By Malcolm Superville
Mergers and Acquisitions (“M&A”) is an umbrella term used to describe the process of combining companies. One company may, for example, purchase a second company outright, or acquire some or all of its assets, or merge with it to create a new company. One of the most popular types of M&A transactions is an acquisition, where an acquiring company (the buyer) buys another (the target company) and transfers ownership. This article explores the change of control provisions found in a target company’s material contracts and why they matter in the context of an acquisition transaction.
A change of control provision entitles a third party to release itself from its contractual obligations with the target through (for example) a right of termination, refusal to grant consent to the transaction, or even to seek damages if the transaction proceeds. A change of control provision in a supplier-distributor contract, for instance, may provide that where the control of the distributor changes, consent of the supplier is required, failing which the supplier would have the power to terminate the supply arrangement upon a change in control of the distributor. These type of provisions crystallise when ownership or control over a company has changed. ‘Control’ can mean any number of things and ultimately turns on its definition as set out in the specific share purchase agreement (‘SPA’). Where an SPA does not define ‘control’, then it will likely be interpreted by referring to the person – natural or legal – who possesses the greater part of the share capital or voting power in a company.
One of the reasons that a buyer may pursue an acquisition transaction is to continue the business of the target company and ultimately maintain or grow the target company’s profitability. The success of this strategy depends on whether the target company will actually be as valuable as it claims to be after the closing of the acquisition transaction. One factor that determines this is the extent to which the buyer, on completion of a deal, can carry-on the business operation of the target in the same way (or at least in a manner that is no less advantageous to the target company) that it was run prior to the acquisition’s completion. This means that the buyer must ensure that it can benefit from the commercial relationships the target company has established with third parties following completion of the acquisition. Whether this can be done depends on whether the target’s material contracts with third parties contain a ‘change of control’ provision.
The takeaway here is ultimately that acquisition transactions are as valuable as the buyer’s ability to acquire a target company and its business without disruption. The extent to which the buyer acquires same depends on the strength of the due diligence exercise performed by its legal advisers. Failure then, to determine whether an acquisition of shares in a target company will require change of control consents risks jeopardising the intended value and timing of a transaction. The parties to such a transaction should therefore ensure that a sufficiently thorough due diligence exercise is performed to mitigate these risks.
From these exercises, buyers can take steps to protect itself by requiring that warranties, indemnities and conditions precedent be included in the SPA to weed out the existence of contracts including change of control provisions; to require that consents from third-parties to contracts in which such provisions exist are obtained prior to completion; and to ensure that there is a mechanism for compensating the buyer as a result of any loss it incurs due to (amongst other things) a decrease in the target company’s value as a result of a third-party contract being terminated post-closing.
While this may seem like a problem for the buyer in an acquisition transaction, a seller will be equally motivated to identify the issues that may arise in the sale of its shares in a target company in order to mitigate any delays; reduce the risk of any significant road blocks arising in the negotiations and maximize the value of its shares in the target company. It is therefore advisable that the seller also conduct a pre-acquisition internal due diligence to identify potential areas of focus or concern to an arm’s length buyer, including whether the target company’s material contracts include change of control provisions.
During an acquisition, the parties involved should:
- Identify and assess whether change of control provisions are included in the target company’s material contracts;
- Review and consider any such provisions to determine if they trigger the need for any consents to be obtained from third parties prior to the completion of the acquisition;
- Determine the likelihood of such consents being granted and length of time it may take to obtain any such consents; and
- Use the information derived from (i) to (iii) above as guidance to determine what types of warranties, indemnities and conditions precedent to the sale should be included prior to the deal’s close.
Notwithstanding the above, while change of control provisions are important because they can affect the value of a proposed acquisition transaction, it is still only one of the many areas that the parties to an acquisition transaction should focus on in a due diligence exercise.
