M&A Vocabulary – Experts explain: Break-Up Fee

published on 18 August 2022 | reading time approx. 3 minutes

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.

Not all M&A transactions are being successfully completed at their first attempt. If a deal fails, generally, most of the time and financial expenses spent on the transaction process, will have been in vain. As a protection measure - primarily in terms of financial expenses - the contracting parties therefore sometimes agree on so-called break-up fees. Since risks of a planned transaction to which a seller is exposed to differ from those of the potential buyer, both seller and buyer may insist on such an agreement:

Break-Up Fee

A break-up fee obligates the seller to pay a predefined amount of compensation if he is unilaterally responsible for the failure to conclude the contract or if he unilaterally breaks off the negotiations. The events for which the seller shall be deemed to be responsible for are explicitly to be included in the respective agreement in advance.

In practice, the following events triggering the break-up fee are mainly to be found:

Conclusion of contract with competing bidders
Occurrence of a previously undisclosed defect in the target company that entitles the potential acquirer to break off negotiations
Lack of approval by shareholders of the target company

The break-up fee therefore serves, on the one hand, as a way of exerting pressure on the seller to stick to the planned transaction and conclude the acquisition deal with the original buyer. Indeed, the potential buyer is exposed in particular to the real risk that the company acquisition will ultimately be carried out with a competing bidder (so-called "interloper") with an economically more attractive offer.

On the buyer's side, on the other hand, the break-up fee is primarily intended to neutralize the economic risk of expenditures made in vain (e.g. due diligence costs already incurred).

This risk increases particularly in the case of public takeovers and mergers, where the seller publishes the merger announcement and the specific conditions associated with it. The appearance of additional bidders is unavoidable in such cases.

However, the break-up fee can also have a direct impact on co-bidders and discourage them from submitting a bid. This is because the seller will ensure that new bids both exceed the purchase price with the initial buyer and cover the break-up fee agreed with him. The latter usually amount to about 1-5% of the transaction value.

Such break-up fees are usually agreed at an early stage of a transaction and are often already part of the Letter of Intent (LOI). This is usually possible without having to observe special formal requirements, i.a., generally, there is no notarization required, even if the purchase agreement is to be notarized at a later stage. Exceptions may arise, however, if the agreed break-up fee leads to an indirect compulsion of the obligated party to conclude a purchase agreement that has to be notarized., e.g. due to the immense amount of the break-up fee. In this case, the inclusion of a break-up fee leads to a de facto obligation to notarize the LOI.

This can be counteracted if the break-up fee clause is designed as a simple compensation clause and only provides for compensation amounts which the seller can actually prove to have incurred.

Reverse Break-Up Fee

A seller may also protect himself by means of a so-called reverse break-up fee. The potential purchaser undertakes to pay a reverse break-up fee to the seller if the reasons for the failure to conclude the contract relate to the seller, i.e. if the seller is responsible for the failure. The seller is exposed to different risks than the potential buyer.

These are mainly

the failure to complete the transaction by a certain deadline ("drop dead date"),
if necessary, a lack of approval from shareholders, or
lack of approvals, in particular from antitrust authorities.

However, the highest risks for the seller are related to the lack of financing commitments by the buyer, so that the takeover cannot be completed for purely monetary reasons.

Practical experience with cross-border transactions

In the German M&A market, break-up fee clauses are mainly used when a transaction party is based outside the European Union. This is increasingly observed in the case of investments by Chinese buyers: Due to the approval processes to be gone through there with partly uncertain outcome, the German seller often demands a reverse break-up fee.

In addition, foreign exchange regulations also play a role in cross-border transactions with China, which apply not only to the payment of the purchase price but also to the payment of break-up fees. It is therefore essential to take this factor into account when drafting the relevant clauses.

Conclusion

Although the agreement of break-up fees cannot fully protect the contracting parties from the failure of a transaction, it can ensure that the counterparty initially gains a certain confidence and, in the worst case, at least the economic risk is minimized.