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Contract design as a risk management tool in corporate acquisitions: theoretical foundations and empirical evidence

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Abstract

This paper provides an overview of contractual measures to reduce acquisition risk for buyers in corporate acquisitions. We distinguish between measures applicable between signing and closing and those used after closing. The most important of these measures are purchase price adjustment agreements, material adverse change clauses, method of payment, earnout agreements, and warranties. We present the theoretical background for each measure as well as results of empirical research. We conclude that adequate contract design can effectively reduce acquisition risk, particularly with respect to target valuation uncertainty stemming from asymmetric information. Despite this potential, empirical research reveals that the use of contractual measures remains underdeveloped and therefore unexploited, especially in Europe. The most important constraints on these contractual measures include complexity, cost of implementation, susceptibility to litigation of sophisticated contract design, and seller bargaining power. The analysis includes suggestions for further research in this area.

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Notes

  1. Downside risk is also called risk in the narrow sense, with risk in the broader sense including also positive deviations as upside potential (Keller 2002).

  2. Below, every transaction in which a buyer (company) gains controlling power over another company is regarded as a corporate acquisition, without taking into account whether the legal autonomy of both companies is retained (Sommer 2012). Therefore, we do not explicitly distinguish between mergers and acquisitions, as implications for contract design are rather limited. Most importantly, no such separation is present in most of the literature concerned with contract design.

  3. Below, by use of the term “acquisition risk”, we always refer only to buy-side risk.

  4. Below, by use of the term “risk management”, we always refer only to buy-side risk management.

  5. Keller (2002) also provides an overview of specific tasks of risk management in the acquisition process on p. 35 and p. 48.

  6. These can e.g. be consent of shareholders of the buying or selling company or supervisory boards.

  7. Note that in most cases this is accompanied by also transferring part of the chances for business development to the seller, as with choosing a certain method of payment or size of equity stake, as well as when implementing earnout agreements. Warranties represent an exception, since they one-sidedly burden the seller; however, they often entail a higher purchase price.

  8. We do not strive to cover all possibly conceivable contract design measures in this paper, as this would seem not feasible in view of the individual nature of acquisition contracts. Yet, we selected the important measures by applying the methodology detailed above and consulting the ABA Study 2013 and CMS Study 2013.

  9. According to our definition of an acquisition, a majority vote is mandatory, which still gives substantial discretion. In case of an asset deal, the term size of equity stake may be misleading. However, single assets or business branches can be excluded, with similar implications.

  10. Please note that these warranties aim at the phase between signing and closing. However, some of them are also explained in Sect. 4.4, as the mechanism is identical. The consequences of a breach of warranty are identical as well.

  11. For post-closing variable payments, refer to Sect. 4.3.

  12. The underlying cause for the deduction of cash is the assumption that it can be classified as non-operating assets and could be used to redeem debt (Bruski 2005).

  13. Note that an entity or enterprise approach to business valuation is mandatory to establish this kind of clause (Mirow 2011).

  14. It is possible to make this difference affect the price by the exact same amount or plausibly through a factor constructed by the ratio of equity and enterprise value (Semler 2010).

  15. Despite the “catch-all” effect, not all manipulation potential is eliminated completely, e.g., the seller might sell operating assets above book value prior to the transaction to raise the purchase price (Reich et al. 2012).

  16. This is of course also true for other contractual measures; however, there appear to be no studies specifically considering this period of time and observing a particular trend with other measures.

  17. Specifically, this may refer to the financial position of the target and the results of its operations and its cash flows or business prospects. Potential reasons for these changes can be roughly classified as market-wide or enterprise-related (Denis and Macias 2013; Kindt and Stanek 2010). For instance, market-wide causes could be an economic downturn in general as well as the market-, industry-, or regulatory environment, and, in a broader sense, natural disasters or terrorist attacks. Enterprise-related reasons are, for example, loss of important customers or employees.

  18. Hence, in spite of the world economic crisis of 2007/2008, exclusions were not agreed on less often, although buyers would certainly have been expected to be more inclined to avoid risks since then (Kindt and Stanek 2010).

  19. Gilson and Schwartz (2005) ascribe this to the buyer’s allegedly better ability to bear such risks. Their reasoning seems questionable, though. Miller (2009) opposes this hypothesis and argues convincingly that, rather, the seller’s risk of incurring considerable damage to the seller’s reputation if the buyer publicly declares (possibly even erroneously) a material adverse change to the target is decisive here. The seller would not accept this risk unless the seller had some influence on the corresponding events.

  20. Only a few exclusions could be interpreted as a positive signal regarding the target’s value. This is why an effective MAC clause would not hurt both buyer and seller.

  21. To this end, the shares must have a sufficient level of secondary market liquidity. Therefore, paying in own shares is relevant almost exclusively for publicly traded stock corporations.

  22. On the other hand, for mezzanine capital payments, the same applies as for payment in stock.

  23. In case of payment in shares, the seller would expect their value to be below the current market price, as the buyer would otherwise not be willing to use them as a medium of exchange.

  24. Caselli et al. (2006) discuss different designs of collars and CVRs, as well as advantages and disadvantages, in detail.

  25. To compensate the buyer for the additional risk when implementing collars, they often also include a maximum value for the market price of the buyer’s shares (Caselli et al. 2006). Yet, the market price exceeding this maximum should occur far less often than it falling below the minimum value.

  26. High market valuation of the target causes a higher risk of overpayment for the buyer; hence, the benefit of a payment in shares is greater as well. Likewise, the buyer’s inducement to pay in shares will increase if the buyer’s own company is overvalued.

  27. Since the seller should then also be better capable of estimating the true value of the shares, lower undervaluation cost for the buyer can well be inferred, so that the importance of information asymmetry would be confirmed, at least regarding the acquiring company.

  28. Under German company law, more than 75 % of shares of a corporation represent a qualified interest that faces no blocking minority, and more than 95 % represent the possibility of a squeeze-out (§293 Abs. 1 S. 2 and §320 Abs. 1 S. 1 AktG). Under United Kingdom company law, at least 75 % of shares of a corporation are needed to pass special resolutions (UK Companies Act 2006 s 283) and at least 90 % represent the possibility of a squeeze-out (UK Companies Act 2006 s 979). In the US, company regulations are state law. For instance, under Delaware General Corporation Law, there is no specified qualified interest; e.g., an approval to mergers and acquisitions requires more than 50 % of outstanding stock entitled to vote (8 Del. C. 1953, §251). A squeeze-out is possible at 90 % (8 Del. C. 1953, §253).

  29. To this end, it is also possible to utilize call options, which allow the buyer to extend his stake at a predetermined strike price (Ernst and Thümmel 2000).

  30. For example, concerning payment pattern, deferred integration, and incentive effects for the seller.

  31. Hence, this constitutes a “truly” variable purchase price in contrast to the mere price adjustments in the period until closing elucidated above (Schüppen 2010). The literature also mentions contracts with partial repayments if the realized performance indicators deviate from the target values (Vischer 2002; Bruckner 2007). However, such contracts have little practical relevance (Tallau 2009b).

  32. In case only revenue is taken into account, the seller could, for instance, spend excessive amounts for marketing to generate additional sales at decreasing profit (Baums 1993). Then again, if solely profit-related items are considered, it must be set out in the contract which expenses are mandatory, such that the seller cannot omit them for the purpose of a higher earnout payment (e.g., expenses for research and development) (Reum and Steele 1970; Caselli et al. 2006).

  33. Even if the seller does not stay in the target’s management, he will instead regularly demand extensive rights to inspection and of consent, which likewise restrict the buyer’s autonomy (Baums 1993; Braunschweig 2002).

  34. Numerous contractual details need to be fixed in addition. These comprise the assurance of the earnout calculation, the timing of the payment, securing the payments, and a conflict resolution mechanism. Since these are rather legal or technical in nature, we do not discuss them in detail. A comprehensive overview is provided by Baums (1993), Vischer (2002), Bruski (2005), and Bruckner (2007).

  35. Tallau 2009b suggests the model by Black and Scholes (1973), while Ernst and Thümmel (2000) suggest the binomial pricing model by Cox et al. (1979). However, neither determine an exact value, but merely an approximation. Essential parameters need to be estimated or simplifying assumptions concerning their distribution need to be made (Tallau 2009a; Ihlau and Gödecke 2010). Then again, more realistic models, such as simulation processes, involve higher complexity, and the pricing as an option by itself is already more complex than application of a DCF method (Tallau 2009b).

  36. Based on a Monte Carlo Simulation approach, these authors show that the expected value for the earnout payment amounts to only 13.8 % of the purchase price.

  37. They develop a theoretical, option-based model to derive the optimal drafting of earnout agreements, assuming a single earnout payment in cash if the performance target is met (Lukas et al. 2012).

  38. Their study, for instance, confirms that for acquisitions in which growth opportunities are likely to be high, the earnout is based on revenue or non-financial indicators more frequently. Profit-based items are rather short-term oriented, and would thus be less suited here.

  39. For non-publicly listed companies, no market value can be directly observed, and furthermore, there are usually less extensive obligations to publicly disclose information prior to the acquisition. When acquiring a company from a different industry, the buyer’s ability to judge industry-specific characteristics is limited. Aside from that, in certain industries like high-tech or more generally, in services, valuation is fundamentally more complex, because growth opportunities are remarkably high in relation to net asset value or because few tangible assets exist anyway. Finally, potential value losses and therefore the buyer’s acquisition risk are greater the higher the transaction value compared with the size of the buyer’s former company.

  40. The authors attribute this result to the higher importance of company-specific vs. industry-specific factors. However, the study does not differentiate between payment in shares and use of earnouts. Thus, a negative impact of payment in stock could offset a potentially positive impact of earnouts. Datar et al. (2001) show a negative impact of payment in stock and conclude that, in cross-industry transactions, the seller faces an informational disadvantage regarding the acquiring company, leading to an adverse selection issue.

  41. The authors’ explanation is that in the German market, abnormal returns for the acquiring company are already higher in general.

  42. The clause usually resorts to the “perspective of a conscientious merchant.” Besides, it is also advisable to regulate in detail the exercise of accounting options for recognition and measurement as well as the maintenance of accounting continuity (Bruski 2005).

  43. Since such tax liabilities can often not be estimated reliably at the date of closing, the seller warrants within a tax clause that the tax provisions disclosed in the financial statements of the target company are sufficient (Hülsmann 2008). However, this is materially identical to paying tax claims as they are issued.

  44. In case additional administrative costs arise besides tax liability due to a breach of warranty by the seller, the buyer can hold the seller liable based on these warranties. Similar reasoning applies to implementation of a warranty regarding the status of an ongoing tax audit.

  45. Exemption limits and allowances differ insofar as, in the case of allowances, only the amount of losses beyond the threshold needs to be compensated. In case of exemption limits, the complete amount of losses needs to be compensated once the threshold is exceeded.

  46. Schüppen (2010) emphasizes that every structuring of the purchase price deviating from a single payment of a fixed purchase price is bought at the price of increasing contractual complexity and proneness to litigation.

  47. Access to corresponding data is definitely a challenge in this respect. However, in co-operation with transaction intermediaries as investment banks or transaction advisors, a study seems feasible.

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Acknowledgments

We thank the Managing Editor, Thomas Günther, and two anonymous reviewers for their thoughtful comments on earlier versions of the paper.

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  1. University of Münster, Universitätsstr. 14-16, 48143, Münster, Germany

    Nils Patschureck, Friedrich Sommer & Arnt Wöhrmann

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  1. Nils Patschureck
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  2. Friedrich Sommer
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  3. Arnt Wöhrmann
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Correspondence to Friedrich Sommer.

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Patschureck, N., Sommer, F. & Wöhrmann, A. Contract design as a risk management tool in corporate acquisitions: theoretical foundations and empirical evidence. J Manag Control 26, 279–316 (2015). https://doi.org/10.1007/s00187-015-0218-x

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  • DOI: https://doi.org/10.1007/s00187-015-0218-x

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