[EP 055] Using Put and Call Options in M&A transactions

Joanna: Hi it’s Joanna Oakey here and welcome back to the Deal Room podcast, a podcast brought to you by our commercial legal practice – Aspect Legal.

Now today we have back the fabulous Elizabeth Lee from Aspect Legal talking to us about using put and call options in M&A transactions. Hi Liz, welcome back!

Liz: Hi Joanna! Thanks for having me back.

Joanna: Great. Okay. Look let’s start off I think by taking a step back and talking about what put and call options are just so that we can make it really clear to our audience what we’re talking about here. So Liz maybe you can delve into what put and call options are.

What is a Put and Call Option?

Liz: Sure. Put and call options are essentially contractual rights that parties have under the contract essentially. From a vendor’s perspective, when they have a put option, it means that they have the right to force the purchaser to buy. Conversely, if the buyer has a call option, the buyer can force the vendor to sell to them. At the core, it’s contractual rights.

Joanna: I guess the other thing we should talk about here is why we would want to use them. Before we get into that, I think it’s relevant for us to talk about where they’re used. They’re used in share sale transactions predominantly where a buyer is only buying part of the shares in an organisation. Is that right Liz?

When are Put and Call Options used?

Liz: Yes, correct. They are often used in mergers and acquisitions transactions in the context of a sale and purchase of shares and where not all of the shares are being purchased outright and therefore you use put and call options to stagger the purchase and sale of the balance of the shares. It’s often used in an earn out situation and also can be used for structuring purposes so if for whatever reason there is tax consideration, a purchaser or vendor does not wish for the transaction to take place in a particular financially year for example they can use these mechanics and structure to achieve the commercial objectives.

Joanna: Maybe it’s useful for us then to dig into a little bit of the considerations when we’re using put and call options because they’re an alternative way sometimes to structure a transaction and they have some benefits for both parties. But there’s also risks and things that are considerations that both of the parties need to really be thinking about before they go down the path of adding in put and call options so maybe let’s investigate those a little bit.

Considering the Option Fee

Liz: Yes. There’s some key concepts in put and call options. There’s the option fee. This is the amount that is paid for the grant of the option. For example, the option fee might be a dollar or the option fee could be significant. It could be represent say 80 percent of the purchase price and then with the balance, being the exercise price, that’s another concept for put and call options, would be whatever installments are left to be paid.

You can have a call option with just one option or put and call option with just the one option or you could have multiple options that come up at different milestones.

Using triggers to manage risk

Joanna: I guess the interesting thing with using put and call option. Once again we’re talking about the situation in a share sale situation where you’re purchasing or the buyer is purchasing part of the shares, issued shares in the company. We still need to start off with due diligence and investigating the underpinnings of the organization.

In this situation, it’s similar to a full company purchase in that the buyer would still want to ensure that it is across any of the skeletons that might be sitting in the cupboard of the organisation that they’re looking to purchase and set up these put and call options. But because you can start off with a smaller portion and structure the put and call options in such a way that there is discretion, it may be that you can I guess delay some of your due diligence if you’re only putting up a small, if the buyer’s only putting up a small amount of capital for the option fee for the original purchase.

That’s certainly something that I think the parties can bear in mind in terms of you know if they’re looking to do a deal really quickly but they don’t have time for due diligence then this is perhaps one way to have a small buy in and set up an option for future purchase.

Liz: Yes. It is possible I suppose if there is a significant event which they, being the purchaser, might feel particularly concerned about. They can certainly use the triggers in the put and call option structure to manage their risk.

For example, let’s say they purchased the business and it’s been embroiled in litigation and they don’t know where that’s going to end up, which will have an impact on the cash reserves of the company, they can use a put and call options to determine the purchase price once that litigation has been resolved so certainly it can be done.

Joanna: Liz, let’s maybe talk about some of the other considerations in using put and call options.

Considering the Option Exercise Period

Liz: The other considerations are that the period in which the options can be exercised. You need to think about will there be an expiry date for the option. Sometimes there is an expiry date, but you don’t have to have an expiry date. But it would be odd to not have an expiring date because in that situation you wouldn’t be able to close out the deal if you don’t have an expiry date.

Then there’s the triggers, what the triggers are and then what if the triggers don’t occur so they are the considerations when you use put and call options. You have to think through and map out all the what ifs before you put it together.

Joanna: Yeah. I think that’s an important thing to mention because it can be easier and I think the reason that we’re talking about this is because if you’re out in the field dealing with M&A transactions, the concept of using this sort of approach can provide some flexibility in the way that you’re setting a deal up. But there are a lot of considerations so it’s a good thing to, if you come up with this idea, to then ensure that you’re dealing with people who understand some of the risks and the considerations, who can pop in there to help guide how the commercial deal can be structured around this sort of approach.

And maybe let’s just briefly touch on what can go wrong. Let’s just quickly go there to provide a few examples for things that anyone dealing with this type of structure should be considering as the sort of issues that can occur.

What can go wrong?

Liz: The things that can go wrong are where unexpected events occur and you haven’t contemplated it. Then you’re sort of left in a situation where the parties have to go back to the negotiation table to agree on what should happen because your crystal ball gazing really when you are buying the put and call option. But you can manage that risk by having provisions in your triggers that allow a catch all so you can certainly allow it. But you’ve got to think right through all the triggers could be.

Joanna: I think other other issues that can occur is for whatever reason at a at a point of trigger one of the parties is unhappy with the exercise price. That’s certainly something that can go wrong for one of the parties in the transaction along the way, because of course you can price your exercise price by way of a fixed price or by reference to other factors like for example EBIT multiples or whatever. I guess that’s something that really needs to be thought through to ensure that both parties will be happy with the exercise price when it comes up.

Liz: Yes, that’s right. And also from the buyers perspective, it’s the issue of control of the company at the end of the day. Put and call options are often sort of paired with a shareholders deal between the two parties and so there will be negotiation on how the company is controlled during the period that the put and call option is still alive.

Joanna: That’s a really good point because for that period of time, these two parties are in bed together. They have to be very clear about how decisions are going to be made and how the company will be run during that period of time. Quite often I find these sorts of areas can be a little bit tricky to think about from the outset but I tell you what. They are sure as hell easier to deal with at the outset than later on if two parties aren’t getting on.

Liz: Yes, that’s right. And the key to this is to make sure that you’ve planned thoroughly upfront as to what the commercial drivers are for you as a purchaser and to make sure that they are captured in all the documentation that’s in place between the buyer and the vendor.

Joanna: Absolutely. Well, thanks Liz! Thanks so much for coming along. I hope our listeners enjoyed it. I think it’s been a hopefully useful topic for them.

Liz: Thanks for having me, Joanna.

Joanna: That wraps up our quick overview on how you can use put and call options in your M&A transactions. Put and call options can be a great tool if negotiated properly. But they are an area where a lot can potentially go wrong if you don’t have the right legal advisors assisting in the drafting. You need people who understand the risks and the considerations involved, and who can help plan thoroughly upfront, and make sure these are properly documented.

If you’re interested in talking to our lawyers about using options in your deals, head over to our website at www.aspectlegal.com.au to book in a free 15 minute discussion with our legal team. There we can discuss with you how put and call options might be able to work in a transaction that you’re considering at the moment or in terms of helping with ideas for how you might approach transactions into the future.

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Thanks again for listening in! This has been Joanna Oakey and the Deal Room Podcast, a podcast proudly brought to you by Aspect Legal.

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