M&A Vocabulary – Understanding the experts: “Break-Up Fee”

To protect themselves against this risk—especially the financial one—the contracting parties sometimes agree on so-called break-up fees. Since the risks of a planned transaction faced by the seller differ from those faced by the potential buyer, both sellers and buyers may insist on such an arrangement.

A break-up fee obliges the seller to pay a previously agreed compensation amount if the seller is solely responsible for the failure to conclude the contract or unilaterally terminates the negotiations. The events for which the seller is responsible are explicitly included in the agreement in advance.

In practice, the following events most commonly trigger the break-up fee:

• Conclusion of the contract with competing bidders
• Discovery of a previously undisclosed defect in the target company that entitles the potential acquirer to terminate negotiations
• Lack of approval by shareholders of the target company.

The break-up fee therefore serves, first, as leverage to keep the seller committed to the planned transaction and to complete the acquisition with the original interested buyer. After all, the potential buyer is exposed in particular to the real risk that the acquisition will ultimately be carried out with a competing bidder (a so-called “interloper”) offering more attractive economic terms.

From the buyer’s perspective, the break-up fee is primarily intended to neutralize the financial risk of wasted expenditure (e.g., due diligence costs already incurred).

This risk increases especially in public takeovers, where the seller makes public an announcement of the takeover and the specific conditions associated with it. The emergence of additional bidders is unavoidable here.

However, the break-up fee can also have a direct impact on co-bidders and deter them from submitting an offer. This is because the seller will ensure that new offers both exceed the purchase price agreed with the initial buyer and cover the break-up fee agreed with that buyer, which typically amounts to between 1% and 5% of the transaction value.

Such break-up fees are usually agreed at an early stage of contract negotiations and are often part of a letter of intent (“LOI”). This is generally possible without any particular form and does not require notarization, even if the actual share purchase agreement must later be notarized. Exceptions may arise, however, if the agreed break-up fee results in indirect pressure on the obligated party to conclude a share purchase agreement that requires notarization later on—for example, due to the immense amount of the break-up fee. In this case, including a break-up fee leads to a de facto notarization requirement for the LOI.

This can be counteracted if the break-up fee clause is structured purely as a reimbursement-of-expenses clause and provides only for compensation amounts that the seller can actually prove were incurred.

Reverse break-up fee

The seller can protect itself with a so-called reverse break-up fee. Under this, the potential acquirer undertakes to pay a termination fee to the seller if the reasons for the failure to conclude the contract originate from the acquirer’s sphere, i.e., are attributable to the buyer. In this context, the seller is exposed to different risks than the potential acquirer.

These are predominantly:

• failure to complete the transaction by a specified deadline (“drop dead date”),
• potentially missing approvals from shareholders, or
• missing approvals, in particular under antitrust law.

However, the greatest risks on the seller’s side arise from the buyer’s lack of a financing commitment, meaning the acquisition cannot be completed for purely monetary reasons.

Practical experience with cross-border transactions

In the German M&A market, break-up fee clauses are used primarily when one transaction party is based outside the EU. This is increasingly observed in transactions involving Chinese buyers: due to the approval processes required there, some of which have uncertain outcomes, the German seller often demands a reverse break-up fee.

In addition, in cross-border transactions with China, foreign exchange regulations also play a role, applying not only to payment of the purchase price but also to payment of break-up fees. This must therefore be taken into account when drafting the relevant clauses.

Conclusion

While agreeing break-up fees cannot reliably protect the contracting parties from a transaction failing, it can help ensure that a certain level of trust is initially extended to the other party and, in the worst case, at least minimize the financial risk.

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