A key goal of a buyer’s due diligence investigation during the course of an M&A deal will be to satisfy itself that on completion of the deal, the buyer will receive the benefit of contracts that the acquired entity (“TargetCo”) has with third parties (i.e. suppliers, customers, etc).
Where third party contracts contain a change of control provision, one potential consequence is that following the purchase of TargetCo, the supplier or customer chooses to terminate the contract and will no longer be required to perform its obligations under the said contract. This can cause disruption in terms of trading and/or even reduce the value of TargetCo (i.e. where it applies to a top revenue-generating customer of TargetCo). This will obviously be of great concern to the buyer.
Change of control provisions are only relevant for share purchase acquisitions. On asset purchase acquisitions, there is no change of legal ownership in TargetCo, as instead the assets themselves are transferring to the buyer. As such, the contracts will need to be assigned or novated, and the buyer will be concerned with securing the consent of the relevant third parties to effect this.
But what exactly are change of control provisions, and how should they be dealt with?
Common change of control provisions
Simply put, a change of control provision is a clause in a contract which gives the counterparty a specific right or entitlement (and sometimes a get-out-of-jail-free card) with respect to the contract with TargetCo, in the event that there is a change in the ownership of TargetCo. This may include, for example:
- an entitlement for the counterparty to receive notice from TargetCo in the event of a change of control; and/or
- a right for the counterparty to terminate the contract upon the sale and purchase of TargetCo.
Where (2.) applies, the contract does not usually terminate automatically, but rather there is a right to terminate. Alternatively, the customer or supplier may make use of its right to terminate by attempting to re-negotiate the existing terms and conditions of the contract with TargetCo, to reach a position where it feels more comfortable with the incoming buyer.
The rationale behind such a change of control provision is to protect the supplier or customer from unwanted changes to the ownership of TargetCo. Its new owner may install a new and unfamiliar management team, or it may change the way TargetCo carries out its business. Alternatively, the new owner may turn out to be a competitor of the customer or supplier.
What constitutes a change of control will ultimately depend on how the provision is defined in that particular contract. There are a few common types of change of control provisions, which are outlined below.
- Direct – This is the most straightforward type of change of control provision, and it will generally be triggered where there is any change in the controlling interest of TargetCo.
- Indirect – If TargetCo has a subsidiary, any change in the controlling interest of TargetCo may trigger a change of control clause in a contract between that subsidiary and a third party. This is because the ownership of the entity which ultimately controls the subsidiary (i.e. TargetCo) has changed.
- Contingent – Whether or not there is a change of control will be contingent on a specific triggering condition, e.g. where the controlling interest in TargetCo has been transferred to a competitor of the counterparty.
How to deal with change of control provisions
During the due diligence phase of the transaction, buyers should pay close attention to any change of control provisions contained in contracts between TargetCo and its major customers and suppliers. Where change of control provisions are spotted in contracts with major customers or suppliers of TargetCo, it would be prudent to obtain consent from the counterparty in question to the change of control, or seek a waiver of the counterparty’s right to terminate the contract prior to the purchase of TargetCo.
Timing will also be an issue to be considered, as the parties will not want to disclose the potential purchase of TargetCo to major customers or suppliers too early (i.e. in case the deal doesn’t go through, for reasons of confidentiality, etc). Ideally, third party consents/waivers should be obtained as close as possible to the exchange of contracts, and once the other terms of the deal have been agreed.