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By: Steven I. Glober, Gibson, Dunn & Cruther LLP.
The purchase price provisions are among the most critical terms of a merger agreement. The value of the consideration to be paid by the acquirer to the target’s stockholders will be affected not only by provisions setting forth the amount of consideration, but also by the form of consideration, the timing of payment, potential adjustments to the amount to be paid, and any rights of set-off that the acquirer may assert against outstanding payments.
The primary forms of merger consideration are cash, stock of the buyer (or another entity), and a combination of cash and stock. The merger consideration may also include promissory notes, forgiveness of debt, or other assets. The deal’s term sheet or letter of intent, if there is one, often includes a detailed purchase price provision. If the parties negotiated such a document, counsel should use it as a starting point in drafting the purchase price provision in the merger agreement.
Cash consideration is appealing because of its simplicity and because cash gives the target stockholders immediate liquidity. This liquidity, however, will result in immediate tax implications for the target stockholders, and thus should be considered in assessing the economics of the transaction. See Choosing the Method of Sale and Setting the Purchase Price and Choosing the Form of Consideration for discussion of the benefits and drawbacks of cash, stock, and other forms of consideration from a tax perspective.
In an all-cash merger, the value of the consideration to be paid remains constant from the date the agreement is signed until the closing date. Therefore, the purchase price provision in an allcash transaction is typically straightforward—it sets forth the cash amount to be paid per share of target’s stock. The agreement may provide for purchase price adjustments to account for possible fluctuation in the value of the target’s business during the preclosing period. For more discussion on purchase price adjustments, see Understanding, Negotiating, and Drafting Purchase Price Provisions Purchase – Price Adjustments.
The agreement also may provide for deferred payments. Deferred payments are usually structured as installments to be paid after closing, either at set intervals or upon the occurrence of certain events. Deferred payments that become payable upon the meeting of certain post-closing performance benchmarks are often referred to as earn-outs and are discussed in more detail at Understanding, Negotiating, and Drafting Purchase Price Provisions – Earn-Outs. The acquirer may demand a set-off right against deferred payments to support indemnification and other post-closing obligations of the target’s shareholders. Likewise, a portion of the cash consideration may be placed in an escrow account or retained as a holdback so that there are readily accessible funds to cover indemnification claims or other specified contingencies.
Cash payment can be made by bank cashier’s check, certified check, or wire transfer. Most often, cash is paid in the form of immediately available or same-day funds sent by wire transfer.
Instead of cash, an acquirer can issue its own common stock (or any other equity security) as the merger consideration. Where stock is the merger consideration, the merger agreement will specify the number of acquirer shares that are payable per share of target stock, known as the exchange ratio. The exchange ratio can be fixed or expressed as a formula that will yield a final number at the closing. More detail follows under “Purchase Price Protections.”
Payment of the merger consideration in stock raises numerous issues that are not present with cash consideration, including valuation and compliance with state corporate and federal securities laws. The issues raised by stock consideration will vary depending on whether the issuer is a public or private company. Listed securities issued by a public company will be more liquid and easier to value than the stock of a private company.
Once the parties agree on a purchase price and payment in stock, the parties must value the stock consideration. If the consideration consists of listed securities, it can be valued in one of two ways: (1) at its market price on a specific date, often the date of signing the merger agreement or the closing date; or (2) using an average market price over a specified time period. Unlike cash, however, the value of publicly traded stock is likely to fluctuate during the pre-closing period. Any downward fluctuation will negatively affect the value that the target’s stockholders expect to receive, while an upward fluctuation will increase the value from what the acquirer expected to pay. As a result, the parties may agree upon mechanisms to limit the risks arising from fluctuation in the market price, such as floating exchange ratios and caps and collars to adjust the number of shares payable to the target’s stockholders.
Stock issued as merger consideration will either have to be registered under the Securities Act of 1933 or issued pursuant to an exemption from registration. Registered stock can be freely sold in the public market unless the seller is an affiliate of the issuer (usually an officer, director, or controlling stockholder) who may be subject to certain selling restrictions. Form S-4 is used to register stock issued as consideration in a merger and, if the stock consideration will be registered, then the merger agreement should contain a provision obligating the acquirer to file the Form S-4. Target’s counsel should note that registration under the Securities Act can be a time-consuming process, requiring a minimum of four to six weeks and sometimes much longer.
Unregistered securities will be restricted stock. Restricted stock cannot be freely sold in the public market unless it meets certain criteria set forth in Rule 144 of the Securities Act of 1933. Specifically, Rule 144 may require that restricted securities be held for a minimum of six months (if the issuer is a public company) to one year (if the issuer is a private company) before they can be publicly sold. The issuer may agree to provide registration rights for restricted stock, which would grant the target stockholders the right to request that the issuer register the resale of their shares under the Securities Act. These rights can be set forth in the merger agreement or in a separate registration rights agreement between the issuer and seller. The registration rights agreement would address the timing of registration and may also provide for penalties that will accrue to the target stockholders if the registration statement is not declared effective after a specified period of time.
In addition to federal securities law issues, stock consideration may also trigger stockholder vote requirements under state corporate law and stock exchange rules. For instance, if the acquirer does not have enough authorized shares to issue to target stockholders in the merger, then the acquirer will need to amend its charter to increase the number of authorized shares. Such amendment of the acquirer’s charter will require stockholder approval. Also, if the acquirer is issuing more than 20% of its outstanding stock as merger consideration and its stock is listed on the New York Stock Exchange, NASDAQ, or other stock exchange, then applicable rules of the exchange may require that a majority of the acquirer’s stockholders approve the issuance of additional shares. (See, e.g., NYSE Listed Company Manual § 312.03; NASDAQ Rules § 5635.) In a merger where the approval of the acquirer’s stockholders will be necessary, the target will typically include a covenant in the merger agreement requiring the acquirer to take all actions necessary to obtain such approval. See “Obtaining Shareholder Approval” in Understanding, Negotiating, and Drafting Covenants –Pre-Closing Covenants.
Rather than have the merger consideration consist wholly of cash or stock, the merger parties may agree to a combination of cash and stock. A number of factors can influence this decision, including:
For example, if the acquirer is a listed company issuing stock in the merger, and it wants to avoid having a stockholder vote, it may add a cash component to the merger consideration and reduce the amount of stock issued to less than 20% of its outstanding stock. By doing so, stock exchange rules that would require a stockholder vote on the acquirer’s side will not apply. On the other hand, if the parties want to structure the merger as a tax-free reorganization, the proportion of cash to stock will have to be limited per the Internal Revenue Code and other applicable tax regulations. Counsel on both sides should weigh the various legal and financial factors at play in the transaction to determine whether the merger consideration should be a mix of cash and stock and, if so, what the proper proportion should be.
Mixed cash-stock consideration can be structured as: (1) a fixed cash and stock component for each share of target stock; or (2) as a cash/stock election in which each target stockholder can choose to accept cash, stock, or a combination of both. In a cash/stock election, there is usually a cap on the amount of cash or stock that the target stockholders can elect and a mechanism for addressing oversubscriptions for one type of consideration.
The merger parties may agree to include certain provisions in the merger agreement in order to preserve the transaction value between signing and closing. Where all or a portion of the consideration is in stock, the transaction value will likely not remain constant during the post-signing, pre-closing period. Pre-closing fluctuations in the acquirer’s stock price present risks for the parties and a lengthy pre-closing period amplifies those risks, particularly if the acquirer’s stock price is volatile. In addition, when consideration is being paid on a per share basis, events such as stock splits, stock dividends, and reclassifications that impact the outstanding shares of the target company will also affect the purchase price, unless the merger agreement contains certain corrective provisions. See “Adjustments to Reflect Stock Splits, Reclassifications, and Stock Dividends” in Purchase Price Adjustments below.
These issues can be addressed in the merger agreement through the use of ratios, caps, collars, and adjustments to reflect changes in the capitalization of the target or the acquirer.
The number of shares of the acquirer’s stock that the target stockholders will receive in the merger will generally be determined by using one of the following ratios:
An acquirer may prefer a fixed exchange ratio because the acquirer will have certainty about the number of shares to be issued and thus greater certainty about the earnings per share and dilution impact of the acquisition. The target, however, may not want a fixed exchange ratio because (1) the target will not know the value of the shares to be paid in the merger until the closing, and (2) the target’s stockholders will bear the risk with respect to declines in the value of the acquirer’s stock.
A floating exchange ratio protects the target’s stockholders from a decline in the acquirer’s stock price by increasing the number of the acquirer’s shares issuable in the transaction, thereby preserving the transaction value. The acquirer also gets some up-side protection. If the acquirer’s stock price rises, the acquisition price remains constant; instead, the exchange ratio will adjust downward, allowing the acquirer to issue fewer shares as consideration. The disadvantage of a floating exchange ratio from the acquirer’s perspective occurs if the stock price falls. In that instance, the acquirer will have to issue more shares to maintain transaction value, thereby exposing the acquirer’s stockholders to unanticipated dilution. This also creates uncertainty regarding the impact of the transaction on the acquirer’s earnings per share and whether the transaction will be accretive. In addition, a substantial decline in the acquirer’s stock price could result in the issuance of more than 20% of the acquirer’s outstanding common stock, triggering requirements under stock exchange rules for the acquirer to obtain stockholder approval that may further delay the closing. (See, e.g., NYSE Listed Company Manual § 312.03; NASDAQ Rules § 5635.)
In either a fixed or floating exchange ratio scenario, the parties could negotiate for a termination right if the acquirer’s stock price falls below or rises above a certain level. For instance, in a deal with a fixed exchanged ratio, the target could demand a termination right in the event the acquirer’s stock price drops by more than a certain percentage (e.g., 15%) before the transaction is to close. Such a termination right would mitigate the market risk that the target would otherwise bear with respect to the transaction’s value. Likewise, in a transaction with a floating exchange ratio, the acquirer could ask for a termination right if its stock price fell below a certain percentage in order to avoid having to issue more shares than anticipated, thereby avoiding dilution of its current stockholders. Parties should note, however, that termination rights attached to exchange ratios introduce deal uncertainty, since it gives a party the ability to terminate the agreement based on market fluctuations. Moreover, such a termination right may not be as important to one or more of the parties if the merger requires stockholder approval. The target’s stockholders can vote against the merger if the transaction value drops to an unacceptable level; likewise, the acquirer’s stockholders may have the ability to vote against the merger if too many shares will have to be issued as merger consideration. For more discussion on termination rights, see Understanding, Negotiating, and Drafting Termination Rights and Fees.
As illustrated above, there are value and dilution uncertainties associated with fixed exchange ratios and floating exchange ratios. Accordingly, the parties often negotiate minimum (floor) or maximum (cap) limits on the value or the number of shares to be issued in the merger. Parties can also use collars, which impose both a floor and a cap on the stock portion of the merger consideration. Collars are particularly attractive in volatile equity markets, with respect to stock that fluctuates substantially in price, and in transactions where the parties expect a lengthy period between signing the merger agreement and closing the transaction. There are many ways in which collars can be structured to suit the particular facts of a transaction. The most common of these are:
Collars can be used in different ways to suit the circumstances of a particular transaction. For instance, in a merger with a fixed exchange ratio, the parties may agree to a collar that is triggered upon a decrease in the acquirer’s stock price that exceeds a general drop in stock prices in the market or among a peer group in the same industry. This is called a double-trigger collar and is meant to give target stockholders protection only if the decline in the acquirer’s stock price exceeds the overall decline in the capital markets. The parties can also provide for termination rights in connection with a collar—that is, either party could terminate the merger agreement if the acquirer’s stock price falls out of the collar range.
Collars can be symmetrical or asymmetrical. A symmetrical collar is one in which the exchange ratio and the corresponding dollar value of the stock lie at the midpoint of the designated range. An asymmetrical collar is one in which the exchange ratio and the corresponding dollar value lie away from the midpoint and closer to one of the end points of such range. Based on a number of factors, one or both of the parties may negotiate for asymmetry. For example, a target may argue that recent favorable developments in its business require an exchange ratio and corresponding dollar value closer to the higher end of the range. On the other hand, an acquirer may argue that recent negative industry developments require an exchange ratio and corresponding dollar value closer to the lower end of the range.
Purchase price adjustments are included in merger agreements to preserve the benefit of the parties’ bargain between signing and closing, and sometimes post-closing as well. The adjustment is often based on an agreed-upon value for the target or a balance sheet as of a specified date. The merger agreement will provide for delivery of a closing date balance sheet or other indicator of the target’s value, and the adjustment will be made based on the difference between the closing date balance sheet or value and the agreed-upon balance sheet or value. The mechanism is intended to assure the acquirer that the business that yielded the purchase price amount is, in fact, the business that the acquirer gets at closing. Purchase price adjustments may be distinguished from earn-outs, discussed below, under which the acquirer agrees to pay additional consideration after the merger is completed based on whether the target achieves defined performance milestones. Earn-outs are often used in situations where the parties have failed to agree on the target’s value or when the target’s business is anticipated to grow significantly or otherwise improve after closing. Purchase price adjustments are also distinguishable from contingent value rights (CVRs), which are rights that can be issued to recipients of stock consideration. CVRs are often used to provide price protection by entitling their holders to receive additional amounts if, after some period of time following the closing, the stock they received in the merger falls below an agreed value.
A purchase price adjustment can occur pre-closing or post-closing. In transactions involving a lengthy pre-closing period, the target may negotiate for a pre-closing adjustment that raises the purchase price in the event its business does better than agreed-upon thresholds. The target may argue against a post-closing adjustment, particularly if its business has been thoroughly audited and is clean. If there is a post-closing adjustment provided for in the merger agreement, the parties should consider whether some portion of the merger consideration should be held back or placed in escrow.
Purchase price adjustments are not substitutes for material adverse change closing conditions that provide a party with the ability to refuse to consummate a merger if there is a change that has a material adverse effect on the target or the transaction. Such conditions are often referred to as MAC Outs and are discussed at Understanding, Negotiating, and Drafting Conditions to Closing –Absence of Material Adverse Changes. The purchase price adjustment mechanism operates only if the merger in fact closes, and allows the parties to fine tune the purchase price after consummation of the transaction. Purchase price adjustments may not capture or correct for all conceivable actions that might skew the ultimate purchase price. However, actions not captured in purchase price adjustments may breach covenants requiring that the target be operated during the pre-closing period in the ordinary course and consistent with prior practice. Such actions also may violate the common absence of developments representation, which states that specified developments have not occurred since a reference date (usually the date of the most recent audited financial statements). As a result, inclusion in a merger agreement of pre-closing covenants and representations and warranties about the conduct of the business is important even in agreements that provide for adjustments to the purchase price. To the extent an action constitutes both a breach of a representation or covenant and an item covered by a purchase price adjustment, care should be taken by counsel to determine which category will be operative. If the action constitutes only a breach of a representation or covenant, counsel should consider whether any damages to the acquirer arising as a result of the breach can be offset against any amounts due to the target’s stockholders under the purchase price adjustment mechanism. When negotiating a purchase price adjustment, the parties should address the following items in the merger agreement:
Events such as stock splits, stock dividends, and reclassifications can have an impact on the number or value of the outstanding shares of a target company. If any of these events occur (either in the target in cash deals or in either the target or acquirer in stock deals) between signing the merger agreement and consummating the transaction, the amount of per share consideration should be adjusted so that the acquirer is not forced to overpay or allowed to underpay for the target. Counsel should confirm that such an adjustment mechanism is in place, as well as a covenant prohibiting the target or the acquirer, as the case may be, from changing its capital structure.
Changes to the outstanding number of shares of the acquirer’s stock could adversely affect any stock consideration paid to target stockholders. For example, a forward split of the acquirer’s stock that lowers the value of the acquirer’s shares would lower the value of the stock consideration. Thus, target’s counsel should confirm that any adjustments made to the acquirer’s stock (both the number of shares outstanding and available for issuance) are accounted for in calculating the number of shares delivered to target’s stockholders as merger consideration.
In an earn-out arrangement, the acquirer agrees to pay additional consideration after the merger is completed based on whether the target achieves defined performance milestones. Earn-outs are most frequently employed when the parties cannot agree on the value of the target or when the target’s business is anticipated to grow significantly after closing. Typically, earn-out arrangements are seen in deals where the target stockholder base is small and those stockholders are expected to continue their involvement in the management of the target’s business after the closing. Common examples of transactions that may benefit from an earn-out provision include acquisitions of startups and early-stage companies, companies with new products or technologies, and those in volatile or cyclical industries.
Earn-out arrangements have advantages and disadvantages. A clear advantage is that an earn-out can help parties reach a final agreement on the purchase price even though they may disagree on the target’s value. An earn-out also allows the acquirer to pay a portion of the purchase price out of the target’s profits after consummation of the merger. A disadvantage of an earn-out, however, is that it can cause the parties to work at cross-purposes with respect to the post-closing operation of the target. The target’s stockholders will want the business to be operated in a manner that maximizes their payout under the earn-out arrangement, which may or may not coincide with the acquirer’s long-term plans for the business. Accordingly, earn-outs can be complex and timeconsuming to negotiate, and ultimately may place some restrictions on how the acquirer can run the target’s business for some period of time after the merger closes.
An earn-out provision in a merger agreement should address the following issues:
For more information on structuring earn-outs and issues that arise in negotiating earn-out provisions, including federal securities law issues pertaining to earn-outs and other contingent payment arrangements, see 1-9 M & A Practice Guide § 9.10.
A contingent value right, or CVR, is a kind of deferred payment that can provide price protection for stockholders receiving acquirer’s stock in a merger. A CVR entitles its holder to receive cash, stock, or other form of consideration after some period of time following the closing of the merger if the acquirer’s stock price falls below a specified level. For example, the merger parties might agree that, if the acquirer’s stock is trading below $10 per share one year after consummation of the merger, then holders of CVRs will be entitled to receive the difference between $10 and the acquirer’s stock price. In such an arrangement, the target’s stockholders get some downside protection for the shares they receive in the merger. In addition, the acquirer can also use the CVR arrangement as a form of earn-out to bridge any disagreements over the transaction value. If the acquirer’s stock price stays at or above the agreedupon benchmark, then the acquirer will not have to pay additional consideration. The acquirer does, however, bear the risk of a drop in its stock price, whether it is due to a general market downturn or the failure of the merger to achieve expected results. A CVR can also be based on metrics other than stock price, such as working capital, net asset value, net debt, net worth, stockholders equity, sales, or cash balances. For example, in Capital Bank Financial Corp.’s acquisition of Southern Community Financial Corp., payments due to Southern Community’s stockholders under the CVRs were based on the post-closing performance of a specified loan portfolio over a five-year period. See http://www.sec.gov/Archives/edgar/ data/1159427/000114420412041650/v319784_defm14a.htm.
In structuring a CVR, the parties will have to determine when the CVR will become payable; what the benchmark trading price will be and how it will be calculated (e.g., based on an average over some period before the CVR becomes payable); whether there will be any caps on the amount payable per CVR; and what form the consideration will take if any amounts become payable (cash, stock, debt, etc.). As with earn-outs and other contingent payment arrangements, a CVR may be considered a separate security under federal securities law depending on how the CVR is structured. For liquidity purposes, the target’s stockholders may want the ability to sell the CVR and may insist on the separation of the CVR from the merger consideration. Whether the acquirer will agree to such a request will depend on its negotiations with the target and its stockholders. For more discussion, see 1-9 M & A Practice Guide § 9.10.
A portion of the merger consideration may be deposited in an escrow account or held back by the acquirer for the express purpose of satisfying any indemnification claims by the acquirer as well as any post-closing purchase price adjustments. Any amounts not used to satisfy indemnification claims or applied to downward purchase price adjustments generally are paid to the target’s stockholders upon the expiration of the holdback or escrow period, which period may coincide with the general survival period for representations, warranties, and covenants.
Stephen Glover is a partner in the Washington, DC, office of Gibson, Dunn & Crutcher LLP and co-chair of both the firm’s M&A practice group and the Opinion Committee.
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