After a muted 2023 to date, mergers and acquisitions (M&A) activity was on the cusp of recovery when the Israel war erupted, compounding the already daunting challenge of high interest rates and uncertain growth.
M&A deals have been patchy across different sectors, and headline grabbing mega deals like Broadcom’s acquisition of VMware and Pfizer’s acquisition of Seagen are becoming few and far between. However, there is broad sense that after the deal dip through 3Q of 2023 and the tacit understanding that “uncertainty is the only certainty”, Buyers and Sellers are prepared to deal in order to scale or to seek growth in newer markets.
What is changing?
Buyers are intensely driven to create value from a deal and are taking great care to select the best portfolios. The fixation with numbers continues, but new areas are emerging which come under scrutiny when buyers assess their targets:
Technology: Both technological capabilities (such as the ability to harness AI, use of cloud, care over cybersecurity) and intellectual property rights (registered, owned, licensed) are being examined in the early stages of an acquisition. These are the tools that will clearly be a lever for value creation.
Sustainability: Businesses that are already entrenched in the ESG (environmental, social and governance) environment, and that have a well articulated sustainability roadmap clearly find favour with Buyers. In particular, businesses which have embraced green practices, set realistic sustainability targets towards attaining net zero, and which have clear pathways to transition to a low-carbon economy are deemed to be better, more attractive targets.
Resources and connections: Attracting and retaining the right talent and business partners is now a business imperative. A business with the ability to rally their employees and business partners, and to work in collaborative arrangements such as joint commercialisation, or joint production and with a demonstrable track record for innovations creates headroom for sustainable growth. Buyers are alive to new opportunities offered by collaborative partnerships and industry networks.
Buyers are looking at value creation with a more nuanced eye, and are guided by transformational business practices that enable lively strategic growth and nimble business and financing models.
Competition Law
The leading competition law concern in M&A transactions is merger control. Depending on the jurisdiction this may require notification or clearance by local authorities if relevant thresholds are crossed. Running afoul of merger control rules can result in financial penalties, behavioural or structural remedies, and even the unwinding of the merger.
As competition law involves more than just a legal analysis, it is important that there is proper aterial Contracts: Material contracts include the third-party contracts of the target company, including contracts with customers, suppliers, agents, distributors, financiers and landlords. The LDD will seek to uncover whether there are any provisions in these contracts that will require the target company to seek notification or consent from the counterparty prior to the acquisition. In addition, lawyers will review material contracts to identify any onerous terms that will affect the target company’s ability to continue its business post-acquisition. For example, there may be provisions in a customer contract where the target company’s proprietary intellectual property is completely transferred to the customers, which may warrant additional rectification prior to completion of the acquisition or further investigation.
Diligence and Feasibility
It is vital that competition concerns are taken into account and addressed early in the transaction. This begins with identifying the relevant jurisdiction, authorities, markets, thresholds, and applicable notification or clearance process and timelines. Buyer and Seller will need to include additional lead time to the transaction even before the commencing the formal notification or clearance process as they will need to make an initial assessment of the markets and their market shares against the relevant thresholds. For transactions spanning multiple jurisdictions, it is also critical to coordinate the different notification or clearance timelines.
Parties will also need to determine whether clean team measures should be implemented and whether due diligence should be conducted at a less aggressive pace if the transaction is at high risk of not being consummated, cleared, unwound or subject to any behavioural or structural remedies. Where parties ultimately assess that the transaction is not feasible, they need to carefully address how to continue as competitors having potentially had access to commercially and competitively sensitive information.
“Gun-jumping”
In jurisdictions where the merger review may be concurrent with parties taking steps towards closing or completion or the transaction is otherwise structured in distinct stages or triggers, parties need to proceed cautiously to ensure there is no coordination and they remain competitors prior to closing or completion of the transaction or relevant stages. Prohibited conduct generally includes coordinating any competitive conduct, pricing coordination or fixing, customer or market sharing, sharing or coordinating of business and research and development (R&D) plans, or other conduct that may fall within general prohibitions against anti-competitive conduct or antitrust rules.
Conduct that has been considered to be “gun-jumping” include acquiring a call option but not the actual shares in the target, sharing competitively sensitive information beyond what is required for due diligence, coordinating conduct and decision-making, and sharing or integrating assets and facilities.
Collaborations
In some jurisdictions, there is a growing recognition that there may be circumstances where collaborations among competitors may be beneficial or at least permissible. Guidelines issued by some of the authorities note that hardcore restrictions would remain prohibited but also lay out certain considerations to aid businesses in assessing whether their collaborations may be permissible.
Some avenues of collaboration could include information sharing, joint production through contracting, or sharing of facilities or capacities, joint R&D, and standards setting and development. Especially with the increased focus on ESG and industry-wide or even national efforts to improve sustainability there is a need for clarity on how competitors can respond to this collectively as an industry without running afoul of competition laws. This may involve an exercise not dissimilar to a due diligence for an M&A transaction to determine what the applicable rules and guidelines, and thresholds if any that need to be observed.
Due Diligence
Importance of Due Diligence
More so than ever, the due diligence (DD) process is a core element in the M&A transaction structure. DD is typically undertaken by the Buyer at the start of the transaction, before a definitive sale and purchase agreement is signed, to highlight any major risks or red flags to the transaction. In recent cases, management interviews also form a critical part of the DD process, so that operational and industry issues can be teased out before closing.
DD typically includes legal due diligence (LDD) and financial or tax due diligence (FDD). In certain situations, the Buyer may conduct operational due diligence (ODD) to determine how the target company runs its day-to-day business, and to assess post-acquisition integration.
Risks identified through the DD process are usually resolved by (i) requiring the Seller to take remediation action pre-completion or (ii) contractual means such as expanding on warranties and indemnities in the definitive purchase agreement (which will be elaborated on below). Insofar as there are “red flags” or “showstoppers”, these should be rectified pre-completion by the Seller so that the Buyer does not take on overly onerous risks of the target company upon completion of the purchase.
In the recent years, there has been increasing pressure on Buyers to conduct deeper and more extensive DD on target companies, partly triggered by the collapse of several high-profile start-ups. In November 2022, cryptocurrency exchange FTX collapsed due to a liquidity crisis and accusations of fraud, despite the injection of huge sums of money from well-known investors such as Singapore’s Temasek Holdings, Sequoia Capital, Blackrock, SoftBank in various fund-raising rounds. Questions on the adequacy of investor’s DD process into FTX, amongst others, were raised and investors had to field queries as to why the red flags that led to FTX’s collapse were not spotted and corrected earlier.
While the above example relates to a venture capital funding, this applies equally (or if not more so) to an M&A deal where the entire (or a significant part of the) target company will be acquired by the Buyer. The risk of a target company’s collapse or liquidity risk becomes significantly greater for the Buyer in an M&A transaction, which warrants a more thorough DD.
Scope of LDD
The scope of LDD typically comprises, amongst others, corporate structure; employment; regulatory licences; contracts with customers, suppliers, other third parties; intellectual property and data protection. Depending on the nature of the business, the LDD scope may be widened or place greater focus on certain areas. We highlight some important aspects of the LDD process below:
- Material Contracts: Material contracts include the third-party contracts of the target company, including contracts with customers, suppliers, agents, distributors, financiers and landlords. The LDD will seek to uncover whether there are any provisions in these contracts that will require the target company to seek notification or consent from the counterparty prior to the acquisition. In addition, lawyers will review material contracts to identify any onerous terms that will affect the target company’s ability to continue its business post-acquisition. For example, there may be provisions in a customer contract where the target company’s proprietary intellectual property is completely transferred to the customers, which may warrant additional rectification prior to completion of the acquisition or further investigation.
On a commercial level, the entire LDD process on the target company’s material contracts also allows the Buyer to understand the nature of the target company’s business – for example, amongst others:
- Who the top customers and suppliers are;
- How the target company contracts with its customers (e.g. by purchase order, a template agreement executed for each engagement, or a master services agreement accompanied by a statement of work);
- Payment terms;
- Whether the target company relies on third party contractors to provide its services or produce its goods; and
- The type and quantity of offtakes and customer commitments, which can potentially indicate a steady/ secure potential revenue stream.
- Employment: Employees are key to a company’s business, and so the LDD process will, at least, involve a review of the employment contracts of key personnel (such as the Chief Executive Officer (CEO), Chief Financial Officer (CFO) and directors). Provisions in the employment contract that are (i) onerous or (ii) not in compliance with Singapore employment laws, will be scrutinised during the LDD. In certain cases, we have seen generous provisions in favour of the employee, such as golden parachutes, or continued payment of an employee’s salary even post-termination of employment. There may also be employee share option plans (ESOPs) disclosed by the Seller during the LDD, which may affect the commercials of the transaction, or need to be dealt with prior to completion of the purchase.
- Licences: Where the target company is in a regulated business, a review of the regulatory licences and the terms and conditions to these licences become important. The LDD will typically seek to uncover, amongst others, the scope of the licence to assess whether it aligns with the licenced business, the expiry date of the licence and whether additional consents from the regulator is required. In certain regulated businesses, the regulator’s consent is required before a change of control can be effected. For example, prior to the share acquisition of a target company holding a Capital Markets Service Licence, approval first needs to be sought from the Monetary Authority of Singapore (MAS). This will then need to be incorporated in the definitive sale and purchase agreement as a condition precedent to completion.
- Intellectual Property: Diligence on the target company’s intellectual property involves a search on the target company’s registered intellectual property on Singapore’s intellectual property register. Commercial agreements or documents may also be reviewed to assess ownership of intellectual property, particularly where the target company outsources work to a third party. If the target company is a technology company, there may be greater emphasis on the intellectual property and data protection aspects of the due diligence which is regarded as the target company’s core business.
- Data protection: A recent trend is the increasing focus on data protection due diligence, particularly where the target company is engaging in a Business-to-Consumer (B2C) business model. Singapore’s data protection laws, the Personal Data Protection Act 2012, are relatively stringent. Penalties for non-compliance can be (i) for organisations with annual local turnover exceeding S$10 million, up to 10% of such organisation’s annual turnover in Singapore or (ii) in any other case, S$1 million. Lapses in data protection can therefore translate into a huge financial risk for the Buyer if the target company is found to be in serious breach.
A typical LDD process takes at least 3 weeks, but remains important to uncover any onerous risks, so that the appropriate rectification action can be taken. The LDD also allows the Buyer to understand the target company’s business and operations, so as to enable further investigations to be made and provide the Buyer with contextual knowledge to negotiate with the Seller on transaction commercials.
Representations and Warranties
Representations and Warranties customarily form a key component in any M&A transaction. Representations are statements of fact whereas warranties are promises or guarantees that Sellers make about the business. Together, these provide assurances to Buyers relating to the condition of the business to be purchased and which the Buyers rely upon to enter into the transaction.
Where a false representation is made, Buyers may be entitled to claim for misrepresentation and may even be entitled to rescind or set aside the contract entirely. Where a false warranty is made, Buyers can claim for damages for a breach of contract and may also be entitled to terminate the contract.
Given the dire implications, representations and warranties are often heavily negotiated between Buyers and Sellers. This process also serves as a means for both sides (more so for the Buyers) to identity potential risks and where and how to allocate them in order to protect each side’s interests.
The attention paid to representations and warranties has been increasing in recent years. In a typical M&A transaction, representations and warranties now cover a large part of the definitive agreements, with the Buyers calling for increasingly detailed representations and warranties to obtain information about the business that is as accurate and as complete as far as possible in order to make better-informed decisions. This increasingly robust disclosure process therefore forces the Sellers to comprehensively disclose truthful and detailed information about the business much more than before (to the extent that in some instances, information which the Sellers are previously unaware of can be flushed out through this exercise).
For instance, there is now an increasing trend to split representations and warranties into various categories, ranging from “fundamental”, and “intermediate” to “non-fundamental”.
“Fundamental” representations and warranties will customarily include the aspects listed below and these are the ones that will typically have the longest survivability and harshest repercussions:
- Organisation and Standing
- Capital Structure
- Power and Authority
- Title to shares (in a share sale)
- Title to Assets (in an asset sale)
- Accounting, financial statements and taxes
Sellers are also expected to prepare a disclosure schedule to supplement, qualify, and disclose exceptions to the representations and warranties made in the definitive agreements.
To better protect Sellers’ interests, scope, qualifiers, caps and baskets – key tools used to allocate risk in the representations and warranties made – should be utilised strategically. Scoping the representations and warranties help define the extent and breadth of the statements being made. Qualifiers such as knowledge, disclosure and materiality thresholds help limit the Seller’s liability to specific circumstances where damages can be sought. Imposing caps and baskets further limit the Sellers’ exposure to financial liability and imposes a threshold of losses that the Buyers must incur before seeking damages.
On scope, it is usual for Sellers to include “no other representations and warranties” and “non-reliance” clauses in the definitive agreements. These clauses seek to limit the representations and warranties that the Buyer is relying on to those expressly set out in the agreement only and nowhere else. In some instances, Sellers may also strategically limit the survival periods for seller representations and warranties post-closing, i.e. limiting the validity of the representations and warranties to a period of say, 12 months after closing.
Common qualifiers to incorporate in the representations and warranties include:
- “to the best of the seller’s knowledge”
- “materially”
- “to the extent required by law”
- “except as otherwise disclosed”
In relation to the knowledge qualifiers, the knowledge standard should be pegged to “actual knowledge” instead of “constructive knowledge” to better protect Sellers’ interests. As compared to the former, constructive knowledge is much broader, encompassing knowledge that the individual “should have been aware of” in his/her capacity.
On caps, Sellers may consider setting an appropriate limitation on the maximum amount of liability to the Buyers or even set a cap for individual or specific claims. On baskets, there are various combinations which the Sellers can avail themselves to, such as using a “deductible” concept (where a threshold is set and Sellers are only liable for the excess), a “return to first dollar” concept (where Sellers are liable for all indemnification claims from the very first dollar, including the amounts within the threshold), or even a combination of both. Baskets based on the “deductible” concept will be more favourable to the Sellers.
Finally, Sellers may also wish to include an exclusive remedy clause to limit the potential liability owing to the Buyers arising from false representations or warranties. Such exclusive remedy clauses typically limit the liability to the indemnification provisions already set out in the agreement so that there is an identifiable quantum in place and any damages will not exceed such quantum.
