When two businesses combine, it has called a merger or acquisition (M&A). In a merger, the two companies form a new entity. In an acquisition, one company purchases and absorbs the other into its operations. The ultimate goal of a merger or acquisition is to create a more efficient and effective entity than the two previous companies. The new entity delivers financial benefits for the owners of the original companies, as well as the owners of the newly merged entity. Depending on the deal, some shareholders may cash out their stocks, while others will keep their shares and profit from higher dividends as the new company grows.
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Why do companies engage in M&A transactions?
There are several reasons for the companies’ tendency towards M&A transactions. The most important reasons are as follows:
- Enhancing capacity
- Acquiring a platform company
- Leveraging existing possessions, and
- Acquiring a business position
Different types and methods of Acquisition
A horizontal acquisition is when one company acquires another company in the same business. This could involve competitors or not, depending on whether both companies sell to the same customer base or not. The advantages of a horizontal acquisition include the potential to increase a company’s customer base, market share, and help expand its reach into new markets. The best example is Procter & Gamble’s 2005 acquisition of Gillette.
A vertical acquisition occurs when one company purchases another company in a different position on the supply chain. The acquirer can be either higher or lower on the chain. Acquiring companies vertically can generate new revenue and reduce costs by simplifying operations, like, 2002 transaction between eBay and PayPal.
A conglomerate acquisition is when a company acquires another company that is in an unrelated industry or is engaged in unrelated activities. For example, a real estate company may acquire an insurance company. Diversification is a main reason for conglomerate acquisitions, as it helps provide stability for a company by having multiple products or services. For instance, Amazon, Alphabet, Meta (formerly Facebook), Procter & Gamble, Unilever, Diageo, Johnson & Johnson, and Warner Media.
A congeneric acquisition is when a company acquires another company that sells different products or services, but to the same customers such as; Amazon and Whole Foods, eBay and PayPal, and Disney and Pixar. This kind of acquisition helps a company increase its market share and expand its product lines.
Overcoming challenges during M&A transactions
Force majeure issues have had a variety of effects on transactions. Specifically, the conditions of the transaction, such as the price, representations, and warranties, may have been called into question.
Each situation is unique and may vary depending on the target, buyer, financing, and sector involved. For example, in the recent crisis (Covid-19) has emphasized a significant challenge in M&A transactions: managing risk and uncertainty. This challenge was particularly critical when a considerable time gap existed between the deal’s signing and closing.
Currently, there are various contractual mechanisms designed to address this issue. These mechanisms include Material Adverse Change (MAC) clauses, hardship clauses, representations and warranties, and even adjusting the sale price.
Material Adverse Change (MAC) clause
The term “Material Adverse Change” (MAC) is a legal mechanism that helps minimize the risks and uncertainties for both the buyers and sellers during the time between when the Merger Agreement is signed and when the deal is completed.
MAC clauses have a specific purpose to outline the conditions that would allow a transaction to be terminated if an event occurs that significantly impacts the situation of the target company. This clause is beneficial for the acquirers as it provides them with the ability to exit the transaction, based on the conditions negotiated with the target.
To avoid any legal disputes regarding the clause’s application, it’s advisable to be as precise as possible when drafting it. During the pandemic, the use of this clause was likely to increase, and practitioners may refer directly to the epidemic (or health risk) in their clauses in the future. This clause is particularly useful as a precedent between the signing and the closing of the transaction.
In future M&A transactions, it may be beneficial to prioritize hardship clauses. This type of clause enables the possibility of initiating new negotiations if an economic or technological event significantly disrupts the balance of services outlined in the contract. Unlike the MAC clause, the hardship clause only allows for renegotiation of the contract terms, and the parties must negotiate the resulting consequences.
Many national legal frameworks have provisions for hardship clauses like; Art. 1195 of the French Civil code, Art. 3531 of the Polish Civil code. The drafter must determine whether it applies only to the seller, who usually bears the cost-related risks of the products, or also to the buyer, who may have a vested interest in maintaining a good relationship with the seller.
It is important to include a comprehensive list of all events that would activate the clause and formally document all scenarios to limit the judge’s discretion, whether the case is heard in state or arbitration courts.
Difference between Force Majeure and Hardship
The hardship clause is occasionally utilized in connection with force majeure, as they have similar characteristics and both address situations where circumstances have changed. But there is still a difference!
“Force majeure” is an event that is unpredictable and prevents a party from fulfilling their contractual obligations or completing them on time. In such cases, non-performance or delay is excused. “Hardship” pertains to a change in economic conditions that does not prevent either party from fulfilling their contractual obligations but makes it much less profitable or even costly for one party, causing them to lose money due to the contract.
Representations and Warranties
Negotiating the representations and warranties of the sellers for the benefit of the buyer can be challenging. These agreements are established at signing but are reiterated on the day of closing. If there is a significant amount of time between signing and closing, there is a risk that they cannot be verified on the closing date.
This is especially true if a guarantee was provided regarding the management of the company during the current financial year. In the future, it may be beneficial to consider updating these guarantees during exceptional circumstances.
Adjusting the sale price
Buyers will increasingly seek a price that can be adjusted based on objective criteria rather than a fixed price. Earn-out clauses may become more prevalent in the absence of locked box mechanisms providing for a predetermined fixed price at signing. Legal practitioners will be presented with an opportunity to address new issues and secure the divergent interests of the parties in light of the current crisis.
At Karimi & Associates Law Firm, our team of experts are dedicated to international trade law and drafting contracts. We offer comprehensive legal services in this field and are ready to assist you with any legal advice or assistance you may need. Please do not hesitate to contact us for our exceptional services.