This article is written by Prateek Giri Goswami, pursuing a Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from Lawsikho.

Introduction

Mergers & acquisitions (hereinafter M&A) are an integral aspect of the corporate world, and they are prevalent in abundance around the world. M&A happens for various reasons, such as a method of expanding one’s business or reviving a faltering business from the claws of bankruptcy thereby becoming an intrinsic part of corporate restructuring. The process of an M&A follows multiple processes before culmination, this article will lay emphasis on the Closing condition and mechanism involved while executing an M&A transaction. 

What are mergers and acquisitions?

M&A is a way of consolidating two entities, when two companies amalgamate together to become one entity it’s called a merger when a merger happens the distinct identity of one company ceases to exist and coalesces into the other company making it into. The very purpose of the merger is based on the adage ‘in union there is strength’, when one company in spite of viable business qualities is underperforming due to certain extraneous reasons, the pragmatic approach is to get merged with a company that can utilize the company’s asset in a better way and is able to capitalize on the business model of the merged company by using the business intelligence of its own company. There are various type of mergers such as:-

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  1. Horizontal merger: Same business line for example competitor`s merger like idea and Vodafone.
  2. Vertical merger: Same business line but different production stage for example Reliance and Flag Telecom group.
  3. Reverse merger: when a parent organization merges into its subsidiary.
  4. Conglomerate merger: Merger of completely different business organizations for example L&T and Voltas Merger.

Whereas, an acquisition is slightly different in nature, in acquisition an entity buys out most of the ownership stakes of the other thereby completely acquiring the control over the latter`s organization, A simple example of acquisition is purchasing the most number of shares of a company by entering into a share purchase agreement. By executing such an agreement the buying company gets control and the ownership of such company. 

The gap between signing and closing of the transaction

Unlike an ordinary agreement, when a share purchase agreement is executed for the purpose of acquisition, the rigmarole begins from here because the process of translating the terms and conditions of the agreement into actions gets started, and this process of transition can be time-consuming depending upon the complexity of the organization with respect to size, assets, governing laws, auditing, etc. The executed share purchase agreement acts as a roadmap to define what the parties are obligated to do in order to effectively implement the terms and conditions of the acquisition, therefore, it is pivotal to draft the terms and conditions of the agreement comprehensively. In any agreement there are certain liabilities on each party to do or to refrain from doing something, similarly, upon execution of a share purchase agreement, it imposes a duty on each party to adhere to conditions that they have agreed in the agreement.

What is the closing mechanism in case of acquisition?

In an acquisition the buyer company purchase enough shares to gain ownership control of the acquired company, at the initial stage of this process the  such as signing a confidentiality agreement, letter of Intent, negotiation on pricing, approvals from board of directors of both the companies, due diligence of each other`s organization to ascertain the viability of the acquisition, intimation to the stock exchange regarding the possible acquisition, intimation to the shareholders and other investors and their approval etc, only after the pre-conditions are fulfilled and there is a firm meeting of minds between both the parties, the process of formulation of an agreement begins, the agreement must contain the schedule for compensation, representation and warranties, necessary approvals and waiver, process of termination and its implications on each party among other conditions, it imposes a legal obligation on each party to comply with all the terms and conditions of the agreement before the actual closing of the acquisition can take place at culmination. The closing mechanism in case of acquisition through share purchase agreement can be explained in the following manner:-

A. Representation and warranties: 

A company value cannot be accurately calculated solely on the basis of its net assets or profit generation, there are other factors involved that indicates the real value of an entity such as goodwill, market reach, customer base, prospective growth, less or no debt, etc, let us understand it with the example of Flipkart Acquisition by Walmart, when it was acquired, Flipkart was not making huge profits, moreover, it had a debt to pay, nevertheless, it was acquired by Walmart on a colossal price of 16 Billion dollars making it the world`s largest e-commerce acquisition, so what was the reason behind such an exorbitant sale, it’s the intangible value that was created by Flipkart, it had a huge consumer base in the Indian market and every company in the world wishes to capitalize on this huge Indian Consumer Base.  

The buyer company cannot assess everything will vet the target seller company and to create certainty, the seller company provides representation and warranties clearly stating the status of the seller company, and representations and warranties play a major role in accentuating viable buyers. Therefore, it is incumbent upon the seller company to honor the things claimed under the representations and warranties and any serious contradiction may lead to derailment of the acquisition process and preclude the closing of the acquisition. 

It is imperative for the seller company to clearly state all the representation and warranties and for further clarity, it is advisable for the seller company to create another schedule, which discloses all the things of the company that is contrary to the representation and Warranties such as the tax of this year is unpaid or company is facing litigation, or any incumbrance, disclosing these things at the outset along with representation and warranties creates transparency and good faith among the parties and protects the seller from getting sued by the buyer for such flaws as they already have been disclosed at the outset. Hence, upon execution of the acquisition agreement (share purchase agreement), honoring and adhering to the representation and warranties becomes the first conducive step to the closing mechanism of the acquisition process.

B. Pricing adjustments: 

In the corporate world, the value of each organization is subject to volatility, as explained above that there exists a gap between signing an agreement for acquisition and actually closing the same, it is expected that a seller company`s valuation during signing the agreement may differ when the actual transaction closes, the uncertainty about this expected change is that the valuation may get increased or it may get decreased, in either case, one party is bound to suffer if the price is fixed unconditionally at the outset while signing the Agreement. Therefore, in order to remedy this the parties agree to a certain method for adjustment of price in the event it fluctuates at the time of closing, according to the ICC Model on Merger and Acquisition Contract– Share purchase agreement the two common methods used for ascertaining price adjustment mechanism are:

  1. Closing accounts principle: It simple and conventional, when the acquiring company is not able to acquire the most latest and adequate financial data of the target organization at the time to determine the current value of the acquired company during the time of closing and it already has been several months before the last audit, therefore, the parties simply agree to calculate the net asset of the company at the time of closing and determine the price adjustments on the basis of a formula agreed by both the parties with respect to price adjustment.
  2. Earn-outs: This method is more detailed and comprehensive, it takes the process of closing accounts and price adjustment one step further, in this one party, at the time of closing prepares a closing account on the basis of generally accepted accounting principles and the other party verified by reviewing the said draft, and if the other party agrees to the veracity of the draft then the value ascertained by such draft is agreed finalized by both parties whereas if the other party disagrees with the valuation on the draft then both the parties can make an arrangement wherein an independent expert will be appointed to check the correctness of the draft and his/her decision would be deemed final. Once both the parties agree to the closing accounts draft then the parties may proceed with the predetermined formula for a price adjustment on the basis of the closing account valuation.
  3. Other factors: As stated earlier all the representation and warranties made by the parties must be maintained in reality by the claiming party, however, what if a representation or warranty turned out to be false at the time of closing or incorrect to the extent that it adversely affects the other party, how will the aggrieved party remedy such breach and negative impact. The aggrieved buyer will ask for a reduction in payment due to the loss it has faced because of the breach of representation and warranties by the seller company, the ways to protect the interest of the buyer is:
  • upon payment by the buyer, the buyer company may ask for an escrow account to be created by the seller if any breach takes place, the buyer shall be compensated from such account;
  • the buyer company may ask for a bank guarantee by the seller till the time of the warranty period;
  • In some countries, there is a practice of creating a mutual account by both parties, wherein a part of the purchase price is kept and it can be only released upon the express consent of the seller, therefore if there is any breach of representation and warranties by the seller and seller refuses to give consent to release the amount from the mutual account so that the buyer can recover losses from it, the buyer can use to recover from such mutual account;
  • The parties may agree to payment in installment by the Buyer, if there is any breach in the future the buyer can withhold the installment but then the interest of the seller cannot be jeopardized and if this arrangement is agreed between the parties, then the buyer will have to provide bank guarantee towards the payment.

C. No external impediment:

The above-mentioned conditions are related to the parties, an external factor also plays a role in the successful closing of the acquisition process, such as any case filed by the third party for an injunction on the acquisition process, any change in the law which prohibits or restrict the acquisition to a certain extent, or any party was not able to procure necessary approvals from the government authorities.  

Closing documents 

At the culmination of the closing mechanism process, both the parties are required to furnish certain documents, and these documents will signify that the acquisition is finally completed, and the acquisition process deems to be closed, these documents are as follows:

a. undertaking by the workers union to carry on their work subsequent to the acquisition;

b. Resolution from primary suppliers to maintain the business as usual and waiver of option to terminate upon a change of control (option to terminate upon a change in control is present in several agreements).

c. Any option right, right to refusal, or any other similar right which bestows any privilege to any shareholder of the seller`s company.

d. Letters of resignation along with the waiver of any claims.

  • Deeds related to the property and business.
  • All the certificates of ownership of several assets of the seller company.

Conclusion

Mergers or acquisition are done with the purpose to enhance and expand business strength and are an integral part of the business world, it is imperative to ensure that the transition in the acquisition is done smoothly and simultaneously the interest of both the parties must be preserved or else things may get backfired and both the parties will get embroiled into protracting litigation, Therefore, by following the above-mentioned process and strategies, all the parties can be benefitted from such transaction

References

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