Spanish M&A standards - IE · legal standards of Spanish M&A agreements. A team made up of Hogan Lovells’ Corporate lawyers and IE Business School researchers has rigorously gathered

Spanish M&A standards

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SPANISH M&A STANDARDS

Acknowledgement

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SPANISH M&A STANDARDS

Table of contents

INTRODUCTION 5

WHY A STUDY ON SPANISH M&A STANDARDS? 6

KEY CONCLUSIONS 9

1. PURCHASE PRICE 101.1 Payment 101.2 Purchasepriceadjustment 111.3 Locked-box 121.4 Earn-out 13

2. BETWEEN SIGNING AND CLOSING: THE INTERIM PERIOD 142.1 Conditionstoclosing 142.2 MACclause 142.3 Managementintheinterimperiod 152.4 Closing 15

3. SELLER’S LIABILITY 163.1 Recoverabledamages 163.2 Limitationperiod 173.3 Baskets 173.4 Liabilitycaps 183.5 Securityforwarrantyclaims 203.6 Disclosure 203.7 Seller’sbestknowledge 20

4. RESTRICTIVE COVENANTS 214.1 Non-compete 214.2 Non-solicitationofemployees 21

5. DISPUTE RESOLUTION 22

6. SOME SPECIFICS TO PRIVATE EQUITY FUNDS 246.1 Incentivestomanagementteams 246.2 Drag-alongrights 25

METHODOLOGY 26

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SPANISH M&A STANDARDS

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SPANISH M&A STANDARDS

Introduction

WearepleasedtopresentthisstudyonSpanishM&Astandards.ThestudyistheresultofajointinitiativebytheIEBusinessSchoolandthegloballawfirmHoganLovells.

Bothinstitutionsshareapassionforinnovationinthelegaldomain:itslecturing,researchandpractice.

Thispassionledustoundertakethisstudy-thefirstofitskindinSpain-onthelegalstandardsofSpanishM&Aagreements.

A team made up of Hogan Lovells’ Corporate lawyers and IE Business Schoolresearchershasrigorouslygatheredandprocessedthedataprovidedby43leadingcorporatesandprivateequityfunds,withtheaimofanalysingthetermsofprivateM&AcontractsnegotiatedinSpain.

WehopethestudyhelpsyouansweraquestionfrequentlyraisedinthecourseofM&Anegotiations:“IsthisclausemarketpracticeinSpain?”

Javier de CendraDean

José M. BalañáPartner

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SPANISH M&A STANDARDS

SpainisacivillawjurisdictionwhereSharePurchaseAgreements (SPAs) are governed by the principleof freedom of contract as there are no laws orregulationsspecifictothem.This,togetherwiththeadoption of the anglo-saxon contractual practice,which has shaped M&A globally, has resulted inSpanishSPAsdealing indetailwitheveryaspectofthe transferof the targetcompanyaswellaswithitspotentialpitfalls.

Unlike other countries, mainly the United States,where research on the actual contents of M&Aagreements has become increasingly widespreadin recent years, in Spainonlya few courtdecisionsprovide some clues as to what these agreementsconsistofandhowtheyoperateinpractice.

In this context, we realised there was a need tocarry out an empirical analysis of Spanish M&Aagreements.

InordertoovercometheabsenceofpubliclyavailableSPAs, we decided to approach leading Spanishcorporates and private equity funds operating inSpain to ask them about their practices in privateM&Adeals.Aheartfeltthankyoutoallofthemfortheirtimeandforsharingtheirexperienceswithus.

Why a study on Spanish M&A standards?

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SPANISH M&A STANDARDS

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SPANISH M&A STANDARDS

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SPANISH M&A STANDARDS

Themainconclusionsofthestudyareasfollows:

• Payment of the purchase price: In80%oftransactionsthepriceispaidatclosing.Ifpaymentisdeferred,thebuyerprovidessecurity,usuallyintheformofanescrowaccount.

• Purchase price adjustment: Morethan50%ofthedealscontainapriceadjustmentmechanism.Netdebtisthepreferredparameterforpurchasepriceadjustments.

• Locked box: Corporatestendnottousethismechanism.Itis,however,widespreadamongprivateequityfunds,whichuseitintwooutofthreetransactions.

• Earn-outs: Thismechanismisusedoften.Itstimeperiodisgenerallysetbetweentwotothreeyears.

• MAC clauses: 40% of transactions contain MAC(“MaterialAdverseChange”)clausesbuttheyarerarelyenforced.

• Interim period: Itiscommonpracticetolimittheseller’smanagementpowersduringthisperiod.

• Representations and warranties: In85%ofthedeals,representations and warranties are “repeated” atclosing.

• Damages: In most cases, damages refer solely todamagesactuallysuffered,excludingindirectdamagesorlossofprofit.

• Limitation period: Fordamagesotherthantax,an18monthlimitationperiodtoclaimismostpopular.

• Baskets: Thestandardis0.5%ofthepurchaseprice.Inover80%ofthecases,thebasketdidnotexceed1%ofthepurchaseprice.60%ofthedealscontained“first-dollar”recovery.

• Liability caps: In23%ofthetransactionsthecapwasthepurchaseprice.Inmostcases,however,capsrangebetween10%-50%ofthepurchaseprice.

• Security for warranty claims: In four out of fivetransactions,thesellerprovidedsomekindofsecurity.Theuseofescrowaccountsandfirst-demandbankguaranteeswasparticularlyprominent.

• Non-compete clause: Nearly 70% of transactionsincludecovenantsnottocompete.Theaveragedurationisbetweenone-twoyears.

• Dispute resolution: Private equity funds preferarbitrationwhilecorporatesdonotexpressaclearpreference.Standardarbitrationisbeforeanarbitrationtribunalwiththreearbitrators.

• Drag-along: Theyareuniversallyusedbyprivateequityfundstoprotectexits.

• Management team incentives: Exitratchetsarethepreferredformulatoincentivisemanagementteams.

Key conclusions

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SPANISH M&A STANDARDS

Purchase price clauses are at the heart of SPAs.They are usually complex as they typically contain adjustments(upwards and downwards), earn-outs dependent on the future performance of the target and, in some cases,deferredpayments.

1. Purchase price

1.1 PaymentThe purchase price is paid primarily in cash at closing (see 2.4 below). Only in one out of five transactions waspaymentdeferred.

In cases where payment is deferred, the buyer invariably provides security. Securities most commonly used areescrowaccountsandparentcompanyguarantees,followedbyfirst-demandbankguarantees.

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SPANISH M&A STANDARDS

Only in one out of fivetransactions in which a priceadjustment mechanism hadbeen provided for did suchadjustment not have anyimpact on the final price.Themain beneficiaries of priceadjustments were the buyers(three times as much as thesellers).

%35302520151050

WorkingCapital

Equity EBITDA NetDebt Cash Other

22%

4%

25%

32%

5%

12%

19%

noadjustmentsweremade

62%

adjustmentsweremadeinfavorof

thebuyer

19%

adjustmentsweremadeinfavoroftheseller

1.2 Purchase price adjustment Morethan50%oftransactionsprovideforsomekindofpriceadjustmentmechanism,incontrastwiththeUS,where85%ofdealscontainapurchasepriceadjustmentclause.

Price adjustment mechanisms require parties to agree on reference financial statements for the purposes ofdeterminingtheadjustment.Thedateofthesethefinancialstatementsusuallycoincideswiththeclosingdate.The buyer is normally responsible for preparing such financial statements on the basis of previously agreedaccountingprinciples.

UnlikeotherEuropeancountries-whereworkingcapitaladjustmentsareusedinmorethan40%oftransactions-ortheUS-wherealmosteverysingledealcontainsaworkingcapitaladjustment-,inSpainthereferencevaluemostlyusedforpriceadjustmentpurposesisnetdebt,followedbyEBITDA.

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SPANISH M&A STANDARDS

1.3 Locked-box ThelockedboxisamechanismwherebythepriceisfixedatthetimeofsigningtheSPA,usingasareferencethefinancialstatementsofthetargetbusinessatagivendatepriortosigning(thelocked-boxdate).Thebusinessriskof the target is transferred to thebuyer from the lockedboxdate.Until closing, thesellerundertakes to refrainfromperformingcertainactions(leakages),suchasdistributionsofdividendsandtransactionsotherthanatarm’slength,aimedatextractingcashfromthetarget.Intheeventofleakages,thepurchasepricewillbereduced.

Thelocked-boxmechanismcanbeusedasanalternativetothetraditionalpriceadjustment(see1.2above)oncethebuyerhasgainedcomfortregardingthefinancialsofthetarget.

Lockedboxismoderatelypopular;onlyoneinthreerespondentsclaimedtouseiteitheralwaysoroften.Nevertheless,corporatesandprivateequityfundsuseittovaryingdegrees.

Intwooutofthreetransactionscarriedoutbycorporates,locked-boxwasnotused.Bycontrast,privateequityfundsuseditintwooutofthreeoftheirdeals.Thereasonbehindthismaybethatprivateequityfundsprefertoinvestincompanieswithstableandpredictablecashflows(forinstancecarparks,motorways,energyproductionplants),whichareverywellsuitedforalocked-boxmechanism.

CorporatesFunds

13%

39%

rarely

33%

29%

sometimes

47%

25%

often

7% 7%

always

%

50

45

40

35

30

25

20

15

10

5

0

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SPANISH M&A STANDARDS

1.4 Earn-outWhenasellerremainsinthetargetbusinessafterclosingasamemberofthemanagementteamorasawaytobridgeavaluationgap,itisquitecommontomakepartofthepurchasepricedependentontheperformanceofthebusinessafter closing (earn-out). As a result, the buyer and the seller share the benefits as well as the risks of the target’sbusinessfollowingtheacquisition.

Theearn-outiswidespreadinSpain(60%ofthetransactions)andtheearn-outperiodisusuallysetatbetweentwoandthreeyears.

In analysing the data above separately for corporates and private equity funds, there are dramatic differencesbetweenthetwogroupsasfarastimingofearn-outsisconcerned.

Thus,whileprivateequityfundssetthedurationoftheearn-outperiodattwoyearsorlessin70%oftransactions,morethan60%ofearn-outperiodsusedbycompanieslastatleastthreeyears.Corporatespreferencetofocusinthemediumtermisconfirmedbythefactthatinnineoutoftenoftheirtransactionsthelengthofearn-outsexceedsoneyear.

Themainreasonforsuchadifferenceisthatprivateequityfundsplacegreateremphasisonmaximisingbusinessperformanceimmediatelyafterclosing,whereascorporatesfavouralongertermapproach.

39%

10%

31%

26%

23%

32%

7%

32%

CorporatesFunds

Oneyear Twoyears Threeyears Morethanthreeyears

22%

Oneyear

22%

Morethanthreeyears

28%

Twoyears

28%

Threeyears

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SPANISH M&A STANDARDS

2.1 Conditions to closing60% of Spanish transactions provide for a periodbetweensigningandtheclosing,ascomparedto80%in the US. This interim period is intended to allowfor the conditions to closing (whether mandatory orvoluntary,asprovidedbytheparties)tobesatisfied.

Where required by applicable law the most commonconditiontoclosingistheapprovalofthetransactionbytheantitrustauthorities.Twooutofthreetransactionsencompassthebuyer’srighttowithdrawfromadealin the event conditions Imposed by the competentauthorities (usually divestments) are consideredunacceptablebythebuyer.

It is worth noting that the number of voluntaryconditionstoclosingallowingthebuyertowalkawayfromthetransactionwaslow.

The period for the fulfilment of the conditionsprecedentrangesfrom3-6months.

2.2 MAC clauseMAC clauses are a risk allocation mechanism whichentitles a buyer to withdraw from the deal when anevententailingmaterialnegativeconsequencesforthetargetbusinessoccursbetweensigningandclosing.

MAC clauses are included in 40% of transactions.Although this somewhat exceeds the Europeanaverage, it is a far cry from the levels in the UnitedStates,whereMACclausesareusedacrosstheboard.

The wording of these clauses is heavily negotiatedand sometimes it includes the quantification of theeconomicimpactthattheeventscoveredbytheMACclausehaveonthetarget’sbusiness.

In 10% of the deals, the MAC clause was enforced. Itneverhappenedinanyofthedealsexecutedbyprivateequityfunds.

2. Between signing and closing: the interim period

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SPANISH M&A STANDARDS

2.3 Management in the interim periodThe wide majority of SPAs include limitations on themanagement powers of the seller during the interimperiod. It is important to bear in mind that suchlimitationsmaynot,underanycircumstances,givethebuyercontroloverthetarget’sbusinessbeforeclosing,inaccordancewithapplicableantitrustregulations.

Inorderforthebuyertooverseethemanagementofthetarget’sbusinessduringthe interimperiod,threesystems are used, none of which prevails over theothers:(i)thedefinitionof“ordinarycourseofbusiness”to which the seller must conform; (ii) the setting offinancialthresholdsandbuyer’sapprovaltogobeyondthem;or(iii)alistofprohibiteddecisions.

Only in 30% of deals was a monitoring committeecomprisingbuyerandseller representativessetuptooverseemanagementduringtheinterimperiod.

2.4 ClosingWhenconditionstoclosinghavebeenmet,thepartiesappearbeforeaSpanishnotarytoclosethetransaction.Electronicsignatures,virtualclosingsandcounterpartcontractsarenotusedduetotheformalrequirementsimposedbySpanishlaw.

A specific penalty is provided for in more than halfof the transactions to the party failing to appear atclosing, without prejudice to the right of the otherpartytoenforcetheagreementandclaimdamages.

2. Between signing and closing: the interim period

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3.1 Recoverable damagesDamages indemnified by the seller occasionally include indirect damages or loss of profit.Therefore, in mostcases,indemnificationiscontractuallylimitedtodirectdamagesactuallysuffered.

3. Seller’s liability

AcriticalaspectinSPAsistodeterminetheseller’sliabilityregimevis-à-visthebuyerwherebybuyermayclaimagainstthesellerfordamagesresultingfrombreachesand,inparticular,fromtheinaccuracyofrepresentationsandwarranties(R&Ws)inrelationtotheassets,liabilitiesand,ingeneral,thebusinessoftarget.ItisworthnotingthatunderSpanishlawnodistinctionismadebetween“representations”and“warranties”.

ThepurposeoftheR&WsistoprotectthebuyerwhensigningtheSPA.In85%ofcases,R&Wsare“repeated”atclosing.The“repetition”orbring-downconditiontoclosingentailsinmostcases,therightofthebuyertoseekremediationifanyR&Wgivenatsigningwasinaccurateatclosing.

TherationaleforincludinginaSPAacomprehensivesetofrulesgoverningseller’sliabilityinaSPAistoexcludetheapplicationofthelaw,whichmaycontaindifferentrulesandprinciples.

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3.3 BasketsIt is commonplace for parties to set aseries of thresholds (baskets) so that thebuyer will only be able to make a claimwhen the aggregate of individual claimsexceedssuchbaskets.

Inmorethan80%oftransactions,basketsdo not exceed 1% of the purchase price.Thepreferredbasketis0.5%,whichoccursin45%ofcases.

3.2 Limitation periodFor tax-related damages (including socialsecurity contributions), the period toclaim coincides with that of the statute oflimitations,withonlyoneinfivetransactionsdepartingfromthatperiod.

For damages other than those mentionedabove,thereisnogenerallyacceptedperiodto claim. However, the most common is18 months, even though in four out of tentransactionslongertermswereagreed.

19%

Morethan24months

23%

12months

21%

24months

37%

18months

44%

Lessthan0.5%

4%

Morethan2%

12%

1%-2%

40%

0.5-1%

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SPANISH M&A STANDARDS

Iftheamountofthebasketisexceeded,thebuyerisentitledtoclaimthefullamountfromthefirstdollar(i.e.“firstdollar”)inabout60%oftransactions.Firstdollarismorepopularamongcorporates.Bycomparison,theUScontinuestofavourtherecoveryofjusttheexcessoftheclaimoverthebasket(i.e.“excessonly”).

3.4 Liability capsLimitingthemaximumliabilityoftheselleriswidelyaccepted.Thisisbasedonthegeneralunderstandingthatitwouldbeunreasonable for sellers to assume liability inexcessof the purchaseprice.Therefore,negotiationfocusesnotsomuchontheprinciplebutontheamountoftheliabilitycap.

Inasignificantnumberoftransactions(12%),noliabilitycapwasestablished.Surprisingasthismaybe,wemustnotforgetthattheremaybereasonsforit.Bywayofexample,iftheselleronlyrepresentstoownthesharesbeingtransferred,thebuyerwillbehard-pressedtoacceptanylimitwhatsoever.

Althoughin23%ofthedealsthecapisthepurchaseprice,inmostcasescapsrangefrom10%to50%.

12%

Nolimit

23%

100%

12%

50-100%

5%

Lessthan10%

28%

10-25%

20%

25-50%

60%

32%

Corporates

Funds

40%

68%

“firstdollar” “excessonly”

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SPANISH M&A STANDARDS

Privateequityfundstendtoagreealiabilitycapof25%to50%andonlyoccasionallyoptforittocoincidewiththepurchaseprice.

Transactions in which the cap exceeds half of the purchase price or where it is simply not stated are almostexclusivelyassociatedwithcorporates.

Despitetheabove,bothcorporatesandprivateequityfundsestablishthat,inrelationtocertainmatters,capsdonotapply.

Theseresults,whicharesimilartothoserecordedinotherEuropeancountries,areinstarkcontrasttothoseintheUS,where87%ofthedealscontainliabilitycapsofupto25%ofthepurchaseprice.

%

50

45

40

35

30

25

20

15

10

5

0

13%

0%

27% 28%

47%

7%

0%

18%

13%

29%

0%

18%

CorporatesFunds

<10% 10%-25% 25%-50% 50%-100% 100% nolimit

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SPANISH M&A STANDARDS

3.5 Security for warranty claimsInfouroutoffivetransactions,thesellerprovidesforsomekindofsecuritytoguaranteetheseller’sindemnificationforR&WsandotherobligationsundertheSPA.Escrowaccounts,withbanksactingasescrowagents,arethemostcommonlyusedtypeofsecurity,followedbyfirst-demandbankguarantees.

R&Wsinsurancehasnotbeenusedmuchbutitisbecomingincreasinglycommon,particularlyintransactionsinvolvingprivateequityfunds.

3.6 DisclosureThereisnocleartrendastotheimpactontheseller’sliabilityoftheknowledgethebuyermayhaveacquiredinthecourseoftheduediligence.

However,thismaynotbeentirelycorrectifweanalysethemodusoperandiofcorporatesandprivateequityfundsseparately.Forprivateequityfunds,thedataavailableforduediligenceisforinformationpurposesandonlythedisclosureschedules in theSPAcontainexceptions to theR&Ws(60%ofdeals).On theotherhand, in60%oftransactions by corporates, the entire documentation which was made available to the buyer, in a physical orelectronicdataroomoperatesasageneraldisclosuretotheR&Ws.

Regardlessoftheposition,intwooutofthreetransactions,thedataroominelectronicformat(CDorsimilar)wasattachedtotheSPA.

Financialandlegalduediligencereportscommissionedbytheseller(vendorduediligence)arenotuncommoninauctionsales.

3.7 Seller’s best knowledgeTheR&Wsaresometimesqualified“tothebestofthesellers’knowledge”.Whatdoesthismean?

Approximately50%oftheagreementsdefineitasfollows:

•Ingeneralterms,knowledgethatasellershouldhaveprevailsoveractualknowledge.

• Knowledgewhichmanagersand/ordirectorshaveorshouldhavebecauseoftheirpositionsisconsideredmorerelevantthanthatoftheseller.

Corporatesemployabroaderrangeofdefinitionsof“bestknowledge”thanprivateequityfunds.

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SPANISH M&A STANDARDS

4. Restrictive covenants

4.1 Non-competeApproximately70%oftransactionsincludecovenantsprohibitingthesellerfromcompetingwiththetarget.

The average duration of this covenant is one to twoyears.

Thepartiesusuallyagreeonspecificpenaltiesincasesofbreachofthiscovenantsinceactualdamagesmaybedifficulttoprove.Theamountisagreedtakingintoconsiderationthesizeofthetransaction.

4.2 Non-solicitation of employeesClauses preventing the seller from soliciting thetarget’s employees are widely used, especially byprivate equity funds. Their typical duration is oneto two years. Only in 16% of the deals was suchprohibitionextendedbeyondtwoyears.

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SPANISH M&A STANDARDS

5. Dispute resolution

Private equity funds prefer utilising arbitration to resolve their disputes (in 80% of transactions). Conversely,corporatesappearalittlelessenthusiasticaboutarbitrationandtend,inequalmeasure,tosettlemattersarisingfromtheirSPAsbeforethecourtsoranarbitrationtribunal.

Partiesnormallysubmitdisputestoanarbitrationtribunalconsistingofthreearbitrators.

5%

80% 15%

TYPE OF ARBITRATION NUMBER OF ARBITRATORS

Two

Three One

13% 87%

adhoc Institutional

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SPANISH M&A STANDARDS

Thegroundsforseekingthird-partyaidareasfollows:• Determinationofthepurchaseprice(earn-out,priceadjustments,etc.).• InaccuracyofanR&Ws.• Amountofdamages.• Enforcementofsecuritiesprovidedbytheseller/buyer.• Breachofthenon-competecovenant.

%

35

30

25

20

15

10

5

0

29% 29%

13%

8%

6%

15%

Enforcementofsecurities

Breachofnon-compete

InaccuracyofR&Ws

OtherAmountofdamages

Determinationoftheprice

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SPANISH M&A STANDARDS

6. Some specifics to Private Equity Funds

Forprivateequityfunds,thesuccessoftheirinvestmentdependsontheperformanceofthemanagementteam,somanagementincentivesarenormallyprovidedfor.Ontheotherhand,whentheydecidetoexit,theymustdososeamlessly.HowdoSPAsaddresstheseissues?

6.1 Incentives to management teamsRatchets are typically used by private equity funds to incentivise management teams of portfolio companies.Generallyspeaking,itspurposeistoincreasetheequitystakeofthemanagersoftheacquiredcompanyprovidedthatcertaintargets(profitability,exitprice,etc.)aremet.Inthecaseoftheso-called“exitratchet”,iftargetsaremet,whenthemanagersselltheirstakeinthecompany,thepricereceivedfortheirshareswillbeproportionatelyhigherthantheonetheywouldhavereceivedfortheiractualpercentageofequitystakeinthecompany.

Privateequityfundsalsoincentivisemanagersbygivingthembonussharesandoptionstopurchaseadditionalshares.

19% 22% 15%44%

Optionsonadditionalshares

Bonusshares Exitratchet Other

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SPANISH M&A STANDARDS

6. Some specifics to Private Equity Funds

6.2 Drag-along rightsDrag-alongrights,wherebyminorityshareholdersmaybeforcedtoselltheirstakeinthetargetwhentheprivateequityfunddecidestoexit,areprevalent.Itisalsohighlycommonforthemanagerstograntcalloptionrightsinfavouroftheprivateequityfund.

Asasecurityforsuchdrag-alongrights,itiscommonplaceformanagerstopledgetheirsharesand,toalesserextent,vestthecompanywithopt-outrights.

%

45

40

35

30

25

20

15

10

5

0

40%

33%

5%

18%

5%

Pledgeovertheshares

Calloption OtherOpt-outrights

Drag-along

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SPANISH M&A STANDARDS

Methodology

Thestudyisbasedontheanswersof43Spanishleadingcompaniesandprivateequityfundstoaquestionnaireofclose-endedquestionsinordertorenderthetaskoftherespondentseasierwhileeliminatinganybiasofsubjectivity.Insomeinstances,questionnaireshavebeenfollowedbyinterviews.

Although “every SPA is unique”, the assessment of the answershas enabled us to take a peek into the contractual practices of therespondents.

Thestudyprovidesinformationonthecontentofmorethan200SPAsexecutedfrom2013to2014by:

• 12IBEX35companies;

• 7listedcompaniesnotincludedinIBEX35;

• 9corporategroups;

• 9Spanishprivateequityfunds;and

• 6internationalprivateequityfundsoperatinginSpain.

Dataon theUSmarketwereobtainedfrom the“2013PrivateTargetM&ADealPointsStudy”preparedbytheMarketTrendsSubcommitteeof the Mergers and Acquisitions Committee of the American BarAssociation’s(ABA),BusinessLawSection.

Further details on the methodology and additional informationcan be found in Francisco Marcos, “Los contratos de compraventade empresas en España 2013-2014” AJ8-228 in the website of IEBusiness School (www.ie.edu/es/business-school) under Claustro eInvestigación>CentrosEspecializados.