IT Due Diligence: Don’t Let IT Be Ignored


Due diligence is a fundamental stage in every M&A transaction and lays the foundation on which a deal is built. However, with so much material to review, companies sometimes don’t pay enough attention to information technology (IT). Not only is this risky from a legal perspective, but it can also negatively impact business success. According to research conducted by Ernst and Young (report available here), nearly half of dealmakers surveyed admitted that more detailed IT due diligence could have reduced the amount of lost value in an M&A transaction.

One of the issues is that IT may not always appear to be a significant component of the deal. However, IT systems are usually quietly operating in the background of virtually every major business across industry groups, not just today’s modern technology companies. For example, a manufacturing company may simultaneously use enterprise resource planning (ERP) software to bind together critical business functions (like product planning, inventory and sales) and customer relationship management (CRM) software to manage customer interactions through the sales cycle, not to mention any standard software and IT systems required for typical office functions such as email and word processing. Often, these systems are expected to run seamlessly on day one after the deal is completed, to enable the M&A transaction’s cost-saving and revenue generation opportunities to be realized.

However, deal makers don’t always put in the effort required to understand the target company’s IT systems, or their own. It’s critical to evaluate from a legal and technical perspective how the IT systems of the two companies will work together and factor these considerations into the M&A process early on. There are many questions to consider, including whether existing IT systems are well-run and produce accurate results (otherwise, due diligence information may not be adequate), whether there are any significant IT implementations planned for the future, whether there are any performance issues with software vendors, and whether all pertinent IT information and documentation have been disclosed.

From a legal perspective, IT contracts can vary widely, ranging from a large vendor’s non-negotiable standard form to one-of-a-kind agreements designed for a particular implementation. In both cases, in addition to considering typical legal terms such as those relating to the allocation of liability, change of control and assignability, it is also critical to evaluate the commercial and technical arrangement established by the agreement and how that fits with the proposed M&A deal. There are many common pitfalls to consider, such as individual purchase orders and statements of work that have not been properly disclosed and reviewed, and the incorporation of additional terms and conditions by reference.

As the common saying goes, the devil is in the detail. When it comes to IT due diligence, it’s important to have the right teams in place, including business, technical and legal professionals to properly evaluate those details in order to achieve M&A success.

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Mid-cap companies expected to continue growing internationally

In a recent study, Business Without Borders International Growth at Mid-Cap Companies, Mergermarket and Mazars have reported that most mid-market companies are looking at ways of driving growth through expansion into new international markets rather than growing domestically. The study analyzed the opinions of over one hundred senior corporate decision makers (CEO, COO, CFO or Head of Strategy) at global mid-market firms, including Canadian players, to discover which markets and regions they are targeting, where they are already achieving success and how they intend to finance their international growth plans.

The report suggests that mid-cap companies worldwide experienced a strong end to 2014. In the increasingly globalized world, most of these players are looking at ways of growing through expansion into new international markets. Approximately one half of respondents already generate more than 50% of their revenues internationally, and around the same number of players already operate in more than 10 international markets. Half of those polled also plan to make an acquisition in the next three years thus becoming one of the driving forces behind global M&A activity in the near future.

The report also reveals that mid-market companies consider Asia as a particularly attractive market for growth, with respondents in EMEA, the Americas and Asia all most likely to cite countries in this region as ones where they are most likely to set their foot in. India and Australia were also suggested as hotspots for future investment by the respondents. The respondents also noted that expansion into Asia would likely bring challenges, stating that Asian markets are one of the most difficult in which to operate.

In terms of financing international growth, 58% of mid-market companies surveyed are likely to use bank debt to fund overseas expansion, with 56% looking to internal profits and 31% to investment from private equity or venture capital. This may signal a trend of returning to bank financing following the opposite trend in favour of alternative lenders seen during the last financial crisis. However, the report also cautions that some reluctance to make more use of the financing opportunities afforded by global capital markets could result in restricted levels of growth for those companies that are unwilling or unable to tap the additional financing available through bond end equity instruments.

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How technology is changing M&A

There is no doubt that technological innovation has impacted the way that corporations interact and do business. Today, technology allows multiple corporate parties in different jurisdictions to communicate, access data, and exchange information instantaneously. In the context of M&A, it is often said that technological advancements such as online data rooms, corporate search services, and information databases have increased the speed at which deals are made. However, beyond these anecdotes, the impacts of technology on corporate transactions is often overlooked and understated. Earlier this month, the Mergermarket Group helped to fill this void by releasing a publication titled Rebooting the Deal Process: How Technology is Changing the Art of M&A (the Report). The Report provides important insight on how technology can enhance value in M&A as well as the risks presented by recent technological trends. The following highlights the main points discussed by the contributors to the Report.

Higher reward: enhanced value in M&A

According to the Report, there are a number of ways in which new technologies have added value to the deal-making process. For instance, the Report points out that the amount of information that is now available on past corporate deals provides guidance to negotiating parties when structuring agreements and helps avoid disputes. Put differently, access to information gives parties insight on industry trends and helps narrow the gap on divisive issues. For example, access to financial data helps parties identify agreeable prices and avoid valuation gaps. The proliferation of information technology has also served to level the playing field between the largest and smallest firms. To a large extent, all negotiating parties have access to the same information regardless of their size of financial resources. More generally, information and communication technologies have increased the speed of M&A negotiations and allow for more timely and informed decision making.

In addition to the above, the contributors to the Report point out that technology has also helped create a more efficient and open marketplace for M&A. The ability to send information electronically around the world has enabled buyers and sellers to connect more effectively than was previously possible. Sellers now have the ability to identify and communicate with interested parties around the world without having to engage third parties or incur sizable expenses. On the other hand, buyers are able to identify target companies and solicit offers in a more timely manner. These forces have in turn increased competition and contributed to a more vibrant M&A market.

Higher risk: challenges presented by the use of technology in M&A      

Although the use of technology presents a number of benefits in the context of M&A, the Report also notes that increased reliance on technology presents a number of risks. For instance, the electronic exchange of corporate information and the use of data rooms for due diligence raises the important issue of data leakage. Whether it be hackers attempting to steal corporate data, reporters trying to obtain information on a pending transaction, or online activists seeking to expose corporate dealings, the use of technology to exchange and store data comes with the risk that this data will fall into the wrong hands. This risk is particularly pronounced for publically traded corporations and other companies with prominent public profiles. According to the Report, the risk of data leakage will impose costs on companies involved in M&A in the form of improved data monitoring and infrastructure. However, the risk of data leakage also poses a challenge to regulatory agencies. When it comes to issues such as insider trading and protecting consumer information, the contributors note that regulators must ensure that compliance requirements keep pace with technological innovation.

Limits of technology: the human aspect of M&A 

Although technological change is inevitable and the use of technology in M&A is bound to increase, the Report highlights that technology has limits. Some of the contributors to the Report expressed the view that there is a distinctly human aspect of deal making. Although it is increasingly rare for parties to sit in a boardroom and negotiate every aspect of a deal, the act of negotiating in person has the effect of humanizing the transaction. Negotiating in person can help buyers and sellers identify the other side’s true interests and priorities and thereby facilitate deal making. At a more fundamental level, personal negotiations can help build trust between parties to a transaction and avoid future disagreement and conflict. While a return to personal negotiations is improbable and in many was undesirable, it remains to be seen if technology can replace the handshake and the other distinctly human elements of M&A.

The author would like to thank Jonathan Preece, aritcling student, for his assistance in preparing this legal update.

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M&A success and the role of audit committee


The role of the audit committee over the last several years continues to evolve in conjunction with the risks to business and financial reporting changes.  The traditional role of overseeing financial reporting and internal and external auditing now encompasses a much broader scope.  Today’s audit committees still maintain their central mandates but they also frequently gauge risk in its countless forms.  With all of these changes, it was foreseeable that the scope and influence of the audit committee would expand during the M&A process and, due to the committee’s experience, would become more involved in the M&A lifecycle, from evaluating the the prospective investment targets through due diligence to post deal analysis, with due diligence being more and more part of the audit committee’s growing risk role.

According to a report entitled There’s no shortcut to M&A success: How audit committees help keep transaction journey on track (the Report) released by KPMG, one area ripe for audit committee involvement is ensuring appropriate due diligence is done. Whether done in house or managed by a third party, the audit committee should make sure that management looks intently at a long list of issues, including but not limited to deal valuation, price and the long term benefits of owning the target.  The Report goes on to stipulate that management tends to look at cost saving measures by undertaking the due diligence process themselves. As this may be feasible for some deals, organizations often underestimate the resources needed and complexities involved and therefore the audit committee’s role should begin from the onset:

The audit committee’s role should begin at least as soon as the due diligence process is planned. The audit committee should challenge management from the outset on the appropriateness of their due diligence measures, finding out who owns the process and whether third-party assistance should be engaged—insisting on it if necessary. They should also consider striking a deal committee tasked with overseeing critical legal and financial issues and asking management the hard questions that may ultimately avoid transactional failure. Companies involved in deals can be overly focused on financials to the detriment of other issues, and the audit committee can help ensure success doesn’t fall through that gap.

For the audit committee who is intent on overseeing the due diligence M&A process, the Report lists out the following questions that should be asked of management.

  1. Who has responsibility for the due diligence and post-acquisition integration planning and implementation?
  2. Do the team members tasked with due diligence and integration have the skills, experience, resources and time to conduct their work? Have you determined whether your deal is complex enough to require 3rd party assistance or integration planning?
  3. What work have you done to substantiate the quality of earnings?
  4. Have you looked at the target company’s long term customer and supplier relationships, as well as the security of those relationships?
  5. What initiatives and programs are in place to retain key personnel?
  6. What measures have been taken to avoid value leakage through price adjustment mechanisms and/or representations and warranties set out in the purchase agreement or related documents?

Bottom line: having audit committees oversee the due diligence process can assist in considerably reducing the risks characteristic to M&A transactions.

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Media sector M&A on the rise

youtube-680x220In a recent article, The New M&A Trend that is Shaking Up the Media Sector, Forbes reported on M&A deals involving mobile-driven, digital first content companies, a type of transaction which is starting to dominate the M&A deal space. Although the article speaks to several different trends in the sector, it’s noted that the most dominant trend involves an uptick in multi-channel network (MCN) deals. The value of these deals multiplied seven-fold between 2013 and 2014—from $200 million to $1.4 billion—and consulting firms are saying these numbers will only continue to grow.

YouTube defines MCNs as “entities that affiliate with multiple YouTube channels, often to offer assistance in areas such as product, programming, funding, cross-promotion, partner management, digital rights management, monetization/sales and/or audience development.”  The consideration: a fair chunk of the ad revenue from the channels involved.  While MCNs are not restricted to YouTube and can theoretically work with any video platform, YouTube’s exposure draws in most MCNs.

MCNs are therefore the middlemen between YouTube channels and advertisers:

It’s a win-win-win situation if done properly: the networks want to help YouTubers succeed by building their brand and helping them make more money which, in turn, makes the networks more money, and the advertisers benefit from the consistent exposure of their products to the right audience on popular YouTube channels – all without having to do the legwork involved in finding worthwhile YouTube channels to advertise on.

Recognizing this potential for greater efficiency and swift monetization, larger, more traditional media companies are eager to acquire these smaller, digitally innovative companies.  Much of the benefit appears to flow from increased access to the Millennial consumer market.  Specific examples noted in the Forbes article include the capacity to leverage existing intellectual property into new stories geared towards younger audiences, direct engagement with movie fans leading up to theatrical releases, and increased participation in the mobile market.

The Forbes article also introduced the following trends in recent media deals:

  • the sharp decline in pay TV subscribers as stand-alone / unbundled over-the-top services increase;
  • greater “global collaboration for content creation, distribution, and monetization”;
  • the transformation of beverage, hotel, and tech brands into media companies; and
  • the pursuit of “niche audience strategy”.

The author would like to thank Rika Sawatsky, articling student, for her assistance in preparing this legal update.

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Lease considerations in the M&A context – Part 2

In a previous post we began exploring lease considerations that landlords and parties to asset purchase and sale transactions should be aware of in the M&A context, including that many commercial leases will require landlords’ prior written consent to an assignment and that the original tenant/assignor typically will not be released from its covenant absent landlords’ agreement (notwithstanding any assignment). We went on to discuss some strategies to mitigate this issue from a seller/assignor perspective, such as requiring releases and/or a replacement covenant from the purchaser/assignee as a condition precedent to closing.

From a purchaser/assignee perspective, in addition to wanting to include express provisions in an asset purchase agreement requiring landlords’ consent to lease assignments, other important closing deliverables/conditions include obtaining landlord estoppels, requiring that notices of key leases be registered on title to the subject properties and non-disturbance agreements being obtained from landlords’ secured creditors.

Estoppel certificates

An Estoppel Certificate is a certificate executed by a landlord confirming key lease details, such as the dates and parties to the lease agreement itself, any amendments, a description of the leased premises, the term of the lease, any renewal/extension rights, the current minimum and additional rent payable, and that the lease is in good standing (or if it is not, details of any arrears or outstanding obligations). An Estoppel Certificate provides a snapshot of the lease status that a purchaser/assignee can rely on as of the date it is executed and, subject to the items included/referenced, it can identify issues that a purchaser/assignee would want addressed prior to closing (such as rent arrears, outstanding payments and/or repair requirements for which tenant is responsible). A landlord is not obligated to deliver an Estoppel Certificate to a tenant or prospective assignee and the lease itself may or may not include language governing such, the timing for delivery and the matters to be covered.

Notice of lease

A Notice of Lease is a notice that can be registered on title to a property setting out the details and existence of a lease relating to that property. The registration serves as notice to third parties that the property is encumbered by such lease and provides security of tenure to the tenant and priority of its leasehold interest vis-a-vis any subsequent registrations on title to the property. Among other things, it can provide protection as against a third party purchaser of the property for value who otherwise would not have had notice of the lease (and arguably could claim that it is not bound by it) and mortgagees of the property from time to time, who would not be bound by the lease in a mortgage enforcement scenario if the lease is registered on title subsequent/subordinate to the applicable mortgage. A lease may include language governing or prohibiting registration of a Notice of Lease.

Non-disturbance agreements

Non-Disturbance Agreements are agreements entered into between tenants and their landlords’ mortgagees, whereby the parties agree that the mortgagee will not disturb the tenant’s use and enjoyment of the leased premises provided that the tenant agrees to attorn and pay rent to the mortgagee in an enforcement scenario. Non-Disturbance Agreements are particularly important if a Notice of Lease has not been registered against title or if a Notice of Lease has been registered against title, but subsequent/subordinate to the registration of a mortgage. Where a mortgage has been registered in advance of, and thus ranks in priority to, a lease on title, a purchaser/assignee will want to ensure that a Non-Disturbance Agreement has been duly executed and delivered, failing which the lease is at risk to a mortgagee who enforces its security (i.e., if it sells the property to a buyer that wants vacant possession). A lease may include language governing the delivery of a Non-Disturbance Agreement and the landlord’s obligations, if any, in obtaining same from its lenders.

While obtaining the foregoing deliverables on or prior to closing is often a matter of negotiation between the parties to asset purchase and sale transactions, the benefits to a purchaser (and risks in not obtaining) should not be ignored. As a practical consideration, when there are a large number of leases being assigned/assumed, parties may sometimes agree to limit all or some of the requests to the most material locations to the seller’s business operations or those locations of particular interest to the purchaser.

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Corporate split-ups expected to rise

Mergermarket, in association with RR Donnelley, has recently released the March edition of its Venue Market Spotlight (VMS) publication, presenting an overview of a study conducted on market participants’ expectations for corporate breakups in the near term. Corporate breakups or demergers, usually carried out in Canada by means of a statutory plan of arrangement or a similar reorganization transaction, are a way for a corporation to separate distinct self-sufficient lines of business from one another with a view to unlocking value and creating strategic focus, or a means to separate a specific asset from the corporation where such asset is underperforming or no longer represents a strategically valuable investment for the corporation as a whole.

According to the VMS study, most respondents expect the volume of corporate breakup transactions to increase over the next 12 months. VMS reports that the majority of the responders to the survey expect that the volume of breakups will be the highest in the Technology, Media and Telecommunications sector, followed closely by the Energy sector; that most of these transactions are expected to occur in the upper segment of the market with values in the over US$5 billion range; and that geographically, breakups will occur predominantly in European and North American markets.

As the VMS article explains, the Technology, Media and Telecommunications sector is the favoured area for corporate breakups as a result of the market’s changing demands, while the Energy sector is primed for restructuring activity as a consequence of the depressed oil prices. The reason the upmarket segment is seen as most favourable for these transactions is the fact that corporations of a significant scale will often have difficulty optimizing the performance of non-core units. In fact, the respondents to the VMS survey cited “focusing on core competencies” as the leading reason corporations will consider undertaking breakup transactions in the next 12 months.

VMS notes that corporate breakups are not without risks. Cited by most respondents to the survey as the most significant risk to undertaking a demerger was the potential loss of synergies present within the larger operating entity prior to a split. Other challenges and risks to corporate separations cited by the study were diminished market value, loss of financial backing, loss of diversification, and loss of economies of scale, among others.

The study does not directly speak to market conditions in Canada. It is difficult to predict whether the expectations of the study will be met north of the American border, given that Canadian market conditions are not identical to those in the United States. Of specific interest is the question whether, given the size of western Canada’s oil sector, the volume of spin-outs and separations will increase in the oil patch in the next year, or whether increased consolidation will be the outcome of the current stage of the commodities cycle.

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The effect of rising interest rates on M&A activity

In recent report entitled The conflict of interest? Rising rates effects on M&A, MergerMarket was commissioned by Toppan Vite to examine the effect of potential rising interest rates on the effect of M&A activity in the coming year.

U.S. M&A activity was at peak performance in 2014 as deal activity increased to over 5,051 deals worth $1.5tn U.S., up from 3,995 transactions worth $937bn U.S. in 2013. However, with a potential rise in interest rates coming in 2015 from the Federal Reserve, many are concerned about its effect on deal activity in the coming year. MergerMarket interviewed seven leaders in the field to determine their views.

What kind of impact will changing interest rates have on the level of M&A activity?

The experts were of the opinion that a key factor related to the impact of rising interest rates on M&A activity is the speed at which the rise in interest rates occurs. A slow, gradual rise in interest rates that comes from a strong economy will likely be coupled with rising corporate confidence that could increase deal activity, whereas a sudden, large increase in interest rates could create higher volatility in the market due to rate shock, ultimately dampening deal activity for a period of time.

Additionally, the type of acquisition ought to be considered. For example, in mid-market M&A, the main impact of interest rates is the price that someone is willing to pay for companies. As interest rates go up, private equity sponsors will have to pay more for the loans underlying the acquisitions, and ultimately, will want to pay less their acquisition. Until a new balance is reached, a slowdown in activity may result.

Do the current high levels of capital negate the effect of rising rates?

Capital markets today are the deepest that they have been in a long time, perhaps ever. Some experts believed that overall market liquidity, both corporate cash and private equity capital, may have a buffering effect of higher interest rates with capital being available to fund despite an increase in borrowing cost.

However, some experts gave a more skeptical view that as the cost of debt goes up, the price that a company can pay goes down. If interest rates are higher, then fixed charges are higher, which raises concern for lenders who are cautious about overleveraging companies because there is now ultimately less cash flow.

How do interest rate changes impact cross-border transactions differently from domestic deals?

The experts were of the opinion that cross-border deal activity is driven by a  number of factors including absolute and relative interest rates, growth rates across countries, country risk and taxes. A fundamental element to consider with respect to the impact of interest rates on cross-border transactions is the rise in U.S. interest rates as compared to the rise in global interest rates. If a rise in the former is not accompanied by a rise in the latter, an increase in deal activity may occur. In such a situation, U.S. companies may perceive overseas targets as an attractive way to take advantage of rebound global growth, especially in light of a strengthening U.S. dollar.

The author would like to thank Jillian Hyslop, articling student, for her assistance in preparing this legal update.

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The return of the REIT

M&A activity involving real estate investment trusts (REITs) is heating up in Canada and south of the border, according to a recent PWC report, “Emerging Trends in Real Estate: Global Outlook for 2015”. Following a succession of REIT conversions in 2014 by companies with significant real estate holdings, coupled with ripe market conditions for REITs, the industry is well-positioned for further consolidation.

To merge or to acquire?

A notable trend among REITs in 2014 was the acquisition of small and mid-sized players by larger companies, ostensibly fueled by increasing shareholder activism.  At the same time, small and mid-sized players are getting together to combine resources, lower costs, diversify their asset bases, and ultimately benefit from synergistic strategies.  Growing exclusively through acquisition can prove challenging, and smaller companies are demonstrating that growth can be achieved in the real estate industry on a lower scale through mergers by similarly-sized players.

REITs in recovery

As interest rates continue to decline, banks remain the most affordable source of development funding for REITs, whose managers can take advantage of historically low rates to access capital, PWC reports.  Indeed, the report describes REITs as “capital magnets” that, through their demonstrated performance, can expect a healthy dividend growth rate of about 3% and a relatively high investor yield of up to 10%.  Population growth in North America is experiencing a steady upward trend which will spur demand for more retail stores of all varieties.  As job growth recovers following the economic downturn, consumers will have more disposable income and the retail sector will be poised for recovery.  Retail properties considered to be undercapitalized will then be in a solid position for capital influx or acquisition.

Consolidation in Canada

Canada’s real estate market is dominated by domestic players – primarily REITs and pension funds.  These market participants are eager to invest in the growing real estate segment of mixed-use properties, which continue to permeate the dense urban centres in large Canadian cities.  PWC reports that pension funds, in particular, are eager to increase their real estate allocations, and consolidation may further be driven by the recent spike in shareholder activism with respect to REITs.  Several experts noted in the report that some REITs continue to trade below their net asset values, further contributing to widespread speculation over mergers and takeovers in the real estate sector.

The year of the REIT

REITs are increasingly looking for growth-based deals and can leverage their unique access to capital from both public and private sources to do so.  In the past, sophisticated investors placed REITs in the ‘alternative’ investments category, whereas today, they are considered a reputable asset class of their own.  Given the relatively favourable real property market conditions in the current year and the strength of REITs in prior years, REITs should continue to gain prominence as an investment vehicle in Canada in 2015.

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Negotiating earn-outs: five key questions to keep in mind

The inclusion of an earn-out clause in a purchase agreement can be a useful tool to help bridge the valuation gap between buyer and seller. Broadly speaking, an earn-out ties a portion of the purchase price to the performance of the business following the acquisition, which the seller can “earn” by meeting post-closing performance targets. According to the American Bar Association’s 2014 Canadian Private Target Mergers & Acquisitions Deal Points Study (the 2014 ABA Study), earn-out clauses were present in 25% of the transactions surveyed, a slight increase from 21% in the American Bar Association’s 2012 study and a significant increase from 3% in its 2010 study.

Acting as a form of acquisition currency, a well-crafted earn-out clause can be attractive to both the buyer and seller. It provides the seller the opportunity to potentially achieve a higher sale price, while providing comfort to the buyer that it will only pay for the seller’s provable or safe earnings on closing. Payment for riskier (or growth) earnings is put off until such earnings are confirmed through the post-closing performance of the business. This can be especially attractive where the seller is a company with a limited track record.

A successful earn-out clause provides a clear and well-understood purchase price adjustment mechanism that aligns the interests of the buyer and seller. The following five questions highlight some of the key considerations that buyers and sellers alike should keep in mind when conceiving, negotiating and drafting an earn-out clause:

1.   What is the appropriate performance metric?

Choosing performance metrics that will align the incentives of the parties is one of the most important steps of structuring an earn-out. In some cases, focusing on a non-financial earn-out metric such as key customer retention, bringing a product to market or securing a key patent might make more sense than using a financial metric. In other cases, the parties may have a more financial focus and prefer to base the earn-out calculation on financial metrics, ranging from top line revenue to an earnings based metric, most commonly EBITDA. Sellers will often prefer to use a revenue-based financial metric, as these tend to be the easiest to calculate and harder to manipulate than metrics further down the income statement. Buyers, by contrast, will tend to prefer an earnings-based metric, which is usually a more accurate indicator of the business’ economic potential. In some cases, the parties find balance and benefit in using multiple metrics, though this can come at the cost of increased complexity. In the 2014 ABA Study, 12% of Earn-out clauses used revenue as a metric, 33% used an earnings based metric and while 53% used some other (including non-financial) form of metric.

2.  Is the involvement of the seller needed to transition the business post-closing?

There can be real value in keeping the seller involved in the business post-closing, particularly if the seller has unique technical or operational expertise or strong customer relationships that need to be transitioned. An earn-out clause provides an excellent incentive for sellers to remain engaged and motivated during the transition period, particularly when their efforts will can reasonably be expected to have a real effect on the post-closing success of the business. In other circumstances, a clean break may be desired, with little to no seller involvement post-closing. Particularly in these cases, it is not uncommon for the seller to seek added contractual protections on the post-closing conduct of the business.

3.  How should the business be run post-closing?

After closing, the buyer will usually want the flexibility to run the business as it sees fit, which may include changing strategic direction if the business environment so requires. The seller, by contrast, generally wants some assurance that the business will be managed in a manner conducive to achieving the earn-out targets and will seek to limit the new ownership’s ability to make changes that could frustrate this goal. The parties must decide, in the context of their transaction, whether and the extent to which contractual covenants relating to the post-closing conduct of business are appropriate. For example, at least 20% of the earn-out clauses examined in the 2014 ABA Study included a covenant to run the business consistently with past practice. Sellers may also seek out a covenant to run the business in a manner to maximize the earn-out, though as noted in the 2014 ABA Study, express provisions of this nature are relatively uncommon. On the opposite end of the spectrum, a buyer may seek to expressly disclaim a fiduciary relationship with respect to the earn-out. Following the Supreme Court’s ruling in Bhasin v. Hrynew, which opens the possibility of an implied general good faith obligation being read into the performance of a contract in the absence of specific language, buyers and sellers may be increasingly interested in taking the time to clearly spell out what the obligations of the parties are and are not intended to be over the earn-out period.

4.  What is the appropriate time period for an earn-out?

The parties will want to carefully consider the appropriate period of time over which to evaluate the earn-out. Too short an earn-out period can incentivise short term behaviour (particularly if the seller stays involved in the business), and may not be indicative of the longer term prospects of the company. Too long of an earn-out period can unnecessarily delay full integration of the business and increases the earn-out risk to the seller. A one to three year earn-out period is most common in the context of Canadian M&A transactions, but earn-out periods of four years or longer were used in 20% of the deals containing earn-out clauses in the 2014 ABA Study.

5.  What happens if the future is different than predicted?

Even if the parties have similar expectations at the time of the bargain, the future is never easy to predict. Accordingly, the parties may wish to consider including provisions that provide for the “buy-out” or acceleration of an earn-out under certain circumstances. For instance, if a buyer believes that there is a chance that it may want to re-sell the business before the end of an earn-out period, it may be beneficial to negotiate in advance the ability to accelerate or “buy-out” the earn-out in order to make the business more attractive to a future purchaser who may otherwise be discouraged from acquiring assets encumbered by an earn-out. Where the parties have covenanted to manage the business consistently with past practice or in some other pre-specified manner, the ability to “buy-out” an earn-out may provide valuable flexibility for the buyer to change strategic direction or fold the target company into its existing business should it become commercially beneficial to do. From the seller’s perspective, an acceleration or early payment provision may help protect against post-closing changes to the business that hinder the likelihood achieving the earn-out. For example, an acceleration clause trigger could be the termination of key members of the management team or a significant change in the manner of the operation of the business. In the 2014 ABA Study, 7% of transactions containing an earn-out clause contained an express acceleration clause.

While earn-out clauses may not be appropriate in all transactional contexts, they remain a useful situational tool when crafted appropriately. Diligent and careful negotiations are necessary to resolve the stress points between the parties to reach an agreement that will hold together after closing and to ensure that incentives are optimally aligned for the benefit of both buyer and seller.

The author would like to thank Matthew Lau, articling student, for his assistance in preparing this legal update. 

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