The cost of diligence and doing the work is high as you begin to move from LOI to close, and M&A Termination fees helps to keep both parties at the table. Tune in as we dive into these fees, why they happen, how to avoid them, and what we've seen in the market.
Break up fees or Transaction Termination fees: A fee put in place by a buyer or a seller that if the deal does not transact as outline, there could be a fee owed to one party or the other. This is a mechanism to help buyers and sellers move along a deal and if the deal doesn't get done, is a safeguard for the parties. It's typically paid by a buyer for making the decision to terminate a letter of intent (LOI) prior to close. These are usually introduced for very specific reasons like something looming or previous interactions between a buyer and a seller. These are not typically common in an IT Services deal, because of the privately held nature of this industry but we have been seeing them more lately. We don't believe this will become a standard operating procedure but does happen on a case by case basis.
Why does this happen? Well, the cost of diligence and doing the work is high as you begin to move from LOI to close, and this helps to keep both parties at the table, and if the buyer decides to terminate, then the seller has some compensation for the effort, and dollars spent on the deal up to that point. Sometimes a deal will fail because the seller found a better deal with a different buyer.
When would you not pay a breakup fee? There are some things that would warrant a transaction being terminated. If a buyer cannot secure financing, a major client terminates their contract between LOI and close, or key personnel decide to not come along for the ride. These scenarios should be outlined in the agreement or a separate agreement.
SPEAKERS
Matt Lockhart, Ryan Barnett, Mike Harvath
Mike Harvath 00:06
Hello and welcome to this week's Shoot the Moon podcast, broadcasting live in direct from Revenue Rocket world headquarters in Bloomington, Minnesota. And you know, if you're a regular listener, Revenue Rocket is the world's premier growth strategy and M&A advisor to IT services companies. With me today are my partners, Ryan Barnett and Matt Lockhart. Welcome, gentlemen.
Matt Lockhart 00:30
I really want to start how long guys, I you know, we're given updates on the on the local home team, you know, regular listeners know, we're up here in the great white north of beautiful Bloomington, Minnesota. And we're cheering on our wolves team who came back for a thrilling close out of their series with the Denver Nuggets. And so we are we're moving on how what's happening, Ryan?
Ryan Barnett 00:59
Yeah, it's exciting to be up north this time of year. Yeah, we got an interesting topic here today. And something that we've seen pop into a few deals recently is a quick reminder, a lot of the things that we that you hear on this podcast are stuff that we're dealing with on a on a weekly basis. And so this was and it was prevalent, and some of the things we're dealing and hopefully helped some of the listeners that are on this podcast. If you have a topic you'd like to talk about, please contact us at info at revenue rocket.com We'd love to talk about all things, M&A and growth strategy related to tech services businesses. But today, we're talking about something called you may call it breakup fees or transaction termination fees, or maybe even heard of a of a reverse transaction termination fee. And that's essentially a mechanism to help buyers and sellers move along a deal. And if not, if the deal doesn't get done, there may be some consequences to that. So we'll start right away with that definition. Mike, why don't you get us going? Can you explain what a transaction termination fee or a breakup fee is? And what are they used in M&A deals?
Mike Harvath 02:13
Yeah, sure thing, right. So a transaction termination fee is a fee typically paid by a buyer. You could call it a reverse termination if it's paid by a seller for making the decision to terminate a letter of intent prior to close. Now, you might say, Well, why the heck would they do that if they entered into LOI? Well, the cost of diligence and doing the work is high on both sides, as you begin to move through loi to close. And the logic here is you want to keep if you're a buyer, and you're going to introduce this concept, or a seller and you're going to introduce this concept is to keep the buyer at the table if you're the seller, of course and if you're the buyer, you want to get the seller at the table, there may be some reason why you think that they might want to exit or terminate the negotiations prematurely. And if they should do that, then you want some renumeration, particularly to offset some of the costs you may have undertaken to begin to move through the transaction. And, and typically, I first want to say that typically, this is not done. In our industry, it's exceptionally rare for there to be a termination fee, even proposed in a transaction. So I'm not proposing that we should suddenly be including them in every deal. But we are certainly seeing more of them. And they usually are being introduced for very, very specific reasons, based on either a buyer having knowledge, previous knowledge or interactions with a seller or vice versa, or because of something that might be known as looming. And one party or the other may want to protect themselves, least offset some of their costs or the other party excellence of negotiation.
Ryan Barnett 04:21
So if I pay here, this right this is a fee put in place by either a buyer or seller, and if they deal does not transact as it is outlined, in typically that letter of intent. There could be a fee owed to one or one party or the or the other. Might you mentioned that in our industry there, they haven't been common. There's some interesting to us about where we work. For example, we work with a lot of privately traded firms. And when we look at transaction termination fees, oftentimes these are associated with public entities, but matter Mike, what's special about why is are they less prevalent in our, in our world?
Matt Lockhart 05:07
Well, I think, you know, Ryan, one, one area may be simply what you just addressed, where there's a lot of privately held businesses that, you know, where the scope of, of the deal is such that, you know, it is not as common as in maybe larger publicly traded, you know, scenarios. I think, you know, another reason may be, you know, we're, we're pretty squarely rooted in the middle market. So, you know, deals that, you know, maybe less than double digits of EBITA. A little less common in those scenarios, as well. And I think then for, you know, also for us just specifically is, we do to, you know, work very hard to align those cultural, strategic and financial fits prior to a letter of intent being executed upon. And so, you know, there should be a very strong intent in the letter of intent to towards closing the transaction. So, you know, those are, those are some of the, you know, some of the things that I think that that we see, now, on the flip side, we are starting to see more of them. And I think that, there could be a variety of reasons, you know, there's just a, there's a lot of frothiness, still in this market, right. And, you know, separating the, the, the shoppers from the buyers, as Mike is apt to say, to say, you know, is something that is is important, and having a breakup fee, you know, certainly puts puts money where the talk is,
Mike Harvath 07:07
yeah, I would also add, you know, a man that just about this in context, when we see we don't see it many times, you know, when there are plenty for years of operating and hundreds of deals we've advised on, you know, I can count maybe on one hand, the number of deals and have had a fee, associated, you know, lock way fee, termination fee, breakup fee, whatever you wanna call it, it's all the same stuff, involved in their deals, and there was very specific reasons for it, and there kind of needs to be in a private to private deal. Very specific reasons for it. Because as you mentioned, if if we've got fit and finish, right, and, you know, we've done our work to get things lined up strategically, culturally and financially, you know, then there's a high probability, you're going to get that deal closed, and there really is no need for for a fee associated with that. opposed to that, you know, these fees started, as Brian mentioned, with public companies, because based on the disclosure rules in the public markets, oftentimes you have to disclose pre close that the deal is going to occur to allow any potential impact to the public markets to impact respective stocks before the deal trades. And that can have negative consequences for one party or the other. And that's part of why they if the deal doesn't close, and that was part of why those fees were initiated in public markets. And private markets, it's different drivers. Right. As I mentioned before, it could be previous knowledge or dealings with a specific suitor or it could have to do with concern about a particular buyer, being someone who re trades deals who, who has a habit of signing letters of intent, and then coming back with different terms on what was proposed. And there's, you know, probably half a dozen other reasons why couldn't be introduced. But I just wanted to provide some level of context and in private to private mid market, IT services transactions, it's exceptionally rare to have these fees included.
Ryan Barnett 09:13
Yeah, and I think that's a it's a great point, and it's a great setup. These fees, even if they are in place, don't necessarily get enacted upon. A major provider of General M&A, so it's not specific IT services companies, but in in 2022, they looked at 140 transactions where there was termination fees, and only four were terminated. That's 3%. In the year before about 6% of deals were terminated that had these termination fees, so the likelihood that it's going through. I do want to highlight your point when a seller let's say you're trying to Sell your company and a buyer comes to you with a letter of intent, a large portion of that then Letter of Intent could be a non compete clause or a no shop clause. And some levels as a seller, you having protection that you're the only person in town I can deal with, if I can't get a deal done with you, and it's because of your issues that you could have a, I want to be compensated for that as a seller, you're kind of at risk is your business could be slowed down, impacted by the the poles of an acquisition. So these fees can be some way to set that off. Mike, I'd be curious if you've seen any trends on how fees are calculated, I will say when you look at the market in general, the trends, the kind of the way that a fee can typically could be calculated it might be on enterprise value, or it may be calculated on or transaction, transaction value or kind of that enterprise value. And they can range from relatively small to up to 6% of the of the deal. So point 3% to 6.2. Is that kind of that median? What have you seen or how have you seen some of these transaction termination fees be calculated?
Mike Harvath 11:29
Well, in the last few we've seen, they're typically indexed at about 1% of the expected enterprise value. So not not a big number, not a huge number relative to the value of the deal, but big enough to get attention on both sides of the transaction, big enough to offset some of the of the risks that may be associated to a seller not being able to, you know market to others that might come along and offset some costs associated with diligence. And you know, kind of same for the buyer, right? If you're consumed and, you know, neck deep and due diligence of a seller, it's likely that you're setting aside capital that you're going to use in that transaction that you're leveraging advisors, you know, that's true on both sides of the transaction to help you kind of move things along, to get through diligence and ultimately get to a deal. And, and so, you know, having some remedy for a premature walk away, or one that would not be, you know, it would be at the discretion of either party on either side, versus something that would be materially found in diligence or something like that, you know, could warrant a fee to be paid.
Ryan Barnett 12:47
And then do you see any difference between a strategic buyer or a financial buyer, when it comes to these fees? When you look at the stats on this, especially on a reverse pick of the financial buyers are actually got higher fees associated with them with a reversal, almost 5% Is that was the average 21 or 4.9%, in 2022, compared to strategic buyers who had about 3.6% to 3.9% of that transaction fee. Do you see any difference between the type of buyer that a seller may mana think differently about?
Mike Harvath 13:30
Well, I would comment that certainly strategic buyers, there's more sponsored strategic buyers now. So the lines are getting much more blurry. When I say sponsored, I mean, private equity sponsored strategics and, you know, pure play financial buyers, you can see why that might be the case, particularly with something like a search fund or a firm that's, you know, trying to do financial engineering or trying to, you know, get into a new market, for example, the the perception of the seller, and I think rightfully so it'd be that that could come at a higher risk of sort of default rate or one that where they wouldn't get the deal done. And that warrants, you know, I guess a higher fee, higher potential risk of breakup. Likewise, and opposed to that, you know, strategic understands the business, right, they know, kind of what they're getting into, and ultimately could be. You could argue that those deals could get done a little easier or have a higher probability of post integration success could have a higher probability of close even. I think what's fascinating about this whole topic is a lot of these fees are actually introduced by brokers that work predominantly in industries that have these fees, where it's more of an SOP. Eat kind of standard operating procedure, versus those that work in a vertical. You know, and again, probably just another business case for working in a lane or with an advisor who spends time here and IT services for tech enabled services.
Matt Lockhart 15:18
I think that's a good point Mike. I think, you know, again, there's, there's, there's, there's so many more entrants into into our space, that, you know, see the value, and the continued value of, you know, within the greater tech enabled services space. And so there's a lot of new investors. And what's interesting about that stat Ryan is, you know, perhaps, you know, when a financial, you know, buyer has really found that fit, they, they want to put some extra umph in that letter of intent, you know, for both parties to, to not, you know, be able to change minds to turn around, etcetera, etcetera. So, you can, you can see that, and, again, is, from our perspective, it hasn't been necessary, I do think that we'll continue to see more of it just as, as this market stays, you know, pretty darn hot, and there are new entrants, and I think it's, it is very much, though a case by case scenario, if it's if it's the appropriate thing to do, because I, it's not going to become a standard operating procedure anytime. So
Ryan Barnett 16:40
you're an editor. This is the one this is the the the one off case that we're talking about here. Are Are there points within a fee or this structure that can be negotiated? Or what are the levers that can be pulled? When talking about breakup fees?
Mike Harvath 17:04
Well, there's, there's certainly, you know, many of them. I mean, as far as exceptions, right? Is that what you're looking for?
Ryan Barnett 17:12
No, not just, is it the length of the how far? Or the length of perhaps a deal? That? Is it the amount that can be? Is it time? Is there a structure in a fee at all? Is it just simple? Just help me understand. We know, are there just what act acts? Can you negotiate? Or what can you negotiate in a breakup fee? Is it a simple, you know, we're gonna have one or not?
Mike Harvath 17:41
Well, I think you want to be able to negotiate in off ramp. So that breakup fee, right, because you don't want to be holding in to do a bad transaction. If you're on the wrong end of a breakup fee, let's say you're going to be a buyer and a seller suggests a termination fee. And you agree to that, in principle, you know, there are certain reasons why you should be able to be allowed out of that deal without a termination. For example, let's say you're unable to successfully secure financing. I mean, that's kind of something that's out of your control, you know, you shouldn't have to pay a breakup fee for that. Or let's say you find a material deviation and their due diligence from what was, you know, position or provided or major error in their financial data, or a major client terminates their contract between the time you sign the LOI and you want to close, or there's key personnel choose to not come along or, you know, there's probably some things that would warrant you stepping away from the transaction, where you wouldn't need to have to pay a breakup fee, it's outside of your control. And those should be outlined in the agreement. Right, they should be outlined in a letter of intent, or in some cases, there's a separate agreement. And, and I would say the same thing for a seller if if, for whatever reason, a buyer asked for sort of a reverse termination fee from you, should you walk away from the deal? There should be some reasons why you could walk away from the deal and those should be included and outlined inside of the LOI. And generally, you know, there's some terms on the termination fee, like for example, you know, you'll pay it, you know, it's got it has to be paid with a certain period of time and a certain way should it be eligible for payment. And all of that detail, kind of how much and when it would need to be paid? And what conditions for which it would need to be paid need to be outlined in the letter of intent or, or in the, you know, termination fee agreement.
Matt Lockhart 20:12
Great points, Mike. I think that this also sort of brings up, you know, when is it the right thing to do, because all of a sudden, you're talking about negotiating around the principle of a deal not coming together? And, you know, it's sort of like, jeez, are we get off on the right foot here? And so, again, we go back to there's got to be some pretty specific reasons why, and a general understanding of, you know, if and then there are scenarios that the are rightly so don't bring a transaction, you know, through through to its fruition. Because, you know, you don't want to slow a deal down. And because you're stuck in negotiating, you know, a breakup clause, but you know, you're kind of going in, potentially, with the wrong intent, if it's not truly necessary. And as we, we remind everybody has, you're executing a letter of intent, the only letter that matters is the I, it's the intent. And, you know, we haven't needed it in the past, you know, but certainly, again, we're seeing more and more scenarios where it could be warranted.
Mike Harvath 21:39
I would also comment that, you know, if you're gonna enter into a letter of intent, you have to remember that the lion's share of that agreement is non binding to begin with. And essentially, what you're doing is codifying a handshake, or a commitment in order to move through this transaction, diligence, and ultimately, the negotiations around the definitive agreement in good faith in in an expeditious manner. So in order to do that, you kind of have to trust the other party, that they're being forthright with their intent. And certainly, there's some bad actors out there, that, you know, misrepresent their intent. But I'd say for the, for the lion's share the vast majority parties in these deals, they they tend to, they tend to do a pretty good job of doing what they intend to do as outlined in the LOI.
Ryan Barnett 22:46
Yeah, I'd say the going back to a one of your points, Mike earlier was, if funding couldn't be secured, that that actually, you shouldn't punish the buyer. And I'd argue that's actually a perfect point of why you want a breakup fee. In some cases, we work with a lot of partners who are in fundraising mode. And if you're continually raising funds, especially if you don't have a committed fund already, having some skin in the game initially prevents a seller from going into an exclusivity period with a buyer who ultimately can't get something done. And I think that is something that, at the very least a seller should have on their toolkit. But as we've seen, use it very sparingly. To summarize, but we heard a lot of what we're, we typically don't see transaction or breakup fees, within letters of intent in our market. Part of that is the markets that we're in are oftentimes private transactions and just don't have the same level of scrutiny. We also don't see the same level of antitrust concerns. So we don't see it as much. If you do see one, there are points that you can negotiate and look at the fee structure of all that is typically based on the enterprise value of it. And as we've said, you don't want to start a negotiation on the wrong foot. So be careful and and scrupulous on when you might employ this tactic in looking at a deal. Mike, I'll turn it over to you for any questions and wrapping it up.
Matt Lockhart 24:25
Thanks Ryan. I think great summary and, and interesting topic. Again, case by case scenario, not common. has to have some pretty specific reasons. And you know, that's why that's why you want a good advisor on your team. So, with that, go wolves, Mike.
Mike Harvath 24:49
Yep. Thanks, Ryan. Great topic today. With that all tie a ribbon on it for this week's Shoot the Moon podcast we encourage all of you to tune in next week. When we unpack more topics around optimizing your growth and transacting M&A deals for tech enabled services firms thanks a lot and make it a great week