Risk Allocation in M&A Deals: Determining Who Gets Which Risk and to What Extent

Merger and acquisition (M&A) deals come with inherent risk. Ensuring strategic risk allocation, that is, determining who assumes which risk and to what extent, is a crucial part of the process from beginning to end. From the exclusivity provisions in the letter of intent (LOI) to the material adverse change (MAC) clauses in the purchase agreement, provisions must be built in to strike the delicate balance of protecting the interests of both buyers and sellers while making sure neither is asked to take on so much risk they walk away from the table. Some people who are considering acquiring a business or taking their own to market incorrectly assume that with proper due diligence, nothing can go wrong. Unfortunately, this sunny line of thinking can lead to sombre consequences down the road. Risks ranging from confidentiality issues to environmental disasters to unpredicted events such as a pandemic can leave buyers and sellers exposed from the initial talks to many years after the close.

The ABCs of the Letter of Intent

Before the buyer proceeds with the due diligence phase of acquisition, both buyer and seller typically sign an LOI, a non-binding document which serves as a template for the major terms of the proposed transaction. Although LOIs vary, must-haves include an indication of price (which, again, is non-binding), a confidentiality provision, and an exclusivity provision, the latter of which means the seller cannot shop the deal around for a period of time. This provision is meant to protect the buyer who will continue to heavily invest time and resources into learning more about the company. Risk allocation plays a significant role in terms of determining details regarding exclusivity. For example, for how long should it be in play? 30 days? 45? What happens if a third party comes from out of the blue and makes an offer? What are the ramifications to the seller if they wish to follow through with the new party? Should the initial buyer receive compensation in the form of a fee, or should any expenses it incurred be paid by the seller? These risks and others are determined and allocated before the LOI is signed.

Identifying Hot Diligence Issues at the Purchase Agreement Stage

From a risk allocation point of view, the details to be negotiated in the purchase agreement essentially reflect the buyer’s concerns over what it is getting itself into, and the seller’s concerns around how long and for how much it intends to be on the hook for anything that goes wrong after the deal has closed. Taking its lead from due diligence, the buyer may discover “hot diligence” issues in play. Such issues tend to vary depending on the target’s type of business. For example, a technology company’s hot diligence issue may include intellectual property concerns such as potential infringement and chain of title issues. A manufacturing company’s hot diligence issue might be environmental risk. Any type of business may have a litigation hot diligence issue in the works, for example, someone somewhere is threatening to or in the throes of suing them.

So, who takes on the risk of such issues and to what extent?

Clearly, a tension exists between the parties. Whereas buyers want multiple representations and warranties on the business, sellers want their liability mitigated. In M&A transactions, reps and warranties allocate risk between the parties. A representation is an assertion to a fact that is true; a warranty guarantees indemnity should that assertion be false. Although it sounds straightforward, the devil is in the details. For example, if a representation begins with To the best of my knowledge …, what exactly is knowledge in this context? And whose knowledge — the President’s? CEO’s? To ensure clarity, often qualifiers are written into the purchase agreement.

Yet another battle lies in determining how long representations and warranties should last after the close. Months, years, indefinitely? Take, for example, taxes, which, oftentimes, is a hot diligence issue. Some clauses ensure that representations and warranties are in effect 90 days after there could ever be an assessment. And what about indemnity? Points of dispute frequently include how long the period of indemnification lasts. Indemnity also comes with tensions surrounding threshold, commonly referred to as “the basket.” So that a seller is not nickel-and-dimed to death, the basket represents the minimum dollar value before the buyer can make a claim. For example, on a 10 million-dollar deal, the seller can only go after the buyer suffers  damages of $100,000 or more. Finally, “caps” are another significant risk allocation issue. What is the highest dollar value the seller can be on the hook for? Ten percent of the deal or up to the purchase price?

Finally, a word on MAC clauses, a closing clause that addresses an adverse material change in circumstances between signing and closing of the deal that greatly affect the target and hence the value on the deal. The pandemic pushed MAC clauses into the fore of the M&A world because it had such an impact on certain industries such as entertainment, for example. MAC clauses are created to protect the interim period of 60 to 90 days between signing and closing. What if something happens that negatively impacts your newly acquired business disproportionately to other businesses? Complex and negotiation-intense, MAC clauses are a critical component of today’s M&A transactions and warrant the advice of experienced professionals.

Reduce Risk with the Experience of an Independent 3rd Party

At Wildeboer Dellelce LLP, we have teams dedicated solely to M&A transactions. This focus provides us with timely, relevant, and in-depth insights into the marketplace. To buyers and sellers, we offer the undeniable advantages of this market intelligence in tandem with decades of experience recognizing must-haves and the inevitable trade-offs that are inherent in M&A deals. Put simply, it’s not enough to know what protections you need moving forward.  You need to know which to concede (oftentimes, ones that don’t matter nearly as much as you or the other party think they do) to, from a risk allocation perspective, get the best deal.

When negotiating with parties that do not have independent third-party expertise in their corner, our lawyers often see how they are winning points for our clients, that were the tables turned, they would never let slip away. M&A transactions are big deals with long-term consequences. For more information on how we can help ensure risk allocation that works in your best interests, contact us today.