There are various ways in which an acquirer can purchase a stake in a target company. The most common method is the payment of a cash amount by the acquirer to the seller, in exchange for the seller’s shares. Other methods include asset-for-share and share-for-share transactions.

In a share-for-share transaction, the acquirer acquires the seller’s shares and, in exchange, the seller receives shares in the acquirer. Share-for-share transactions offer various benefits to sellers and acquirers, including:

• potential upside for the seller if the acquirer’s share value appreciates;
• tax efficiencies (Section 42 of the Income Tax Act makes provision for these transactions to be tax neutral);
• preservation of cash and debt capacity; and
• lower transaction costs.

Like any M&A deal, share-for-share transactions are not without risk. In recent years, there have been several high-profile deals which either collapsed or the sellers suffered significant losses.

In 2016, retail giant Steinhoff acquired footwear retailer, Tekkie Town.¹ In exchange for 58% of the shares in Tekkie Town, the founding shareholder received Steinhoff shares worth R1,85 bn. A year after the deal was concluded, Steinhoff imploded after its auditors discovered that it had been overstating its profits for over a decade. Following the revelation, Steinhoff’s share price plummeted by more than 95%. Without oversimplifying, the impact was that each R1 worth of shares that the seller had received in the Tekkie Town deal was suddenly worth five cents.

This transaction highlights the risks that sellers are faced with in share-for-share transactions. Sellers need to be aware of the risks and take steps to protect themselves. Some of the ways to mitigate downside risk include due diligence, earn-out arrangements, warranties and indemnities, price adjustment mechanisms and escrow arrangements.

Due diligence

Before accepting shares in the acquirer as consideration, the seller must take steps to establish that it is receiving shares in a financially sound entity. It is vital for the seller to conduct some form of due diligence on the acquirer to get insights into the latter’s affairs, on which the value of the acquirer’s shares is premised.

Due diligence should focus on, among others, the financial statements, tax and legal affairs, governance, reputational issues, and any other factors that impact the value of the acquirer’s shares.

Warranties and indemnities

Obtaining warranties and indemnities from the acquirer is another way for a seller to mitigate risk.

A warranty is a contractual assurance by one party – in this case, the acquirer – to another as to the true state of the affairs of the acquirer. If a warranty later turns out to be false, then the seller may have a claim against the acquirer. An indemnity is a promise by one party to hold the other party harmless in the event that a loss arises from a specific event.

To mitigate its risk, a seller may seek warranties and indemnities in respect of, among others, the accuracy and truthfulness of the acquirer’s financial statements, tax compliance, and losses resulting from the conduct of the seller or its directors.

Shareholders in the 2014 Alviva deal saw a significant decline in the value of the shares they had received in the acquirer, when a director of the acquirer was implicated in a bribery case after the conclusion of the transaction.² Well drafted warranties and indemnities in respect of acquirer conduct can mitigate the seller’s risk in such cases.

Earn-outs

The seller may negotiate an earn-out arrangement, in terms of which it will only accept a portion of the acquirer’s shares upfront, and only accept the remainder if the acquirer meets certain performance targets. Such a target may be a revenue target, or that the acquirer’s share price reaches a particular value after a certain period (the earn-out period). An earn-out may be structured in a way that ensures that the seller is entitled to an agreed cash amount instead, or a return of some of its shares if the acquirer fails to meet the performance targets.

Price adjustment mechanisms

Price adjustment mechanisms may be applied if certain events occur during the negotiation of the deal or once it is concluded. An example of an adjustment mechanism the seller may use to mitigate against downside risk is a material adverse change provision, in terms of which the purchase price is adjusted downward if the value of the acquirer’s shares falls below a certain threshold before the deal is finalised. Alternatively, the seller may be entitled to an additional cash amount if the acquirer’s share value decreases within a certain period after the conclusion of the deal.

Escrow arrangements

An escrow arrangement, where the seller’s shares are held in trust for an agreed period, may also be used to protect the seller against breaches of the acquirer’s warranties and indemnities. Depending on the terms agreed between the parties, the seller may be entitled to a return of the shares held in escrow in the event of a breach by the acquirer.

While share-for-share transactions offer various benefits in M&A deals, it is clear that they should be approached with the necessary level of caution. A share-for-share deal presents the seller with comparatively more risk than a share sale where a seller receives a cash amount. In light of this, it is crucial that sellers take the necessary steps to mitigate their risk before accepting the acquirer’s shares as consideration.

1. Steinhoff International Holdings N.V v Tekkie Town (Pty) Ltd [2016] ZACT 103.
2. The bribery charges against the acquirer’s director were subsequently withdrawn.

David Hoffe is a Partner and Tuelo Mokoka and Siyabonga Nyezi are Associates | Fasken.

This article first appeared in DealMakers, SA’s quarterly M&A publication.

DealMakers is SA’s M&A publication.
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