Beyond the Headline Number: Terms to Consider in an M&A Deal

When discussing client goals in a technology M&A engagement, we use the term “optimal outcome”  instead of “highest value.” While the topline number is often what gets the headlines, there are a large number of other factors that can make or break a deal. Understanding current market terms on everything from indemnities to earnouts to representations and warranties is vital when negotiating with a buyer, and favorable terms on these items are a vital component to an outcome that is truly optimal for a technology company seller.

Note: While these market terms are broadly applicable for middle-market M&A deals across industries, specific statistics refer to the technology industry.

Representations and Warranties: These are the assertions made by the seller to the buyer about what they are buying. Representations are about the current state of affairs, while warranties are about the future. Most of the terms below revolve around the specific ways to allocate the risk that any of the reps & warranties specified in the contract turn out to be untrue. The amount of money to be paid the buyer in this case is the indemnity.

Indemnity Escrow Amount: This is the portion of the purchase price held in escrow to serve as a fund to satisfy indemnification claims against the seller. Escrow amounts are typically calculated as a percentage of the purchase price. For technology companies this can range from less than 5% to greater than 15%; current market conditions generally put this in the range of 10% to 15%.

Indemnity Escrow Period: This is the length of time after the transaction closes that the indemnity escrow is held before being released to the seller. This can be less than a year to greater than two years, but currently runs between 12 and 18 months.

Reps & Warranties Survival Period: This is the length of time after closing during which a party may make claims for breaches of reps and warranties. Today’s market conditions put this between 12 and 18 months. This is also known as the “general survival period.”

Carve Outs to General Survival Period: Certain reps and warranties may be carved out of the general survival period, and be extended for a longer period of time. These include, but are not limited to, broker’s fees, employee benefits, intellectual property, taxes owed, capitalization, title to assets and due authority to make the sale in the first place.

Indemnity Basket Type: The basket defines the amount of indemnifiable losses a party must incur before it can seek indemnification. There are two types. The true deductible basket means that basket serves as a deductible, and the indemnifying party is responsible for all losses exceeding the basket amount. The tipping basket (also known as the dollar-one basket) means that the indemnifying party is responsible for all losses, once those losses reach the basket amount.

Indemnity Basket Size: The indemnity basket size differs based on the type of basket. Both true deductible and tipping baskets are calculated as a percentage of the purchase price, and both can range anywhere from 0.025% to greater than 1.5%. However, current market conditions set the true deductible basket size range from just south of 0.75% to 1%, while tipping basket size ranges are smaller, ranging from under 0.25% to 0.75%.

Indemnity Cap Size: This term limits a party’s maximum liability. For most deals today, the cap typically ends up at 15% of the purchase price.

In addition to indemnifications, there are a handful of other terms that can change based on current market conditions.

Earnouts: Earnouts are not standard in today’s environment, but can become part of the consideration in some cases. Most often they are used to bridge the gap between the buyer and seller’s enterprise valuation expectations, but they can also be used as a sweetener to retain key employees.

Asset Deals & Assumption of Liabilities: In a “vanilla” asset deal, all liabilities are retained by the selling company, while all assets go to the acquirer. However, there are typically specified liabilities and assets that the buyer will acquire; these are determined during negotiation.

Stock Deal Structures: Today’s market conditions generally encourage a cash-free, debt-free transaction with working capital provisions to ensure that business is not disrupted. Any excess cash on the balance sheet is typically either dividended out to shareholders or left in the company and added to the purchase price.

While specific market conditions generally prevail in all these circumstances, all of these items can — and must — be negotiated prior to closing. That’s one reason you want to be sure to have a legal and advisory team that not only knows and understands current market expectations, but that has the respect of the buyer, command of the terms, and deep negotiation experience.