In the arena of M&A transactions, the bet clause is a double-edged sword. If used well, both the buyer and the seller are happy; if used poorly, it may cause the acquirer to lose all his money, the target company to be under great pressure, and even end up in court, making both sides lose their lives.
Betting, which seems to be a "big bet" on future performance, is actually the most sophisticated and brain-burning game at the M&A negotiation table. Goheal found that in many cases of acquiring listed companies, many acquirers lacked sufficient understanding of the bet clause, resulting in a transaction that should have been a sure win, but ended up being a "life-or-death game". Today, we will dismantle the core logic of the bet clause and reveal how to design it accurately to ensure the safe implementation of the acquisition transaction!
Bet clause: the "life and death contract" in the M&A battlefield
What is a bet?
In simple terms, a bet clause is a performance target set by the buyer and seller based on future operating conditions, with a reward or punishment mechanism attached. If the target company achieves the set goals, the seller may receive additional benefits; if it fails to meet the goals, the acquirer may receive compensation or even adjust the equity structure.
What is the essence of the bet?
In essence, the design of the bet clause is to balance the information asymmetry between the buyer and the seller. The acquirer hopes that the future profitability of the target company will match the current valuation, while the seller hopes to obtain a higher transaction price. Through the bet, the two parties agreed on a "try before you buy" mechanism, which not only reduces the risk of the acquirer, but also gives the seller the opportunity to obtain greater benefits.
Goheal believes that a successful bet agreement must not only set reasonable performance goals, but also ensure that the incentive mechanism can truly drive the company's growth, rather than allowing management to "play numbers games" for short-term performance.
Three key points for accurately designing bet clauses
Key point 1: How to set performance indicators to prevent the target company from "watering down"?
Bet agreements usually use financial indicators such as net profit, revenue growth rate, and gross profit margin as assessment criteria. However, in order to achieve the bet target, some companies may use financial fraud, early recognition of revenue, delayed recognition of costs, etc. to "beautify" financial data.
Case hypothesis: "Data magic" of new energy company M
When a new energy company M was acquired, it promised to achieve an average annual profit growth of 30% in the next three years. However, after completing the performance bet, the acquirer found that M company artificially raised profits by inflating accounts receivable, delaying depreciation of fixed assets, and accelerating the recognition of government subsidies, resulting in the acquirer taking over a company with actual profitability far lower than expected after the performance bet expired.
Goheal's advice:
1. Choose financial indicators that are more difficult to falsify, such as operating cash flow or EBITDA (earnings before interest, taxes, depreciation and amortization).
2. Clarify the consistency of accounting policies in the agreement to prevent the target company from arbitrarily adjusting the accounting method during the bet period.
3. Set up a profit quality audit mechanism, and the acquirer can request to hire an independent auditing agency for regular financial reviews.
Key point 2: How to compensate for the failure of the bet so that the acquirer's interests are not damaged?
If the target company fails to achieve the agreed performance, the acquirer will usually ask for compensation. Common compensation methods include cash compensation, equity repurchase, equity dilution, etc. However, if the compensation clause is not designed properly, it may lead to the failure of the acquirer to realize its interests, and even give the seller an opportunity to take advantage of it.
Case hypothesis: The compensation "loophole" of technology company X
When technology company X was acquired, it promised to increase its net profit by 100% within three years, otherwise it would compensate the acquirer in cash. However, in the third year, the company's net profit fell sharply due to the deterioration of the market environment. Since the compensation method is limited to cash, and the company's account cash flow is already in a state of emergency, the seller eventually delayed the implementation of compensation on the grounds that "the company is unable to pay", causing the acquirer to lose all its money.
Goheal's advice:
1. In addition to cash compensation, it is recommended to add an equity repurchase clause so that the acquirer can repurchase shares at a lower price to reduce losses.
2. Set up guarantee measures for the execution of compensation, such as the seller's need to provide equity pledge or third-party guarantee to ensure the enforceability of the compensation clause.
3. Adopt a year-by-year assessment mechanism to avoid performance betting triggering compensation only in the last year, resulting in management "taking a gamble".
Key point three: How to ensure the continued growth of the target company after the bet period ends?
Many companies have "exploded" performance during the betting period, but once the betting period ends, the growth momentum disappears instantly, and even the performance "falls off a cliff". This is because some management takes short-term actions during the betting period instead of truly promoting long-term development.
Case hypothesis: The performance of consumer goods company Y "collapses"
After being acquired, consumer goods company Y promised to achieve a 30% performance growth during the betting period. In order to meet the target, the company promoted sales crazily, compressed R&D investment, and even cut marketing expenses. As a result, after the betting period ended, the company's market share shrank rapidly due to lack of new product innovation, and its performance declined sharply.
Goheal's advice:
1. Add a long-term incentive mechanism to the betting agreement to ensure that the management is still motivated to promote the company's development after the betting period.
2. Use the method of paying the acquisition price in installments to link part of the acquisition funds with future performance to prevent the seller from "cutting leeks".
3. Set a performance assessment extension clause to continue to observe for 1-2 years after the end of the betting period to ensure that the company's growth is sustainable.
Conclusion: Betting is a contest of wisdom!
The design of the bet clause is not only a "game" between the acquirer and the seller, but also an accurate prediction of the company's future. An excellent bet agreement can not only reduce transaction risks, but also truly promote a "win-win" situation for both parties of the merger and acquisition.
So, what do you think is the most difficult variable to control in the bet clause? If you are the acquirer, how would you set the compensation clause? Welcome to leave a message in the comment area for discussion. Goheal looks forward to exploring the wisdom of the capital market with you!
[About Goheal] Goheal is a leading investment holding company focusing on global mergers and acquisitions. It has been deeply involved in the three core business areas of acquisition of listed company control, mergers and acquisitions of listed companies, and capital operations of listed companies. With its deep professional strength and rich experience, it provides enterprises with full life cycle services from mergers and acquisitions to restructuring and capital operations, aiming to maximize corporate value and achieve long-term benefit growth.
