What Is Breakup Fees?
Breakup fees, also known as termination fees, are a predetermined financial penalty paid by one party to another if a proposed merger or acquisition (M&A) deal is terminated under specified conditions. These fees are a common component of corporate finance transactions, particularly in the context of large-scale deals where substantial resources are expended during the negotiation and due diligence phases. The primary purpose of a breakup fee is to compensate the would-be acquirer for the time, effort, and resources invested in structuring and pursuing the deal, and to deter parties from withdrawing without a valid reason. They also serve to mitigate the financial and strategic disruption caused by a failed merger or acquisition.
History and Origin
The concept of breakup fees evolved as M&A transactions became more complex and costly, with parties investing significant resources before a deal's finalization. Early uses of such fees were designed to protect bidders, particularly those acting as "stalking horses" in auctions, who might incur substantial costs in conducting due diligence and setting a floor price for an asset. Over time, breakup fees became a standard tool for deal protection, widely accepted by courts, particularly in Delaware, a key jurisdiction for corporate law. Delaware courts have generally upheld breakup fees within a range of 3% to 4% of the transaction's equity value, though higher percentages might be accepted in smaller deals, provided they do not unreasonably deter other potential bidders12, 13.
Key Takeaways
- Breakup fees are contractual payments made when a merger or acquisition deal fails under specific, pre-agreed conditions.
- They compensate the non-terminating party for expenses, time, and opportunity costs incurred during the deal process.
- Breakup fees also serve as a deterrent against a party backing out without justification, promoting deal certainty.
- The fee amount is typically a percentage of the deal's total value, usually ranging from 1% to 3%.
- Common triggers for breakup fees include a target company accepting a superior offer or failing to obtain shareholder approval.
Formula and Calculation
A breakup fee is not calculated using a standard formula with specific financial inputs, but rather it is a negotiated amount. However, it is typically expressed as a percentage of the deal's total equity value.
The calculation for the absolute value of a breakup fee is:
For example, if a company is being acquired for an equity value of $10 billion, and the negotiated breakup fee percentage is 2.5%, the breakup fee would be:
This amount is intended to serve as liquidated damages for expenses and losses incurred by the non-terminating party.
Interpreting the Breakup Fee
The interpretation of a breakup fee largely depends on its size relative to the overall deal value and the specific circumstances under which it is triggered. A breakup fee is generally viewed as a reasonable compensation for expenses incurred by the jilted party, such as legal fees, investment banking fees, and the costs associated with due diligence. It also accounts for the opportunity cost of having spent time and resources on a deal that ultimately fell through.
From the perspective of the target company's board of directors, agreeing to a breakup fee can be a strategic move to encourage bidders and signal commitment, potentially leading to a higher offer or a more committed buyer. However, an excessively high breakup fee might be viewed as preclusive, discouraging other potential bidders from making superior offers, which could conflict with the board's fiduciary duty to maximize shareholder value. Conversely, a very low fee might not adequately compensate the buyer for their efforts or act as a sufficient deterrent against deal termination.
Hypothetical Example
Consider "Alpha Corp.," a publicly traded company that enters into a merger agreement to be acquired by "Beta Inc." for $500 million. As part of the contract, they agree to a breakup fee provision: if Alpha Corp. terminates the agreement to accept a superior offer from a third party, it must pay Beta Inc. a breakup fee of 2% of the deal value.
One month later, "Gamma Holdings" submits an unsolicited offer to acquire Alpha Corp. for $550 million. After careful consideration, Alpha Corp.'s board of directors determines that Gamma Holdings' offer is indeed superior and withdraws from the agreement with Beta Inc.
In this scenario, Alpha Corp. would be obligated to pay Beta Inc. a breakup fee:
- Deal Value: $500 million
- Breakup Fee Percentage: 2%
- Breakup Fee Amount: $500,000,000 * 0.02 = $10,000,000
Gamma Holdings, the new acquirer, might often cover this breakup fee as part of its superior offer, effectively increasing its total cost to acquire Alpha Corp. and compensating Beta Inc. for its efforts in the initial merger attempt.
Practical Applications
Breakup fees are prevalent in corporate transactions to protect parties involved in high-stakes deals. They serve several practical purposes across various aspects of corporate activity:
- Mergers and Acquisitions (M&A): Most commonly, breakup fees are found in M&A agreements to compensate a buyer if the target company walks away from a deal, often to accept a higher bid from another party. An example includes the proposed $54 billion acquisition of Shire by AbbVie in 2014, where AbbVie faced a $1.6 billion breakup fee when the deal stalled due to U.S. Treasury changes on tax inversions11.
- Deterring Competing Bids: By imposing a cost on a target company that accepts a higher offer, breakup fees can make it more expensive for rival bidders to succeed, thus increasing the likelihood that the initial deal will close.
- Covering Expenses: The fee is typically designed to cover the expenses incurred by the acquiring company, such as legal fees, accounting fees, and advisory fees. An actual SEC filing illustrates how a breakup fee clause is structured, detailing the amount and the conditions for payment10.
- Promoting Deal Certainty: The existence of a breakup fee incentivizes both parties to work towards the successful completion of the transaction, as pulling out without cause incurs a financial penalty.
- "Stalking Horse" Bids: In bankruptcy auctions, a stalking horse bid sets a minimum price for the assets being sold. Breakup fees are often offered to the stalking horse bidder to compensate them for their effort and risk, encouraging participation and ensuring a robust bidding process.
Limitations and Criticisms
While breakup fees serve important functions in M&A, they are not without limitations and criticisms. A primary concern revolves around their potential to deter competitive bidding, thereby limiting the ability of shareholders to receive the highest possible price for their company. If a breakup fee is too high, it can create a barrier for other potential bidders, who would need to factor the fee into their offer, effectively raising the cost of entry for a superior bid.
Regulators and courts, especially in Delaware, closely scrutinize breakup fees to ensure they do not become "preclusive" or unfairly entrench a favored bidder. For instance, some court decisions have indicated that while breakup fees generally fall within a 3-4% range of the transaction's equity value, higher percentages can "test the limit" of what is considered reasonable, particularly in smaller transactions9. There have also been instances where courts have overturned previously approved breakup fees, citing errors of fact and law or inadequate disclosure, highlighting the legal complexities and potential risks associated with these provisions8. Some academic research suggests that while breakup fees can increase deal completion rates, they may not always lead to higher premiums for target shareholders, depending on other deal features7. Furthermore, the specific wording of a contract is critical, as a termination fee may not always be considered the sole remedy for a breach of a merger agreement6.
Another area of criticism arises in cases involving antitrust concerns. A deal might include a reverse breakup fee (paid by the acquirer to the target if the deal fails due to regulatory issues), but even traditional breakup fees can be scrutinized for their impact on competition5. The interplay between deal protection measures, including breakup fees, and broader corporate governance considerations is a continuous area of legal and financial debate4.
Breakup Fees vs. Reverse Termination Fees
While both breakup fees and reverse termination fees are types of financial penalties stipulated in M&A agreements, they differ significantly in who pays whom and under what circumstances.
A breakup fee (or termination fee) is paid by the target company to the acquirer if the deal is terminated under specific conditions, most commonly when the target's board accepts a superior offer from another bidder. It compensates the initial acquirer for their sunk costs and lost opportunity.
Conversely, a reverse termination fee is paid by the acquirer to the target company if the deal fails due to the acquirer's inability to close the transaction. Common triggers for a reverse termination fee include the acquirer failing to secure necessary financing, failing to obtain its own shareholders' approval, or—very commonly—failing to obtain regulatory approval, particularly antitrust clearance. This fee protects the target from the disruption and uncertainty caused by a buyer who cannot or will not complete the deal.
FAQs
What is the typical size of a breakup fee?
The typical size of a breakup fee usually ranges from 1% to 3% of the deal's total value, though it can vary based on the size and complexity of the transaction. In2, 3 some smaller deals, it might be a higher percentage.
Why do companies agree to pay breakup fees?
Companies, particularly target companies, agree to breakup fees to incentivize potential acquirers, protect against financial losses incurred by the buyer during the negotiation process, and demonstrate commitment to the transaction. This can encourage a higher initial bid and a more serious approach from the potential buyer.
Can a breakup fee be challenged or overturned?
Yes, breakup fees can be challenged in court, particularly if they are deemed to be excessively high or to unfairly restrict competition. Courts, especially those in Delaware, review these clauses to ensure they do not violate the fiduciary duty of the target company's board of directors to its shareholders. The specific terms of the contract and the circumstances of the deal termination are critical factors in such challenges.
Are breakup fees always paid in cash?
While breakup fees are typically paid in cash, agreements can sometimes specify alternative forms of payment. For example, a letter of intent might allow for payment through the issuance of common or preferred stock with an equivalent market value.
#1## What happens if a deal fails due to a material adverse change?
Many merger agreements include clauses for a material adverse change (MAC) or material adverse effect (MAE) that could allow a party to terminate a deal without incurring a breakup fee. A MAC clause typically refers to an unforeseen event that significantly impacts the target company's financial condition or business prospects. The exact definition of a MAC is heavily negotiated and can be a source of dispute if a deal unravels.