This month the M&A Market Trends Subcommittee of the Mergers & Acquisitions Committee of the American Bar Association published the 2013 Private Target Mergers & Acquisitions Deal Points Study. The biannual study reviews publicly reported merger and acquisition transactions involving a public buyer and a privately held target company. The study summarizes these transactions based on a myriad of different deal terms to capture trends in the M&A market. The 2013 study is based on 136 transactions that closed during calendar year 2012.
Although the 116 slides of the 2013 study include many insights on trends in the M&A market, here are three of the more notable trends revealed:
1. Indemnification “Baskets” Are Becoming Smaller; “Mini-Baskets” Are On The Rise: According to the study, more than 95 percent of M&A transactions contain an indemnification “basket,” which is a threshold amount of losses/damages the buyer must incur before it is entitled to indemnification for breaches of representations and warranties. The theory behind the basket concept is that a seller wants to avoid being “nickeled and dimed” for indemnification claims. The 2011 study revealed that the median basket was 0.65 percent of transaction value (e.g., for a $10 million transaction, there would be a $65,000 basket, and the buyer would not be entitled to indemnification until its aggregate losses exceeded $65,000, subject to customary exceptions). However, baskets are getting smaller as a percentage of transaction value. The 2013 study shows that the median basket was 0.50 percent of transaction value, potentially giving a buyer a chance at greater recovery.
However, the decrease in basket size may be partially explained by an increase in the use of “mini-baskets.” A mini-basket (also often referred to as a “de minimis” basket) is a smaller threshold amount that must be exceeded in order for a single claim to even be eligible for indemnification. For example, if a transaction has a mini-basket of $5,000, any losses that the buyer incurs that are less than $5,000 are not eligible for recovery from the seller and typically do not count toward the losses included in the main indemnification basket. Although the majority of deals still do not use mini-baskets (according to the 2013 study mini-baskets were present in 30 percent of transactions), the frequency increased significantly from the 2011 study, which revealed the presence of mini-baskets in 17 percent of deals.
As more buyers agree to the inclusion of a mini-basket, we would expect to see an overall decrease in the size of the primary indemnification basket. A mini-basket means that a buyer will potentially have fewer claims for which it can recover and fewer claims that will count toward the basket; thus, buyers will argue for lower baskets to increase the likelihood of recovery for claims that are larger than the mini-basket. Furthermore, although the 2013 ABA study did not look at average sizes of mini-baskets, anecdotally, we are seeing larger mini-baskets than in previous years, which will also lend weight to a buyer’s argument for a smaller main indemnification basket.
2. Escrows (as a Percentage of Deal Value) Are Also Shrinking: According to the 2013 study, escrow accounts (which are typically used as a source to pay the buyer’s indemnification claims, but can also cover things such as working capital and other purchase price adjustments) continue to decrease in size as a percentage of the transaction value. Escrow sizes dropped in 2010 to 9.19 percent of the transaction value (as compared to 9.93 percent in 2008). The 2013 study shows that in 2012 average escrow sizes dropped even more significantly—from 9.19 percent to 7.14 percent.
It is difficult to pinpoint a single explanation for the 2012 decrease in escrow sizes as a percentage of transaction value. Recent studies on post-closing indemnification claims have revealed that in most instances sellers ultimately receive a majority of escrowed funds, which may mean that escrows have historically been higher than needed to adequately protect buyers against losses. Although these studies may not be the reason for the drop in escrow size, they may provide buyers some comfort that smaller escrow accounts are not necessarily reason for concern.
Additionally, while percentages are instructive, absolute dollars are king. The bottom line is that a buyer must feel comfortable that there are enough funds in escrow to cover pertinent claims. In terms of absolute dollars deposited in escrow, the actual amounts may have increased. Transactions included in the 2011 study had a median transaction value of $90 million, which translates roughly to a median $8 million escrow account. By comparison, transactions included in the 2013 study had a median transaction value of $150 million, which translates roughly to a median $10 million escrow account.
3. Earnouts are Normalizing: When a buyer and a seller disagree regarding the valuation (or prospects) of the target business, one solution to bridge the valuation gap is to include an earnout within the deal. This means that a portion of the purchase price is payable at closing and a portion is payable over time, assuming that the target meets certain benchmarks or milestones post-closing. Earnouts can be complicated and can involve significant negotiation as to the operation of the target post-closing.
According to the 2008 ABA study, earnouts were present in 29 percent of deals that closed in 2007. The uncertainly of the M&A market of 2009 led to an increase in the use of earnouts—38 percent of all reported deals according to the 2011 study. However, based on the 2013 study, the use of earnouts has fallen back to pre-recession levels—an earnout was found in 25 percent of the 2013 study transactions.
The average length of the earnout period has also decreased. According to the 2011 study, 36 percent of transactions with earnouts had an earnout period of 36 months or longer. The 2013 study shows that earnout periods are most commonly 12 months (32 percent of all transactions with earnouts) and only 21 percent have earnout periods of 36 months or longer.
While every transaction has its own unique issues and negotiating leverage, the 2013 Private Target M&A Deal Points Study does serve as a helpful reference for M&A industry professionals as well as buyers and sellers. The three trends noted above are just a few of the more notable trends pulled from the 2013 study. For additional trends on earnouts, materiality scrapes, indemnification caps, survival periods, sandbagging language or other deal points, please feel free to contact Andrew, Lisa or any of the other professionals in Hirschler Fleischer’s M&A practice group.