Security in M&A practice

In a business acquisition, much ultimately revolves around the allocation of risks between the seller and the buyer. Both parties may face real risks, and safeguards determine how those risks are allocated. In this article, you will learn which forms of safeguards are common in M&A practice, how buyers and sellers protect each other, and how this plays out in a specific practical example.

Why security lies at the heart of every acquisition

At the time of an acquisition, various interests converge. The buyer pays a (substantial) sum for a business that they do not yet fully understand from the inside and wants the assurance that what has been promised by the seller is indeed accurate. Naturally, it is advisable to always carry out a due diligence investigation in order to familiarise oneself with (most of) the risks. Once the transfer date arrives, the seller will hand over their business and wants to be certain that the full purchase price will actually be received. This is because the parties may agree that part of the purchase price will only be paid at a later date, such as through an earn-out or other deferred payments. It is also possible that a financier is involved in the transaction and requires collateral in order to provide the necessary financing. In practice, the way in which these interests are safeguarded often determines whether a transaction succeeds and on what terms.

This is particularly relevant for SMEs+ and large enterprises. The sums involved are substantial, the structures are often more complex than in a small acquisition, and the counterparty is frequently a holding company or a company set up specifically for the transaction. It is precisely in such cases that it is important to consider carefully in advance which form of security is appropriate for which risk.

Security for the buyer

In principle, the buyer will always wish to stipulate as many guarantees and indemnities as possible in an acquisition. After all, any loss they may suffer will have to be compensated by the seller. However, such agreements are only as valuable as the party standing behind them. If the business is sold by a holding company that distributes the proceeds to the underlying shareholder(s) after the transaction, the buyer may be left with a valid claim against a virtually empty company. Various forms of security exist to prevent this.

A commonly used form is escrow. A portion of the purchase price is then temporarily held by the solicitor or a bank and released only after an agreed period, so that recourse is available for any claims. A bank guarantee works in a similar way: a bank guarantees the seller’s obligations, so that the buyer is not dependent on the seller’s liquidity should a claim arise.

If the seller is part of a larger group, a group guarantee or parent company guarantee provides a solution. The parent company then guarantees the obligations of the selling subsidiary, ensuring the buyer has a solid party to fall back on.

An equity maintenance agreement is also frequently entered into. Under this, the seller undertakes to maintain a minimum level of equity capital for a specified period, so that the company can continue to meet its obligations arising from the guarantees and indemnities. This undertaking is particularly suitable where the seller is a holding company that could be stripped of its assets following the transaction, whilst an escrow or bank guarantee is not quite commercially viable. However, it is important that the undertaking is formulated in concrete and enforceable terms, with a clear duration and a measurable equity level. A vague commitment offers virtually no protection in practice.

Finally, W&I insurance (warranty and indemnity insurance) is also gaining ground in the SME+ segment. In this case, an insurer assumes the risk of a breach of the warranties. This enables a clean exit for the seller and provides the buyer with a solvent party to turn to. Do bear in mind the exclusions and cover limits, however, as not every risk is insured.

Security for the seller

Above all, the seller wants the assurance that the purchase price will be paid in full. In a traditional transaction, this is well regulated because the purchase price is channelled through the notary’s escrow account and the shares are only transferred once the funds have been received. Matters become more complicated when part of the price is paid at a later date, for example via an earn-out, a deferred purchase price or a loan from the seller to the buyer (a vendor loan).

For that deferred portion, the seller can use the same instruments as the buyer, but in reverse. A bank guarantee or a group guarantee provides certainty that the remaining payments will be received, particularly when the buyer is a company set up specifically for the acquisition and has no equity capital. In addition, the seller may stipulate a charge over the shares sold, so that, in the event of default, they can realise the shares and, if necessary, regain control of the company. An escrow arrangement may also be useful here, for example to bridge a dispute over an earn-out without the full amount having already been paid out.

What we see in practice

In practice, we regularly see parties stipulating various forms of security, with a capital preservation agreement often being one of the more commercially attractive options. After all, a bank guarantee and an escrow arrangement incur costs: the bank charges fees for the guarantee, and with an escrow arrangement, part of the purchase price is tied up for a long period in a blocked account. A capital preservation undertaking does not incur these direct costs and can therefore make all the difference for both parties. On the other hand, an escrow or bank guarantee is a more robust form of security: the creditor can seek recourse directly against the frozen funds or the bank, without being dependent on whether the parent company actually fulfils its commitment to preserve the assets. A capital maintenance undertaking does not offer this direct recourse and, as a rule, results only in a claim for breach of contract, the value of which depends on the extent to which recourse can be had against the parent company. The choice between these instruments is therefore always a balance between costs and the level of security the parties require.

Which option is most appropriate in your case depends on the scale of the transaction, the nature and duration of the guarantees, the financial position of the selling party and the level of security you require. We would be happy to advise you on whether, in your situation, a capital preservation undertaking is sufficient, or whether a more robust form of security, such as an escrow or bank guarantee, is preferable, and on the precise wording required to ensure that the chosen instrument actually offers you protection.

Conclusion

Security arrangements are not a mere formality in M&A practice, but play a key role in determining whether a transaction is acceptable to both parties. Whether you are buying or selling, a well-thought-out package of security arrangements protects your position and prevents unpleasant surprises later on.

Questions

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