What Is Break Up Fees?
A break up fee, also known as a termination fee, is a contractual provision in a merger or acquisition (M&A) agreement that requires one party, typically the target company, to pay a predetermined sum to the other party, usually the prospective acquirer, if the deal fails to close under specific circumstances. These fees fall under the broader category of corporate finance and serve as a financial safeguard for parties engaged in complex business transactions, aiming to compensate the non-terminating party for the time, resources, and opportunity costs incurred during the negotiation and due diligence process40, 41, 42. The inclusion of a break up fee provides a level of certainty and security, discouraging parties from unilaterally backing out of a signed contract without valid cause38, 39.
History and Origin
Break up fees have a long history in business negotiations, designed to protect parties from the risk of a deal falling through and to ensure a vested interest in seeing the transaction to completion37. Their prevalence in mergers and acquisitions has grown significantly over time. In 1989, only two percent of M&A transactions included such a fee, but by 1998, this figure had climbed to 60% of all deals, further increasing to roughly 87.5% by 201136. This rise reflects the increasing complexity and costs associated with M&A transactions, where substantial resources are expended on legal, financial, and strategic reviews between the announcement and completion of a deal34, 35. Originally, these fees were primarily structured as payments from the target to the acquirer, but the concept has evolved to include reverse break up fees, which address situations where the acquirer terminates the deal33.
Key Takeaways
- Break up fees are contractual payments made in M&A deals if the transaction is terminated under specified conditions.
- Their primary purpose is to compensate the party that invested time and resources in the deal but did not cause its failure.
- Common triggers for break up fees include the target company accepting a superior competing offer or its board changing its recommendation.
- These fees generally range from 1% to 5% of the total deal value, though the precise amount varies based on transaction size and complexity30, 31, 32.
- Courts, particularly in Delaware, scrutinize break up fees to ensure they are reasonable and do not unduly deter alternative bids29.
Formula and Calculation
The calculation of a break up fee is typically straightforward, expressed as a percentage of the total transaction value or enterprise value of the target company. While there isn't a universally fixed formula, the general concept can be represented as:
Where:
- Deal Value refers to the total monetary consideration of the merger or acquisition, often based on the equity value of the target company.
- Agreed Percentage is the negotiated rate, commonly falling between 1% and 5% of the deal's value27, 28. This percentage is determined during the negotiation of the merger agreement.
Interpreting the Break Up Fee
Interpreting a break up fee involves understanding its role as both a deterrent and a form of compensation. For the acquiring company, the fee represents protection for the substantial investments made in financial analysis, legal work, and management time. If the target company's board, acting under its fiduciary duty to maximize shareholders value, decides to pursue a superior offer from another bidder, the break up fee ensures that the initial acquirer is not left without recourse for their sunk costs26.
From the perspective of the target company, agreeing to a break up fee signals commitment to the proposed transaction, making the initial offer more attractive to the buyer. However, the fee must be carefully calibrated; an excessively high break up fee could be viewed by courts as coercive, effectively precluding other legitimate bids and potentially violating the target board's fiduciary duties25.
Hypothetical Example
Consider "Acquirer Corp." proposing to purchase "Target Co." for $1 billion. After extensive due diligence and negotiations, they sign a definitive merger agreement that includes a break up fee clause. This clause stipulates that if Target Co. terminates the agreement to accept a superior offer, it must pay Acquirer Corp. a break up fee of 3% of the deal value.
Suppose, before the deal closes, "Competitor Inc." emerges with a significantly higher offer for Target Co. The board of Target Co., after careful consideration and consultation with its advisors, determines that Competitor Inc.'s offer is indeed superior and in the best interest of its shareholders. Target Co. then decides to terminate the agreement with Acquirer Corp. to accept Competitor Inc.'s offer.
In this scenario, Target Co. would be obligated to pay Acquirer Corp. a break up fee of $30 million ($1 billion * 0.03). This payment compensates Acquirer Corp. for the considerable expenses incurred during the acquisition process, including legal, accounting, and investment banking fees, and the lost opportunity to pursue other deals.
Practical Applications
Break up fees are a fundamental component in large-scale mergers and acquisitions, particularly in public company transactions where deals are announced, and competing bids might emerge24. They are also common in private equity deals, though the specific triggers and types (e.g., reverse break up fees) can vary23.
One key area of application is in discouraging "deal jumping" or ensuring commitment. The fee provides an incentive for the target to complete the deal and serves as a form of liquidated damages for the acquirer if the target backs out for specific reasons, such as accepting a topping bid22. Break up fees can also come into play if regulatory approval is denied, although this often triggers a "reverse break up fee" paid by the buyer if they cannot secure necessary clearances due to antitrust law issues21. For example, in the proposed Sprint and T-Mobile merger in 2019, the break up fee was set at $600 million to discourage Sprint from accepting a higher offer20.
Limitations and Criticisms
While break up fees serve a protective function, they are not without limitations and criticisms. Regulators and courts often scrutinize break up fees to ensure they do not become so onerous as to unfairly deter other potential bidders or act as a penalty that prevents the target company's board from fulfilling its fiduciary duty to seek the best value for shareholders18, 19.
In Delaware, a prominent jurisdiction for corporate law, courts have generally upheld break up fees within a range of 3% to 4% of the equity value as reasonable, though higher percentages may be accepted depending on specific circumstances17. However, if a fee is deemed "preclusive" or "excessive," it can be challenged or even disallowed. A notable example occurred in the bankruptcy of Energy Future Holdings Corp., where the Delaware Bankruptcy Court initially approved a $275 million break up fee but later reversed its decision, disallowing the fee due to errors of fact and law15, 16. This case underscores the importance of clear disclosure and the potential for judicial review of such fees, demonstrating that even large, previously approved fees can be overturned14.
Break Up Fees vs. Reverse Break Up Fees
Break up fees and reverse break up fees are both mechanisms used in M&A agreements to compensate one party if the deal is terminated, but they differ in who pays whom and under what circumstances.
| Feature | Break Up Fee (Termination Fee) | Reverse Break Up Fee |
|---|---|---|
| Payer | Typically the target company (seller) | Typically the acquiring company (buyer) |
| Recipient | The acquiring company (buyer) | The target company (seller) |
| Triggering Events | Target company accepts a superior competing offer, target board changes recommendation, failure to obtain target shareholders approval12, 13. | Acquirer fails to secure financing, failure to obtain necessary regulatory approval (e.g., antitrust), or buyer's material breach of contract10, 11. |
| Purpose | Compensate the initial buyer for wasted efforts and resources, deter rival bids, and ensure deal certainty9. | Compensate the seller for disruption, expenses, and lost opportunities due to the buyer's inability or decision to close8. |
While break up fees protect the buyer from a "walk-away" by the target, reverse break up fees protect the target from a buyer's failure to close, often due to unforeseen financing or regulatory hurdles7.
FAQs
Why are break up fees included in M&A deals?
Break up fees are included to compensate the prospective buyer for the significant time, money, and resources (such as legal and financial analysis costs) invested in a potential acquisition if the deal falls apart due to reasons specified in the agreement, often because the target company accepts a better offer6. They also act as a deterrent to discourage the target from abandoning the deal without good cause.
What is a typical size for a break up fee?
Break up fees typically range from 1% to 5% of the total deal value4, 5. The exact percentage can vary based on the size and complexity of the transaction, industry norms, and specific negotiated terms. Courts may scrutinize fees that are perceived as excessively high, as they could hinder competition3.
Who pays a break up fee?
In most cases, the target company (the company being acquired) pays the break up fee to the acquiring company if the deal is terminated under certain conditions, such as the target accepting a competing offer or its board withdrawing support2. However, in some scenarios, a "reverse break up fee" may be paid by the acquiring company to the target if the acquirer fails to complete the deal due to issues like financing or regulatory approval1.