This article is written by Saksham Grover, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.

Introduction

Mergers and acquisitions are extremely complicated business deals that need a great deal of legal, financial, and consultancy effort. Mergers and acquisitions (M&A) can be defined as the unification of a company’s business endeavours by acquiring or merging with the business operations of another company. Despite the fact that both names are sometimes misinterpreted as interchangeable, they are distinct concepts in their entirety. An acquisition is a transaction in which the acquirer company buys the target company’s majority ownership and becomes the new owner. A merger is when two companies come together to establish a new entity. Needless to say, these large transactions result in significant changes in the company’s management and financial structure. The distinct cultures of these firms are bound to be exchanged as two separate enterprises come together. One of the most significant obstacles that organizations confront during M&A deals is cultural differences. However, the target/old entity may not be able to meet everyone’s expectations. In the same way, not everyone is welcome in the newly founded company. As a result, top executives of such companies have an “exit” mechanism in place to prevent these issues. This article discusses the reasons why CEOs opt to leave during M&A transactions, as well as the legal concerns that may arise during their departure.

Issues in transactions

There are several factors that should be addressed upfront when negotiating an M&A transaction (preferably at the letter of intent stage or as soon as possible after the execution of a letter of intent). When considering a deal, the target company and the acquiring company should think about the following points: 

1. Deal Structure

A transaction can be structured in three ways: 

1. Stock purchase; 
2. Asset sale, and
3. Merger.

Within each option, the buyer and target have opposing legal interests and concerns. When negotiating a certain agreement structure, it’s critical to understand and address material concerns. The following are some of the most important deal structure considerations: 

1. Liability transferability: Unless otherwise agreed to in writing, the target’s obligations are passed to the purchaser by operation of law when a stock transaction is completed. Similarly, the surviving entity in a merger will absorb the obligations of the other corporation by operation of law. Only those liabilities identified as assumed liabilities are transferred to the acquirer in an asset transaction, while the non-designated liabilities remain the target’s responsibilities.
2. Third-party contractual permission requirements: If the target’s current contracts restrict assignment, pre-closing authorization to assign must be sought. Unless the applicable contracts contain specific limitations against assignment upon a change of control or by operation of law, there is no such permission needed for a stock purchase or merger.
3. Stockholder approval: The target’s board of directors has the authority to approve an asset sale at the corporate level without the permission of individual stockholders. A stock sale, on the other hand, necessitates the permission of all selling stockholders. When unanimity is impossible to achieve in the context of a stock sale, a merger can be used as an alternative, in which the acquirer and target establish a mutually acceptable stockholder approval level sufficient to complete the transaction.
4. Tax repercussions: Depending on the structure, a transaction can be taxable or tax-free. Both asset sales and stock purchases have immediate tax implications. Certain mergers and/or reorganizations/recapitalizations, on the other hand, can be structured so that at least a portion of the sale profits is tax-deferred.

• An asset sale is most advantageous from the standpoint of the acquirer since a “step-up” in basis occurs, resulting in the acquirer’s tax basis in the assets being equal to the acquisition price, which is normally the fair market value. This allows the purchaser to depreciate the assets significantly and increase profitability after closing. A target would be responsible for corporation tax on an asset sale, and its shareholders would be responsible for tax on any dividends received.
• The selling shareholders would pay long-term capital gains on a stock acquisition if they had owned the stock for at least a year. The acquirer, on the other hand, would only receive a cost basis in the shares purchased, not the assets, which would remain constant and result in a negative result if the fair market value is higher.
• A third option is to defer at least some of the tax burden through a merger/recapitalization, in which case the boot would be tax-free until its final sale.
• Compromises are conceivable, for example, where the parties complete a stock acquisition with all of the above consequences remaining the same except that the deal is designated an asset deal for tax reasons, allowing the acquirer to achieve the desired basis step-up in the assets.

2. Question of equity vs. cash

For both parties, the manner of payment for a transaction may be a deciding factor. The following are the components of deal financing:

1. Cash: From the target’s standpoint, cash is the most liquid and least risky way because there is no ambiguity about the transaction’s genuine market value and it eliminates contingency payments (except the potential of an earn-out), both of which can effectively preempt competing offers better than equity. It can be obtained from working capital/excess cash or untapped credit lines from the acquirer’s perspective, but doing so may lower the acquirer’s debt rating and/or alter its capital structure and/or control in the future.
2. Equity: This entails the payment of the acquiring company’s equity, which is issued to the target’s stockholders at a predetermined ratio proportional to the target’s value, to the target’s investors. The issuance of shares may help to improve the acquirer’s debt rating, lowering future debt financing costs. A stockholders meeting (possible deal rejection), registration (if the acquirer is public), brokerage fees, and other transaction costs and hazards exist. The issuance of stock, on the other hand, will often allow for more flexible deal structures.

The final payment type may be indicative of the value the acquirer has on itself (for example, acquirers often offer equity when they believe their equity is overpriced and cash when they believe their equity is cheap).

3. Working capital requirements

Working capital adjustments are commonly included in M&A transactions as part of the purchase price. The acquirer wants to make sure that the target has enough cash on hand to cover the business’s post-closing needs, such as commitments to customers and trade creditors. The target seeks to be compensated for the asset infrastructure that allowed the company to operate and earn the profits that sparked the acquirer’s interest in the first place. A successful working capital adjustment protects the acquirer from the target starting:

(i) An expedited debt collection;

(ii) Delayed inventory purchase/sale for cash; or 

(iii) Delayed payment of creditors.

The difference between the sum of cash, inventory, accounts receivable, and prepaid items minus accounts payable and accumulated costs are the standard working capital adjustment. The definitive agreement will include a system that compares the actual working capital at closing to a target level, which is deemed as the normal level for the operation of the business based on a historical examination of the target’s operations over a predetermined period of time. The working capital calculation will also take into account uncommon or abnormal elements, “one-offs,” add-backs, and cyclical items. The true-up resulting from the post-close working capital adjustment normally occurs within a few months of the closure, and dispute processes are spelt out in the definitive agreement if there are any disagreements between the parties over the calculation.

4. Escrow and earn-outs

Any contingency to the payment of the purchase price in a transaction, including any escrow and any earn-out, should be fully stated in the letter of intent. The objective of an escrow is to give a buyer redress in the event that the target’s representations and warranties are breached (or upon the occurrence of certain other events). Despite the fact that escrows are common in M&A transactions, the terms of an escrow can vary greatly. Typical parameters include an escrow dollar amount ranging from 10% to 20% of the total consideration, with an escrow period ranging from 12 to 24 months from the closing date.

Earn-out provisions are less prevalent, and they’re mostly utilized to close the valuation difference between the target and the acquirer. Earn-out provisions are usually linked to the business’s future performance, with the target and/or its stockholders only getting additional compensation if specific milestones are completed. It’s critical to make the milestones as objective as possible when designing earn-out terms. Future revenue and other financial measures are common milestones. The target’s worry with earn-outs is that when the deal closes, the target loses control of the company, and decisions made by the acquirer after the deal closes can have a significant impact on the capacity to meet the agreed-upon milestones.

5. Representations and warranties

Traditionally, representation and warranty have been lumped together as a single idea, and most people regard them as interchangeable terms. However, the two concepts are unique and distinct from one another, with distinct characteristics and, as a result, various legal remedies. To ensure that the right remedies are connected to the relevant terms in an agreement, it is critical to understand the variations between them and to use them appropriately. Also, to guarantee that non-lawyers involved in the agreement’s drafting and implementation have a thorough knowledge of the implications of these provisions.

In an M&A transaction, the process of writing the terms of the representations and warranties comprises numerous rounds of talks between the buyers and sellers. Buyers want as many representations and guarantees as they can get to reduce their risks, while sellers want a smooth exit with as little liability as possible. Typically, the target firm seeks representations and warranties that are “narrowly defined” — that is, confined to only a few specific issues — when writing such transaction agreements. The buyer firm, on the other hand, wants the representations and warranties to be “wide and flat,” meaning they should cover as many potential difficulties as possible.

Even though an error meets the three standards/components provided in Section 18 to produce a misrepresentation or a patent breach of warranty, it may not always result in repercussions under Section 19 of the Indian Contract Act. As a result, contractual protection is required in this area, which is frequently outlined in great detail through indemnities, liquidated damages, and the right to terminate the contract. This would, of course, be contingent on the parties’ negotiating power. A failure of a representation/guarantee relative to the license to perform telecom business may require the seller to deliver liquidated damages to the full extent of the consideration paid by the buyer in a transaction involving telecom firms, as such a warranty is vital to the acquisition. However, because non-payment of stamp duty or the expiration of some lease agreements may not be fundamental to the main business, no specific remedies may be granted.

Each transaction would have its own set of concerns/challenges in terms of finding sufficient representations/warranty stipulations on the part of the investor or buyer, depending on the sector of the target. In this context, the translation of due diligence findings into transactional documentation, as well as a thorough grasp of the relevant sector and its operations, is critical. While drafting transactional papers, it’s also important to consider the repercussions of breaching material representations and warranties.

6. Indemnification

In any M&A deal, target indemnification provisions are always heavily discussed. What forms of indemnification claims will be capped at the escrow amount is one of the first questions to be answered. All claims may be capped at the escrow in specific cases. There are usually a few exceptions to this cap: claims arising from fraud and/or willful misrepresentation usually go beyond the escrow and are frequently capped at the total purchase price. Breach of “fundamental reps” (such as intellectual property or tax) may also extend beyond the escrow. Another business word to negotiate with relation to indemnification is whether or not there will be a “basket” for indemnity purposes. To minimize the annoyance of small-dollar arguments, most acquirers have a minimum claim amount that must be met before they may seek indemnification – which could include a genuine “deductible” where the acquirer is not allowed to go back to the first dollar after the threshold is met.

7. Liabilities (joint and several)

The question of joint and several liability is related to the idea of indemnity. Because most transactions involve multiple target stockholders, one of the most important issues to consider from the acquirer’s perspective when it comes to indemnification is how much each of the target’s stockholders will participate in any indemnification obligations after the transaction closes (i.e., whether joint and several or several but not joint, liability will be appropriate). Each target stockholder is personally accountable to the acquirer for any future possible losses under joint responsibility. If the culpability is shared, each target stockholder is only responsible for his or her proportionate share of the damages. It should go without saying that the acquirer will virtually always want to hold each target stockholder fully liable for any future potential claims. Target stockholders, on the other hand, will generally oppose this strategy, especially if there are controlling stockholders and/or financial investors involved (both of which traditionally resist joint and several liability in every situation).

8. Closing issues and conditions

A list of closing conditions will be included in a section of the definitive agreement that must be met in order for the parties to be compelled to close the transaction. These are frequently negotiated as part of the final agreement (although sometimes a detailed list will be included in the letter of intent). Appropriate board approval, the absence of any major unfavourable change in the target’s business or financial conditions, the absence of litigation, the receipt of a legal opinion from the target’s counsel, and needed stockholder approval are all examples of these factors. The stockholder voting threshold, which must be met for the deal to be approved, is one of the more highly negotiated closing conditions. Despite the fact that the target’s operating documents and state law may need a lower approval barrier, acquirers often request a very high approval threshold out of fear that stockholders who have not authorized the transaction would exercise appraisal rights. Before committing to such a high barrier, the target should carefully examine its stockholder structure (although from a target perspective, the more stockholders approve the transaction the better, the target just does not want the acquirer to have the ability to walk away from the transaction).

9. Non-competes and non-solicits

A covenant not to compete or solicit, in the context of an M&A transaction, is a promise by the target’s selling shareholder(s) not to:

• Engage in a defined business activity that is competitive with the target’s/for acquirer’s a specified post-closing time frame or after the termination of employment with the target/acquirer, or 
• Attempt to lure away customers or employees of the target.

For such constraints to be enforced, they must be

• Reasonable in terms of time and scope, and 
• Supported by consideration.

Because an M&A transaction typically involves the sale of a business and payment of a material amount of consideration to the selling shareholders, courts have generally deemed such consideration adequate for purposes of enforceability, both in terms of scope (i.e., any material business competitive with the target/acquirer) and multiple years of duration.

Conclusion

During the modern business world, mergers and acquisitions processes have grown dramatically. This technique has been thoroughly established in order to renovate commercial relations. In India, the idea of mergers and acquisitions is real and is being implemented by government agencies. Some well-known fund-related organizations accepted mergers and acquisitions agreements, which helped to rebuild India’s commercial sector. Since 1991, India’s fiscal revolution has unlocked and brought up a slew of issues in both domestic and international arenas. Because of the intense competition in the global market, the Indian company has decided to pursue mergers and acquisitions as a critical strategic decision. The mergers and acquisitions framework in India has evolved throughout its history. The immediate effects of mergers and acquisitions have also varied throughout the Indian financial system’s various divisions. The frequency of Indian business creative obtaining outside ventures was not all that common in the past. Mergers and acquisitions performance is important for a company’s growth strategy. The reimbursement of mergers and acquisitions that were genuinely produced and maintained for the long-term growth scheme. Although the effectiveness of M&A is said to be dependent on the Board’s plan, the flexibility of the intervention era, and the interests of the parties, they can achieve their goal if they are properly equipped with the goal of successfully completing mergers and acquisitions.

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