Breakup fee clause, also known as “termination fee” clause, is often included in the Letter of Intent, a Memorandum of Understanding, a Term Sheet or other preliminary documents involved in Mergers and Acquisitions transactions (M&A).
Although, as a general rule, M&A’s letters of intent tend to be non-binding in nature, the breakup fee clause is different, and, together with a small set of additional provisions such as exclusivity, confidentiality and jurisdiction, the breakup fee clause is binding and enforceable against the parties.
A breakup fee clause stipulates a specified amount (fee) payable by the company or the sellers of the company’s stock (depending on the transaction structure) to the purchaser, upon the occurrence of pre-specified events or circumstances (triggering events) that lead to termination of the M&A transaction. In simple terms, breakup fee clause stipulates the fee (penalty) payable when the seller backs out from the deal. The breakup fee is usually calculated as a certain percentage of the value of the entire deal. Generally, it is between 1% to 3% of the original value of the deal.
The concept of breakup fee not only tends to protect the interest of the purchaser, and it could also protect the interest of the seller(s). In the case of a reverse breakup fee, the fee is payable by the purchaser to the seller(s), if the transaction was not completed because of the purchaser’s fault. The intent of this clause is to protect the interest of the seller(s) and compensate them for the time and money spent, and perhaps different opportunities lost. Thus, this clause could either be enforced against the seller(s) or the purchaser.
To better understand the concept of breakup fee clause it is important to answer the question “Why breakup fee clause is used”?
As M&A transactions require a lot of time and resources right from the execution of the letter of intent till the completion of the transaction. The purchaser also needs to undertake due diligence which also requires a lot of time, energy and money. In such a scenario, if the seller(s) do not complete the transaction then the purchaser will have to bear a significant loss of time and money. Hence, this clause is used to ensure that they transact with seller(s) who are committed to the negotiations.
Furthermore, a contract that is announced but not completed can have unintended consequences for the parties involved. Given the foregoing, it’s understandable that players would want a watertight agreement that prevents one party from “walking out” and leaving the other party high and dry after significant effort and expenditure. Thus the concept of breakup fee and a reverse breakup fee is principally used to safeguard the interest of parties involved.
Events that can trigger the breakup fee clause are dependent on the facts and circumstances of each transaction and are also subject to negotiation because parties generally try to restrict their liability in the event of non-completion of the transaction. However, the most common events that trigger breakup fee clause are as follows:
- When the seller(s) chooses any other purchaser other than the purchaser whose name is included in the letter of intent.
- Failure to obtain the required corporate consents of or by the seller(s).
- Seller(s) backing out of the agreement to sell the company.
- Seller(s) unwillingness to execute their part of the acquisition deal.
Now that the breakup fee clause has been discussed in detail it becomes pertinent to discuss the concept of a reverse breakup fee.
Events that trigger the reverse breakup fee clause are as follows:
- When the purchaser is unable to arrange finance to consummate the acquisition.
- Failure to obtain the required corporate consents of the purchaser (like an IC approval).
- Failure to achieve milestones on time required for successful completion of the transaction.
However, this provision does not provide absolute protection and there are certain exceptions when a purchaser is allowed to back out of the deal without having to pay any breakup fee. For example, if the purchaser finds out any defect in the target/seller company during the due diligence process or if there is a substantial change in market terms, etc. These exceptions are also pre-negotiated and included in the letter of intent.
From the above discussion, the concept of breakup fee and reverse breakup fee is quite clear. As M&A deals hold a certain degree of uncertainty, breakup fee clauses tend to safeguard the interest of the purchaser company by creating an obligation on the target company. The breakup fee clause requires negotiation as to trigger events and quantum of fee, etc.
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