Merger and Acquisition Letters of Intent – Hold Me Back!

Most letters of intent describing acquisitions in Silicon Valley, as elsewhere, will describe the material points of a transaction. Although a properly drafted letter of intent will provide that the business points of the deal are nonbinding, it is difficult in the course of any negotiation to change a business point already agreed upon. As a result, take care to describe those points that are most important to a transaction and to leave others to be negotiated as part of the definitive agreement.

The most important point is obviously the purchase price. This can be expressed, among other ways, as an absolute amount. If the transaction is a merger, the absolute amount is converted into a conversion or exchange rate based on the market value of the acquirer’s stock over a period of time preceding the closing.

It is very unusual for the price to be paid all at once. Typically, the amount ultimately paid will be subject to post-closing adjustments based on issues unrelated to financial performance (often referred to as a holdback) as well as issues related to financial performance or other milestones (often referred to as an earnout). These provisions must be considered very carefully, as they are often a source of litigation. This blog will only discuss the holdback.

The liability holdback is the most significant holdback and is used to cover any liabilities which may arise after the closing. The holdback is used to help protect the buyer when the state of the Company, often described as representations and warranties, is found to be inaccurate. These liabilities can arise when the Company is sued after the closing, e.g., when an infringement claim is made, or can arise if a representation is inaccurate, e.g., when a cost of a particular liability is found to be greater than originally disclosed. Liability holdbacks will also cover any liability arising out of the seller’s failure to perform an obligation.

The percentage of the liability holdback varies considerably, although they typically are between 10% and 20% of the purchase price. For known claims that cannot be quantified yet, a separate holdback can be created, and the amount held back can vary with the amount of the claim.

The audit holdback, another common holdback, is that amount of money to be used to cover any adjustment which may be required to adjust, following a post-closing audit, an inaccurate working capital cushion. The employee retention holdback is another holdback that is used where employees are crucial to a target company, where an amount is held back for a period of time and reduced if employees depart the target company after the closing.

The amount of time that funds will be held back varies. Liability holdbacks typically run between one and two years. Audit holdbacks will typically run for 90 to 120 days after the closing to encourage the audit to be completed. Employee retention holdbacks can run to one year, and potentially longer.

My next blog will discuss the earnout, and the portions of this important mechanism that are usually found in a letter of intent.