Weighing up risk and return is not a new concept. Why is it then, that in many M&A transactions in Asia the counterparties negotiate and often ôagreeö the purchase price up front, long in advance of any discussion about the level of risk that each will bear after completion?
The devil IS in the detail - unfortunately!
In M&A transactions in Asia the Sale and Purchase Agreement (ôSPAö), the principal legal device for allocating transaction risk between buyer and seller, is all too often left until the end of the transaction process with the lawyers told to go away, typically with minimal instruction, to ôsort out the detailö. An overwhelming desire to execute the deal, a piecemeal approach to the transaction process, or sometimes simply inexperience in the complex field of M&A, there are a number of reasons why the contractual and completion aspects are either overlooked, or passed off as being secondary or ôless sexyö in nature, relative to other aspects of the deal.
The consequences of such neglect can be serious. More likely than not it will result in strained relations during the latter part of negotiations. The buyer will insist the price offered was based upon the seller retaining a substantial degree of risk through the provision of comprehensive warranties and indemnities in the SPA û the seller will, of course, take the opposite view. It may result in missed opportunities which could have enhanced the return on the deal, through the allocation of a higher degree of risk to the other side. Worse still, there are many examples where insufficient attention to the SPA and completion process has resulted in one side accepting a price which, with the benefit of hindsight, was quite clearly out of line with the level of transaction risk assumed. Often this does not become apparent for several months, or even years, after the deal has completed.
Total risk versus residual risk
It is important to differentiate between total transaction risk and the risk retained by either side post completion. An assessment of the former is a key objective of the due diligence process and incorporates a variety of different factors including an assessment of market and commercial risk, financial and tax considerations, and legal/regulatory issues. Other areas may also be taken into account depending on the nature of the deal and the targetÆs business and location. It is the residual risk retained by the seller or assumed by the buyer, however, after the risk allocation process is complete and after insurance arrangements and other risk management techniques have been taken into account, that is relevant to the pricing of a transaction.
Charts: Pricing the deal should take account of the allocation of risk after completion
Consider the scenario demonstrated in the charts above. As a result of its due diligence effort, a prospective bidder has assessed the total transaction risk associated with the target company and the overall deal structure. It now has to come to a view in terms of its pricing strategy û under scenario A it could offer a higher price in return for comprehensive protection through the SPA. This may incorporate a completion audit process or other such purchase price adjustment mechanism. In scenario B, however, it should offer a much lower price, in return for the higher level of transaction risk accepted.
A seller should apply the same logic when weighing up the consideration it is prepared to accept, given the risk that the buyer would have it retain. This requires an equal amount of preparation and forethought. A well prepared seller for example, having commissioned its own vendor due diligence exercise in advance of the acquirer coming in, is often able to reduce the level of transaction risk it retains û or indeed negotiate a better price - than would otherwise be the case.
More than just a job for the lawyersà
Arguably, the single most important aspect of the SPA relates to the completion accounts process, including format, content and basis of preparation. Typically the accounts as presented at closing act as the key reference point against which many of the sellerÆs representations, warranties and indemnities are measured, essentially the ôstake in the groundö for the purposes of allocating risk. As such, this area warrants particular scrutiny by the accountants involved in the transaction, working in conjunction with the legal team appointed by each principal. For example a common cause of dispute is the fact that, in the absence of specific additional guidance in the SPA, Generally Accepted Accounting Practices (ôGAAPö) allow a significant degree of latitude in the preparation of accounts.
As a seller there are a number of ways to limit the risk retained when warranting the completion accounts:
- Consolidated accounts rather than entity level.
- High materiality threshold to be applied.
- GAAP to accord with local jurisdiction, rather than International Accounting Standards.
- Normal accounting policies of the vendor to be applied which may be less conservative than "best practice".
- Income statement and/or balance sheet only. No cashflow statement or note disclosures.
- Management accounts rather than statutory accounts.
- Unaudited rather than audited.
- The acquirer will normally, of course, take the opposite view in order to obtain as much protection as possible.
Other areas of the SPA to consider from a financial and tax perspective include:
- Notwithstanding the definition of completion accounts themselves, there will usually be a number of other items which could shift the balance of risk depending on their interpretation. Areas where problems often arise include the definitions of profit/earnings, EBITDA, net assets, and working capital. This serves to highlight the fact that even commonly understood terms or phrases warrant close scrutiny by relevant experts in the SPA drafting process.
- Does the structure set out in the SPA accord with that recommended by your tax advisors? Have the accounting implications been properly thought through?
- Completion process.
- Accountants are frequently engaged in the completion process, either to perform a full audit exercise or some other form of review. Have they been consulted in terms of the precise mechanism, including proposed scope of work and timing?
- Representations, warranties and indemnities.
- Typically the due diligence process will result in several different reports (e.g. tax, legal, financial, commercial). It is important that relevant individuals from each of these teams provides input to the draft SPA, both to ensure that key risk areas identified are suitably covered and also to ensure that the wording proposed by the lawyers is appropriate.
- Tax deed.
- Usually a stand-alone document, it is crucial that specialist tax input is sought in the preparation and review thereof.
- Other aspects of the SPA that usually warrant specific review by financial and tax experts include the disclosure letter and the exhibits at the back of the SPA.
To rely solely on legal advisors during the SPA negotiation and drafting process exposes the seller or buyer to the risk that some of these details will be overlooked, or the implications thereof underestimated. This often happens where a detailed Memorandum of Understanding or Letter of Intent is signed at an early stage in the process, without appropriate consideration of the ultimate risk allocation/completion mechanics. In these situations it can be difficult to try and introduce new concepts at a later stage, which can impact adversely upon the negotiation process.
The SPA is a crucial aspect of the overall M&A process. Once signed, the allocation of risk between the seller and buyer is fixed û there is no second chance. The benefit for those that appreciate the importance of this process, and afford sufficient priority and resource thereto, is a significantly greater probability of success.
Jim Woods is a partner in the Transaction Services group at PricewaterhouseCoopers, specializing in financial due diligence and related M&A advisory services.