conditions that are more easily-achieved are able to effectively protect their deal by making it relatively certain that the conditions will be satisfied—and therefore, the buyer will be forced to close.
But let’s say our seller is successful in getting a set of easy-to-meet closing conditions in the purchase agreement. What happens if the buyer still can’t or won’t close? That’s where things really start to get interesting.
Most purchase agreements will provide for a “specific performance” remedy. This means that, if the closing conditions are met but either the buyer or the seller still refuses to close, the other can ask a court to still force the parties to do the deal. Problem solved, right? Well, maybe. The next—and most important—question is whether the buyer actually has the wherewithal to carry out the deal.
Let’s say MegaCorp decides to buy Little Guy, LLC. Little Guy feels pretty good that MegaCorp can follow through with the deal even if they can’t get outside bank financing. However, MegaCorp—as is often the case—decides to use a new subsidiary to enter into the purchase agreement with Little Guy. Like many large companies, MegaCorp often operates through dozens of subsidiaries falling under its corporate umbrella.
But the problem for Little Guy is that, if Little Guy ever has to enforce the contract against MegaCorp’s subsidiary, it also has to ask itself whether that subsidiary actually has any way to satisfy a court order requiring it to go through with the deal. A $100 million judgment against a company that doesn’t actually own anything is worth…nothing. So Little Guy will need MegaCorp to contractually backstop its subsidiary’s obligations in some fashion—a critical but always difficult negotiation.
3. Termination Fees + Reverse Termination Fees
Once in a while, I’ll have a seller I’m representing ask me to put in a “break-up fee” or “termination fee” in case the deal doesn’t close for some reason. I tell them that they actually want a “reverse termination fee” because the termination fee protects the buyer, and the reverse termination fee protects the seller. The seller—grateful for my wise counsel, I’m certain—usually responds with something like “OK whatever…(whispers under his/her breath) nerd.”
So what do these terms mean for your deal?
For buyers, a termination fee protects the buyer against the deal not closing due to certain issues outside of its control. For example, if the buyer invests several weeks of time and hundreds of thousands of dollars on due diligence only to find out that the seller’s shareholders won’t ultimately approve the deal, the buyer will probably want some compensation for its losses.
However, for the reasons stated above, many of these types of risks are less prevalent in the private company deal. So we actually don’t see too many termination fees. But occasionally, we see the reverse termination fee. The reverse termination fee compensates the seller for its time, effort and expense if the buyer doesn’t close the deal for certain reasons.
What reasons? Glad you asked.
The seller won’t get a reverse termination fee if the buyer finds something in due diligence that changes its view of the deal. But the seller may well have a claim to a reverse termination fee if the buyer can’t get financing to close the deal. So we might see the reverse termination fee crop up in situations when the buyer’s failure or refusal to close is due to circumstances that the buyer controls (or is at least better able to control).
But, wait a minute. If the buyer can’t get financing, will it actually have any money to pay the reverse termination fee? And, if it has money, why do we need the reverse termination fee if the seller has the ability to rely on the specific performance remedy you talked about before?
Someone has really been paying attention!
The short answer is that the seller actually doesn’t need the reverse termination fee if it has a specific performance remedy, if it has another party that’s contractually standing behind the buyer’s obligations, if that party can pay the full purchase price, and if the seller is willing to go to court to sue for the full purchase price. If any of these “ifs” don’t work for the seller, then the seller needs a different remedy.
And, as we talked about above, the buyer oftentimes doesn’t want its parent company or financial sponsor as a party to the purchase agreement. In those cases, the seller may only be able to get the parent company or financial sponsor to guarantee payment of the reverse termination fee, but not 100% of the purchase price. So, the reverse termination fee may simply be as good as it gets for the seller. Not ideal, but the seller may decide that the reverse termination fee at least gives it enough protection to move forward.
And how much is the termination fee? As usual, it depends, but it’s often a few percent of the total purchase price. That percentage changes based on the size of the deal, the identity of the buyer, the deal risks involved, and others.
Deal protection gets much less attention in the private company context, but it’s still just as important. Knowing the risks to your deal and how you might protect against them will give you peace of mind and put you in the best position for success.
Next Month: 2021 New Year’s Resolutions
Read last month’s piece: Restrictive Covenants: A “Tommy Boy” Case Study