Private M&A: Equity consideration transactions - Enhanced due diligence, more extensive warranties and alternative risk allocation

The past eighteen months have seen a steady increase in sellers accepting consideration other than cash in private M&A transactions.

Equity issued by private companies raises questions around the level of comfort which a seller requires in order to accept such consideration as an acceptable alternative for cash. Equity consideration is also considerably more complex from a process perspective, as strictly speaking there are two separate transactions with different deal dynamics being merged into one (i.e. the sale of a business by the seller, and a (minority) investment in the purchaser).

This puts even more pressure on determining the appropriate risk allocation between deal-making parties which has, as a general matter, already been receiving more attention given the general uncertainty in the markets and the current economic, regulatory and political environment. Below we explore a few key points when assessing whether a non-cash consideration structure could be workable for a transaction.

Seller due diligence on the purchaser

In most M&A processes, due diligence is carried out by the purchaser on the target business. Where a seller acquires an equity stake in the purchaser in exchange for its sale of the target, it will want to carry out its own due diligence on the purchaser. This may add additional strain on the purchaser’s management, which will already be involved in the due diligence exercise on the target and negotiating the terms of the overall transaction. Purchaser management will also need to assist in setting up a data room, providing information on the purchaser’s business and responding to the seller and its advisers’ queries.

We have seen that the level of such sell-side due diligence can range considerably from light touch (similar to the approach taken in the past in transactions involving investments in emerging companies), or highly detail-oriented. Where parties want to explore sell-side W&I insurance on the purchaser warranties, the latter will be preferable in order to ensure a comprehensive scope of insurance coverage.

More extensive warranties on the purchaser

Warranties applying to the purchaser in ‘plain vanilla’ SPAs often only concern purchaser capacity, authority and certainty of funds. Where the purchaser is also the issuer of the equity being paid in consideration for a target, the result is likely to be a (potentially significant) expansion of the purchaser warranty catalogue, given the increased relevance of the purchaser’s operations which underpin the value of its equity instruments.

Requesting additional warranties of the purchaser can trigger lengthy negotiations and discussions similar to those seen regarding seller and target warranties. An often-discussed approach is one of mirrored warranties, i.e. that the substance of the warranties applying to the seller and the target should apply equally to the purchaser. We have seen this mostly in cases where the purchaser is operational in the same or a similar sector or business as the target group which it is acquiring, where it may therefore be sensible to have the same or substantially similar protection for both parties. Of course, in the end, the scope of warranties is often a case-by-case matter and also largely depends on the bargaining power of the parties involved.

Risk allocation

Some of the risk allocation points which are particularly relevant for equity consideration transactions are as follows.

Challenges with classic risk allocation mechanisms 

• Purchase price adjustments. The valuation method used to determine the value of the equity issued by the purchaser may be different than the valuation method used for determining the purchase price of the target being acquired. We have encountered numerous emerging companies using the valuation of their latest funding round as a basis for the valuation of their own equity instruments used as consideration in the context of their envisaged acquisition of a target. This means adhering to a historical price which is presented as having little or even no margin for negotiation or adjustment, including for any quantitatively measurable issues which may have been identified during the due diligence process.
• Specific indemnities. A specific indemnity triggering a cash indemnification by the purchaser may not be the desirable instrument to address potential risks which may crystallise in the future, as the seller will hold a stake in the purchaser (i.e. the entity paying out under the specific indemnity) post-transaction. This may create an undesired dynamic between the purchaser and the seller.
• Warranty claims. Like with specific indemnities, it may also not be desirable to claim against the purchaser in case of a breach of warranties. Again, such may result in an undesired dynamic between parties holding an economic and/or voting participation in one another.

Reciprocal W&I insurance

W&I insurance can be particularly a helpful risk allocation tool to address some of the above concerns. This of course assumes a relatively clean due diligence and comprehensive coverage being offered by the insurance underwriter. Issues again arise when there are significant exclusions in insurance coverage, which may trigger discussions around whether excluded subject matters or warranties should be backed by recourse against a warranting party (and whether claims for damages against the warranting party should form primary or secondary recourse, i.e. sitting next to or on top of the W&I insurance policy).

We have seen various approaches being taken, with many deals done on the basis that the W&I insurance is supplemented by the warranting party being liable for certain excluded warranties which are considered material by the party benefiting from the warranties. Less frequent is a more comprehensive liability regime whereby the warranting party can be held liable for any claims for damages not covered under the W&I insurance policy (including, for example, for excess claims for breaches of (usually fundamental) warranties in case the policy limit is exceeded).

Calculation of damages

Even in transactions where the suite of warranties and the liability regime concerning each of the seller/target and the purchaser are mirrored, the outcome of damage claims may still be very different.

• Difference in applicable law. If the transaction documents governing the sale of the target, on the one hand, and the issuance of equity in the purchaser, on the other hand, are subject to different applicable laws, the manner in which damages are calculated may be very different. Broadly speaking, this may lead to situations in which damage claims of one party take into account damages suffered at target company level (which is often the case in continental European jurisdictions), and damage claims of another party only take into account the difference in purchase price resulting from the breached warranty being untrue (which is the other common approach globally).
• Pro rating of damages and impact on drafting of financial thresholds. Depending on the applicable concept of damages (see above), the limitations on liability applying to the purchaser warranties may merit a different approach than those customarily applied to seller warranties. It may be worthwhile, for example, for the de minimis and thresholds to take into account the proportion of equity which will be held in the purchaser instead of tying such values to the purchaser’s overall valuation (as the damage for the seller will likely be proportionate to its stake).

In summary, equity consideration transactions are inherently complex and bespoke. As the number of such transactions increase, market practices are emerging and evolving. Having visibility of what is being done globally on such deals helps negotiate the best outcomes for our clients.

Our team is of course happy to advise and help you navigate the field.