What are the main differences in M&A transaction terms between acquiring a business from a trade seller and financial sponsor backed company in your jurisdiction?
Private Equity (2nd edition)
M&A transaction terms do not differ significantly in terms of the seller’s nature as a financial sponsor or trade seller, although this may have an impact on the pressure a seller has to close the deal (i.e. a financial sponsor who is close to the liquidation phase). That being said, the most important difference are any transaction loose ends and seller’s potential post-closing obligations. A financial sponsor will usually require a clean exit. Deferral of payments or escrow mechanisms (i.e. for future liabilities) will usually be resisted – albeit not necessarily rejected - by a financial sponsor (in fact, in some cases an escrow agreement is the prevailing alternative to address post-closing liability of the seller - i.e. if the seller is a special purpose vehicle). Moreover, sellers post-closing obligations (i.e. non-compete) differentiate depending the nature of the seller. A buyer will be more emphatic in asking a non-compete from a trade seller that operates in, or is related to, the target’s industry; at the same time a financial sponsor will not undertake any such obligation which will be restrictive either to the financial sponsor or to any entities the financial sponsor’s is currently or in the future related to.
The differences in approach between a trade seller and financial sponsor backed entity are not specific to the Luxembourg market.
In general, financial sponsor backed sellers are reluctant to grant anything other than the basic warranties (i.e. warranties as to their own ability to enter into the transaction documents and perform thereunder and title to shares).
It is also less common to have delayed escrow payments or earn out mechanisms in such transactions as, typically, such sellers wish to complete the sale as promptly as possible and distribute the consideration to ultimate holders.
Financial sponsors will seek a clean exit and more often dispose of assets through a controlled auction. This is one of the reasons that financial sponsors favor the locked box approach, providing the possibility to distribute the consideration more quickly. The absence of any post-completion adjustment eliminates the need to hold back funds in case adjustment works against the seller.
For the same reasons, sometimes financial sponsors are only prepared to give limited “fundamental” warranties (i.e. due existence, due authority and title to shares). Therefore, increasingly buyers of businesses that are owned by financial sponsor are taking out warranty and indemnity insurance to ensure that (full) operational warranties can be obtained backed by appropriate financial protection.
Currently, there are only minor differences in M&A transaction terms between acquiring a business from a trade seller and financial sponsor backed company in the Norwegian market.
Financial sponsors have traditionally been somewhat more resistant to provide comprehensive representations and warranties in share purchase agreement than trade sellers. With the breakthrough of W&I insurance in the Norwegian market around five years ago, which nowadays is used on almost all sales process conducted by financial sponsors, they are, however, able to offer the same representations and warranties package to the buyers as trade sellers.
Aside from that, financial sponsors are generally less willing to take on any residual liabilities under the share purchase agreement, such as specific indemnities, than trade sellers. Financial sponsors often need to liquidate their holding structure in Norway and abroad to repatriate proceeds in a tax efficient manner. A full liquidation may however often not be possible if the liquidating company has outstanding contingent liabilities remaining under the share purchase agreement.
It is important to set out the reality of Polish M&A transactions from the outset.
In certain jurisdictions, there is a marked difference in the terms offered in comparable deals, depending on whether the seller is a trade seller or a private equity fund.
Private equity funds often give substantially curtailed seller protection, for instance.
Polish M&A are different. Here, the critical issues are the negotiating power of the various parties and, in particular, the sophistication of their advisers. So in a situation where two leading M&A law firms are retained, the result may be a shared understanding of certain deal parameters and a shorter negotiation process, comparable to an English law transaction elsewhere.
In circumstances where these parameters are not present, the rule is “what you negotiate is what you get”. Accordingly, there is a wide degree of variability in deal terms.
Financial sponsors generally demonstrate strong desire to avoid or limit their post-closing exposures (e.g., indemnification obligations, covenants, etc.), including by use of (i) representations and warranties with limited survival periods, cap and escrow of certain portion of the purchase price, (ii) higher de minimis and/or basket thresholds and (iii) W&I insurance policies.
A financial sponsor more often uses a controlled auction and has a more strict view on terms such as that: (i) the buyer must assume the merger clearance risk; (ii) there will be no conditions precedent to completion (except for mandatory merger control clearance) ; (iii) the sponsor backed company will not offer any representations and warranties unless the buyer takes out a warranties and indemnities insurance policy (“W&I insurance”). Almost all PE backed exits will require the buyer to take out W&I insurance.
The key difference we see is that financial sponsors are often more reluctant to give representations and warranties or indemnities than trade sellers. The two main reasons for this difference are in our view the following: First, financial sponsors' aim to have a clean exit with limited (potential) outstanding liabilities in order to be able to distribute the exit proceeds to the investors. Second, financial sponsors are, by trend, less involved in the day-to-day business of the target group and, therefore, not in the same position as trade sellers to assess potential risks.
Financial sponsors usually dispose of assets through a controlled auction. Financial sponsors favour the locked box approach, allowing a clean exit and providing the possibility to distribute the consideration more quickly. The absence of any post-completion adjustment eliminates the need to hold back funds in case adjustment works against the seller. Financial sponsors are sometimes only prepared to give limited “fundamental” warranties (i.e. due existence, due authority and title to shares), in particular in secondary buy-outs.
Financial sponsors selling a company are seeking a “clean break” at time of closing in order to accelerate return on investment payable to their stakeholders. The use of R&W Insurance with limited recourse available by the buyer beyond the scope of the policy is therefore common practice. The structure of the purchase price is also affected by this priority to receive consideration upfront; as such, mechanisms of deferred consideration, earn outs and rolled equity are less frequent where the seller is a financial sponsor.
One of the main differences between a financial sponsor and a trade seller is the degree of participation in the target company’s operation, where the trade seller (or the founder) is relatively much more active in operating the company. Therefore, when a purchaser purchases shares from, for example, a founder of the target company, it would expect the founder to make broad representations and warranties related to the target company's business and operation. Such representations and warranties on the operation of the target company would normally include due authorization and capacity, the full, complete and accurate disclosure of the legal, business and financial due diligence materials, compliance with applicable law, and timely payment of relevant taxes, etc. On the other hand, financial sponsors, who normally don’t participate in the daily operation of the company, are usually willing to make only limited representations and warranties, e.g., their capacity to enter into the deal, and clean title to the shares to be sold. Correspondingly, the indemnification obligation and liability cap that a financial sponsor is willing to bear thereunder is also much more limited than a trade seller. Financial sponsors are less likely to commit to an indemnity obligation for a long time because, for example, a fund has a life of 8 to 10 years only. Moreover, where a trade seller has more than one businesses and some of which are horizontally related (for example, on the different levels of the same supply chain), the M&A terms may also address the business relationships among the related companies, given the change of the ownership and control of one of them.
The representations and warranties provided by financial sponsors and management are generally limited to core warranties, i.e. title to shares, capacity, authority and insolvency, in a secondary LBO where the scope of the representations and warranties granted by trade sellers is substantially wider and will cover operational matters (e.g. compliance with laws, employment, taxes etc.).
Almost all transactions involving financial sponsors are based on locked box mechanisms whereas trade sellers continue to use completion accounts. However, the use of lock box mechanisms is more and more frequent in trade sales as well.
Financial sponsors, unlike trade sellers, will also refuse non-compete or non-solicit undertakings so as to avoid any constraints in their future acquisitions.
Finally, because they want to stream up the proceeds as soon as possible after completion of the transaction, financial sponsors tend to refuse to assume any residual liability vis-à-vis the purchasers. As a result, specific indemnities are quite rare. Financial sponsors will also be reluctant to put in place escrow accounts to guarantee the payment of any indemnification amount.
Many financial sponsor exits are achieved through a locked-box structure. This is because it provides an effective date agreed prior to signing and no earn out mechanisms or other purchase price adjustments. This allows for a clean exit with clearly defined proceeds delivered to investors. In addition, the buyer generally receives very limited essential warranties (authority, capacity and title) in financial sponsor backed deals, and obtains W&I insurance for operating warranties. Broad indemnities are uncommon with the exception of tax indemnity, the sole recourse of which is against a W&I insurance policy, or certain identified risks, such as environmental, known litigation, etc. There are also short time limitations for all claims.
The main difference rests on the nature of the sale. Financial sponsors generally seek clean and unencumbered exits from their investment (portfolio company) so as to allow them to upstream the return of their investors, whereas trade sellers seek to maximize gain regardless of the undertaking of risks.
The principle of a ‘clean exit’ for private equity sellers in order to return cash to investors following an exit is a key driver for some of the main differences we see between M&A transactions involving sponsors versus trade sellers.
Private equity sellers typically favour locked box price pricing mechanisms to provide pricing certainty at signing. Trade sellers are not necessarily opposed to locked box mechanisms but many trade sales involve a level of separation or carve-out from the trade seller’s business that could make locked box mechanisms unsuitable.
Normally selling sponsors only give fundamental warranties with management giving the business warranties. A trade seller will normally give both fundamental and business warranties as management are unlikely to see a significant payout from the transaction, and may also stand behind a tax indemnity. W&I insurance is becoming more prevalent in transactions involving PE and trade sellers alike as trade sellers look to do transactions on terms which replicate a sponsor’s clean exit.
Buyers are also unlikely to obtain comfort from private equity sellers with respect to non-competes or non-solicitation covenants relating to the business, while trade sellers are likely to offer some protections within acceptable parameters.
Financial sponsors need to achieve a clean exit which allows them to distribute a clearly defined amount of sale proceeds to their investors. This approach influences purchase price mechanics as well as indemnity and warranty coverage given by sellers.
Transactions involving financial sponsor sellers commonly results in limited warranties. However, where financial sponsors are on the buy side, it is not unusual that they insist on full warranties and indemnity protections (save, in our experience, where the potential sale is to another financial sponsor and in which case the terms are more relaxed). To fill the “warranties gap” arising from a sale by financial sponsor seller, the seller may be willing to agree to a retention or escrow of the purchase price pending the outcome of a particular event (e.g., obtainment of regulatory approvals for the sale).
Unlike trade sellers, financial sponsor backed sellers resist terms that subject disposal proceeds to any risk and therefore negotiate against clawback provisions under warranties and indemnities. It would not be uncommon for a financial sponsor seller to provide an indemnity subject to caps and with minimal survival periods. When given, fundamental warranties can be expected to have a survival period of 5 – 7 years and tax warranties of up to 10 years.
The main difference in acquiring a business from a trade seller versus acquiring it from a financial sponsor would be the nature of representations, warranties and indemnities that are provided for the relevant acquisition. While trade sellers are more comfortable providing representations and indemnities with respect to business and operations, a financial sponsor is not comfortable providing these. Financial sponsors prefer to provide only title, authority, capacity and insolvency-related fundamental representations. A financial sponsor may back up the representations provided by the company, founder(s) and/or the management through indemnity, without providing any business representations itself. However, this may be in rare cases, with such representations and indemnities being heavily qualified with concepts such as actual vendor knowledge. It may also be that the indemnity is backed or completely excluded by providing a warranty and indemnity insurance for which the premium and costs could be partially or fully borne by the financial sponsor seller. Though such insurances are not very common in pure India-based M&A transactions, queries regarding the same are definitely gathering momentum.
A significant difference between acquiring from a trade seller versus a financial sponsor is with respect to earnouts. The principle of deferred payments is applied here, where acquisitions from trade sellers are linked to a maximum holdback of 25% of the total consideration amount. This is because, as per the foreign exchange rules in India, in the case of any transfer between a person resident in India and a person resident outside India, within a period of up to 18 months from the date of the transfer agreement, a maximum of 25% of the total consideration can be paid by the buyer on a deferred basis or can be settled through an escrow mechanism. This is also true if the entire consideration is paid at the outset, with up to 25% being indemnified by the seller for a period of up to 18 months from the date of payment of the full consideration. The earnout of 25% in these forms can be done through indemnity payouts or may be linked to the achievement of milestones or key performance indicators to be met by the seller, which may also be given in the form of a put option with a minimum internal rate of return. It is also crucial to note that such earnouts are required to, at all times, until their full and final payment, meet the pricing guidelines set out under the foreign exchange rules which, currently, state that the consideration shall not be less than the fair market value of the instrument being sold, where the trade seller is resident in India. These provisions are important to understand how domestic and foreign parties view such deferred payment arrangements and earnouts. Given that a maximum of 25% can be held back, the buyer could acquire a minimum of 75% from the trade seller, which would, in turn, entitle the buyer to complete control under company law. Therefore, once such control is fully established in any case, the decision of the earnouts with respect to the remaining 25% (or less) depends on whether the buyer is a domestic entity or a foreign one. A domestic buyer will not have to comply with pricing guidelines prescribed under the foreign exchange rules of India, whereas a foreign buyer will have to ensure that the consideration is not less than the fair market value, at every point in time when the earnouts are made. Therefore, usually, it is ideal for foreign buyers to purchase approximately 75% from the trade sellers, to avoid foreign exchange non-compliances, and for domestic buyers to simply purchase (on a deferred consideration basis) a larger percentage, up to 100%, given that there is no risk of foreign exchange non-compliance in that respect. However, the ultimate decision depends on the factors at play, on the time periods and shareholding percentage involved, and on the potential impact of a partial transfer vis-à-vis a full transfer.
Additionally, advisory contracts and/or employment lock-ins are common in deals with trade sellers in India. In our experience, we have seen buyers insist on founders and/or key managerial personnel of the company continuing their employment even post the acquisition, for the purpose of a smooth transition. This could be done through contracts of an advisory nature or contracts specifying lock-ins for such key employees. Any earnouts to be received by the trade sellers may become subject to such continued employment and/or the completion of the advisory arrangements.
Another key difference is with respect to non-compete obligations. In acquisitions from trade sellers, we have seen non-compete covenants being imposed on founders and/or key managerial personnel, in various cases. However, in rare cases, even financial sponsors are subject to non-compete restrictions, depending on their shareholding, seat on the board of directors and extent of control in the company.
The most significant difference is the pricing mechanism used, with trade sellers typically favoring a completion accounts mechanic whereas financial sponsors tend to have a preference for pricing the transaction on a locked box basis.
The locked box concept involves the seller providing, and generally warranting, a balance sheet for the business being sold at a point in time before signing of the SPA, but generally as close as practicable to the potential completion date. This balance sheet is used to fix the equity price in respect of the cash, debt and working capital actually present in the target on the relevant locked box date.
The resulting equity price is written into the agreement as an amount and paid by the purchaser at completion. This price is not adjusted further following completion and the sale and purchase agreement will not require the preparation of any completion accounts. As a result, the purchaser effectively takes on the financial risks and rewards of ownership of the business from the locked box date.
The other main difference between trade sellers and financial sponsors is the use of W&I insurance, which is now almost standard practice for financial sponsors when selling but is much less common in the Irish market when acquiring a business from a trade seller.
Hannes Snellman: Financial sponsors tend to prefer a locked-box pricing mechanism to closing accounts, particularly when on the sell-side. Moreover, deal certainty is a decisive factor for financial sponsors resulting in minimum conditions precedents. The typical closing conditions include merger clearance (if applicable), other sector-specific clearances and deal-by-deal negotiated requirements. Financial sponsors typically endeavour to achieve a ‘clean exit’ with only limited fundamental warranties given by the seller, especially as the use of (buyer-side) W&I insurance has become common in Finland. While the management may provide more extensive warranties than the financial sponsor seller, typically all sellers are treated equally in the sale and purchase agreement due to the drag-along provisions in the sellers’ shareholders’ agreement often requiring equal treatment of all sellers.
In general, financial sponsor backed sellers are reluctant to grant anything other than the fundamental representations and warranties.in these types of sell are also common not to have escrow payments or earn out mechanisms. In other hand, the trade seller shall give all types of reps and warranties and the “fight” between purchaser and seller will be the findings in the due diligence to be inserted in this section of the SPA. Also, it is standard to have escrow or earnout payments after a period of time (normally five years).
Private equity sellers tend to prefer locked box structures (see question 5).
While well advised trade sellers usually prefer locked box structures as well, closing adjustments are more frequently agreed with trade sellers than with private equity sellers.
Experienced private equity sellers will try to avoid business warranties and indemnities (and instead just provide warranties on title and capacity). In addition, experienced private equity sellers will be very keen to limit recourse for warranty claims (e.g. to an amount paid into escrow) as well as any other post-closing liability.
Where private equity sellers are forced to give business warranties, they will seek back-to-back warranties from management and underwrite a seller’s warranty and indemnity insurance policy or offer the buyer management warranties instead (which are usually linked to a buyer’s warranty and indemnity insurance policy). The latter structure has the benefit that the private equity seller will not have to concern himself with post-closing warranty litigation.
In contrast to this, it is fairly common for trade sellers to give business warranties without a warranty and indemnity insurance.
Private equity sellers will try to limit post-completion covenants to access books and records and sometimes assistance in relation to pre-completion affairs. Usually, all buyers will insist on non-compete and non-solicitation covenants (which private equity sellers will typically try to resist). Trade sellers are usually more likely to offer and accept post-completion covenants.
Financial sponsors strive towards a “clean exit”, which can be achieved by excluding potential post-closing liabilities to the greatest degree possible. A clean exit allows the financial sponsor to distribute to its investors a clearly defined amount of proceeds from the portfolio company sale more quickly and with greater certainty. Financial sponsor sellers typically structure sales to provide for (i) a working capital based purchase price adjustment, with sole recourse to an escrow amount for downward purchase price adjustment, (ii) the buyer obtaining R&W insurance, with the buyer’s recourse limited to the coverage of such R&W insurance (or R&W insurance and a specified, limited escrow amount, which is often expressed as a portion of the deductible / retention under the applicable R&W policy (typically, 50%)) and (iii) survival of claims for a limited period of time following closing, if at all. While trade sellers are increasingly employing these same tactics with success, in our experience, the full suite of these limitations are more prevalent in financial sponsor backed transactions.
As sellers, financial sponsors tend to avoid any post-closing exposures and to limit post-closing covenants and indemnification terms. Limitations on indemnification include short survival periods for representations and warranties (sometimes such survivals are less than a year after the closing) and incorporating de minimis, deductible or basket and cap thresholds or amounts with respect to indemnification payments. Cap amounts negotiated by financial sponsors are often lower than those negotiated by trade sellers.