Continuing our discussion of M&A Issues, we are going to talk about breakup fees today.
A breakup fee is a payment made by the buyer to the seller if the M&A transaction doesn’t close.
Many M&A transactions do not include breakup fees, particularly smaller transactions. But as the value of the transaction rises and the potential disruption to the seller’s business increases, it is more likely that the transaction will include a breakup fee. The negotiation of the breakup fee can be an important part of the letter of intent (LOI) negotiation and there are cases where merger deals have not happened because both parties could not agree on a breakup fee.
As a buyer, you want to avoid and/or limit the size of breakup fees as much as you can. And you want to be very specific about the circumstances in which you would pay them. You can and should carve out as many reasons for a deal falling apart from the breakup fee as you can.
As a seller, you want to include a breakup fee in the LOI for a bunch of reasons. First and foremost, it is a good way to make sure the buyer is serious about the transaction. It is a lot like a down payment in a contract to purchase a home. It forces the buyer to signal the seriousness of their interest.
In addition, the merger transaction can be very distracting for the seller and the seller’s management team. If the selling company goes through a prolonged M&A transaction and then the deal does not close, there can be significant negative impact to the business and the breakup fee is a way to get protected from that negative impact. However, a one time cash payment is rarely the solution to the problems that result from such a situation.
When you are selling your company, ask your lawyer right up front about the appropriateness of a breakup fee. He or she will tell you whether it is typical in your kind of transaction. The smaller and quicker the transaction, the less appropriate it is.
But don’t just listen to your lawyer. Decide in your gut whether the seller is serious about the deal or not. And try to anticipate how disruptive the transaction will be to your business. If you have any qualms about the seller’s intentions or the disruption that will ensue, ask for a breakup fee. And if the buyer is unwilling to include one, think hard about whether you want to do the transaction.
A break up fee is the other side of the mirror from a “no shop” provision. Regardless of which side you are on, they draw an almost perfect balance.
Because they accrue to the benefit of the other party.
Buying something and you don’t want the seller to just troll your offer around? Insist on a confidentiality provision, a no shop provision and a liquidated damages provision in the event either are breached.
Selling something and don’t want to provide a free look? Insist on earnest money and a break up fee. A break up fee is just a liquidated damages provision.
The other thing to understand is that a break up fee or a no shop liquidated damages fee — as exclusive remedies — may be cheap insurance as it quantifies the downside and avoids lengthy litigation.
One last thought, in certain instances it may be advisable to actually make someone deposit the break up fee or the no shop liquidated damages with a third party subject to specific escrow instructions in much the same way that the earnest money in a real estate transaction is held by a title company.
An alternative is a letter of credit with clear and precise funding instructions.
I have used all of these mechanisms and when done on the front end, they prevent a lot of pissing and moaning on the tail end.
Even seemingly symbolic amounts of money are useful as they make the buyer or seller rise to a moral standard. Most people will do what they commit to do if it is in writing. Most people who negotiate like hell on these kind of things are not going to do what they say they are going to do. It is a good pre-nup test.
This article was originally written by Fred Wilson on February 21, 2011 here.