Reverse Termination Fee

What is a Reverse Termination Fee?

Or should I say… reverse breakup fee? You heard it right. A reverse termination fee is also known as a reverse breakup fee in business, mergers, and acquisitions, and corporate transactions. But why is that?

A reverse termination fee happens when a buyer walks away from a seller of a business during an acquisition deal. Acquisitions occur when a buyer acquires a company to drive its growth or expansion. As a result, the acquirer changes who controls the target company.

When a buyer, who is part of a company, cannot meet the financial criteria to buy another company (target company), he/she must pay the target company a certain amount of money as a compensation fee.

The fee is paid to a target company to make up for the target company’s efforts in the deal. Often, target companies looking to be acquired will look for potential ‘parent’ companies that offer reverse termination fees as part of the contract.

We’ll look more into the characteristics of these fees. So whether you’re reading as a potential buyer or seller yourself, a curious reader, or someone looking to break into the private equity industry, you’re in the right place.

role of reverse termination fees in deals

Whenever a company selling itself wants to account for risks, it’s important to include a reverse termination fee in its provisions to protect itself against losing a large sum.

A buyer wants these fees because they might find a better, more suitable deal. So if they decide to pursue a different deal instead, they’ll owe the target company reverse termination fees for backing out of the deal late.

Companies that offer a reverse termination fee part to a deal are preferred since they give more of a safety net to different merger and acquisition deals. There are two main reasons:

1. The target company cannot secure the financing for the purchase by the specified date of the deal transaction.
2. The target company may not have met the conditions listed in the contract by the specified deal date.

So that if the target company of a deal isn’t able to uphold their end, the buyer can safely provide them with breakup fees and then move on from the deal. They wouldn’t have to worry about carrying out the deal if they walked away from it, no matter the reason.

There are several other reasons a buyer wants to terminate an agreement. One other reason may include the involvement of a third party. For example, another company may offer a higher deal price for the target company, and an aware buyer may see this and want to back out.

Another reason buyers end the agreement is that they may just not earn enough money to complete the transaction. The buyer would need financing not only for the deal itself but also for directing the newly acquired company.

Why would a lack of financing happen, though? In short, here are a couple of different potential factors:

1. After an M&A deal is announced to the public, shareholders of either the selling or buying company may change the price of shares significantly. In addition, uncertainty and fear over the deal may mean companies will face low value.
2. A buyer may incur a loss in debt or a decrease in liquidity.
3. Key operational players in a deal, like executives, may leave the company.

A third reason a buyer ends a deal is out of fear or worry about antitrust laws and regulations. Legal authorities may block the agreement because it may breach a country’s antitrust laws – regulatory authorities don’t want to see a deal mean monopolization.

On the other hand, target termination fees are the opposite of reverse breakup fees. They are used whenever the seller walks away from the buyer and then pays the buyer a certain sum.

Target companies normally benefit from compensation given to them by the buying company once the deal is complete. However, if a deal doesn’t go through at all, that may mean that a target company may face operational losses, which breakup fees would be helpful for.

The amount of money included in breakup fees varies, too. While no minimum amount is universally recognized, these fees typically take up a sizable portion of the deal value. Most reverse termination fees will be about 2-4% of the deal.

Reasons for a reverse termination fee

In an M&A deal, few precedents must occur before a breakup fee is issued (or even considered). Because breakup fees are somewhat of a last-minute resort, the deal has to follow these general guidelines first:

• Coming up with a strategy for a deal
• Finding potential targets
• Doing valuations on the target company
• Negotiating a certain deal value based on the valuations
• Evaluating based on due diligence
• Finalizing a contract
• Financing the deal
• Closing the deal                                                                                                                                                                                                                                                  

Several crucial steps precede the actual deal finalization process. First, companies must fully conduct research and prepare themselves when getting into a deal.

Most reverse breakup fees come into play during the financing part of an M&A deal. When a buyer company cannot secure adequate funds to finance the deal, the reverse breakup fees come into play.

Often, target companies will ensure that their acquiring company has a provision of breakup fees in the contract that they pursue. An acquirer with that provision has an increased credibility level for future deals they choose to go through.

Before reverse breakup fees are paid, what needs to happen first is a contract’s termination. Termination is just when the buyer says “no” to the deal. The breakup fees will then back up contracts that the buyer terminates.

The buyer will initiate reverse breakup fees, but the key difference is that the seller or the target company first instills regular breakup fees. Both will occur at about the same time in the process (after the deal's financing).

If a buyer wants to terminate an agreement because it can’t raise enough financing, reverse breakup fees will be less than if it were to end the deal because of potential third-party interference. 

Impact of Reverse Breakup Fees in Deals

Reverse breakup fees impact deals by stopping them almost entirely. However, fees are not meant to serve as a barrier to deals – rather, they are paid after a deal is ended entirely.

The amount of money the seller gains from the fees changes in different situations. Most importantly, the fee amount is just a portion of the whole deal’s value. The target company can then improve operations or profits using the new money.

What’s in it for the buyer after giving up the fees is also a new opportunity. The buyer can find another deal that’s better suited to their expenses. How would this help them? Because the first reason they walked away from the deal was due to their preferences!

If the buyer pays reverse breakup fees upfront, then they’ll be able to save themselves in a couple of ways:

1. The buyer successfully avoids a legal confrontation with the seller if they may not have met the adequate financing requirements.
2. The seller avoids the risk of operational losses that they might’ve faced if the buyer company acquired them.
3. The contract is successfully implemented, as both sides abide by the terms listed in the agreement. 

So, all in all, when a deal is ended with the promise of termination fees, it also means that the buyer can potentially get by with benefits while the seller gets a fair amount of money.

Once again, the seller’s compensation is only a percentage of the deal’s volume. But in most cases, reverse breakup fees are much better for buyers simply because they don’t have to pay the full amount of money they would’ve had if the deal had gone through.

Now, what makes reverse termination successful… vs. not? Despite its high regard, reverse termination may also be a mechanism of economic loss or inefficiency. Why is that, though? Shouldn’t it successfully be providing the needs of the buyer and the seller?

Successful reverse termination

At their core, these fees are risk mitigation mechanisms when set at the right price (see Rutgers RTF Report). When the price is just right, the shareholders of a buyer’s company will feel just as happy as the company managers.

But what factors affect measuring a fair price for everyone indirectly and directly involved in the deal?

1. Costs to the buyer and the buyer’s shareholders
2. Risks associated with fully completing the deal, including how much the acquisition of the target company would benefit the buying company. More specifically, risks can be measured in several ways (PWC - Risks in M&A Deals ):
   • Representations and warranties issued
   • Working capital, or how much liquidity a company has through the difference between current assets and liabilities
   • Investor/shareholder terms
   • Target firm size and capability

Unsuccessful reverse termination fees

One of the biggest factors considering reverse termination fees as “unsuccessful” is their price relative to target termination fee prices. As we said earlier in the intro, if target companies were to terminate the deal, then they owe the buyer target termination fees.

However, fees owed to the target company should be larger than the target termination fees offered. This is because the target company may face more risks than the buyer in the deal, so they should be compensated fairly.

When a buying company evaluates a target company for a fair price, it should consider how much of an impact it’ll have on the seller. For example, higher fees may be much more helpful to a target if it’s much bigger in size compared to the firm it’s trying to get.

What’s even more surprising about this type of compensation compared to target termination fees is how much less they occur. According to the same report by Rutgers, target breakup fees are included in about 98% of deals, but reverse breakup fees are only part of 37% of the deals.

How does reverse termination actually work?

Is there a process behind it? A method to the madness? How do the buyers call off a deal properly and professionally? First, let’s take a look at the characteristics behind reverse termination.

As mentioned earlier, breakup fees are supposed to be part of the actual contract in the first place. Without being a provision in the acquisition agreement – or the agreement used to highlight the terms and conditions of purchase – the deal can’t end.

The first step down the road is for the analysts of the buyer company to identify potential triggers or reasons for the buyer to neglect the deal. Some of the ones we already outlined include the entry of a third-party, lack of financing, or potential breach of antitrust laws.

Next, the company will want to analyze the potential risks more before officially plugging the plug. This involves a deep evaluation of the target company, including what its costs and profits may look like under the buyer's leadership.

Finally comes the actual end of the deal. But again, as long as the buying company follows the termination agreements detailed contractually, it’ll be able to end the deal and pay its fees by the last date of the deal.

example of a reverse termination fee

Since reverse breakup fees aren’t included in every M&A transaction, the ones included will vary widely. And as previously mentioned, the amount of the fees will change depending on the buyer’s reasoning.

One widely regarded example of reverse breakup in action involves Blackstone Capital Partners, and Emdeon Inc. Blackstone agreed to pay 3.6% of the deal value in reverse breakup fees if it wasn’t able to raise enough money for the deal.

Conversely, with Eagle Parent’s attempt at trying to buy Epicor Software Corp., it said it’d pay 7.5% of deal value in reverse breakup fees if it didn’t want to carry out the agreement, but only 2.5% if it wasn’t able to raise enough money for the deal.

The first ever large deal to include a reverse breakup fee was between Mars Inc. and Wrigley Jr. Co. The deal was $23 billion in value. Since then, most reverse breakup fees in smaller transactions are typically valued in the millions.

Think of your favorite golfing equipment and places! Topgolf International was acquired by Callaway Golf Company in 2020 with a value of about 3% compared to the overall transaction value.

You can also thank your favorite larger companies for deals with much larger reverse breakup fees as a percentage of deal volume. Google, for example, held a $2.5 billion reverse breakup fee with Motorola Mobility Holdings. This was 25% of the entire deal’s value!

The higher the percentage that the breakup fees are out of the entire deal volume, the higher the commitment of the buying company to the deal. Google had 25% listed in its contract because it was confident in carrying out the deal from start to finish.

Conclusion

All in all, reverse termination fees are a business method to help with mergers and acquisitions. Founded out of private equity firms, these have now become widely used by companies of all sorts.

Breaking into a job in private equity and venture capital isn’t easy. Still, if you manage, you’ll successfully land a role among top financial executives who deal with these topics daily.

And remember that it’s not about knowing everything before you step into the job, but being eager to learn. Of course, you should know financial and business fundamentals before going into any serious position, but specialized topic areas will have much more info on them later on.

What you should know, however, is that:

• Deals are not always going to work, whether or not because of finances.
• Negotiating contracts won’t always mean they’ll work out.
• If you instill a backup plan of termination fees, they can help you as strong backups.

To learn more about deals and what applies to you, feel free to check out WSO’s mentorship program here.

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

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