To Call or not to Call: The rise of the Put and Call Option in M&A Transactions

Why should I read this?

It is fair to say that global M&A has had an interesting three years.  The World in general has been wrestling with economic and geopolitical uncertainty brought about by events largely outside the day-to-day control of dealmakers: the pandemic, the war in Ukraine, spiralling interest rates, record inflation, challenges in obtaining acquisition finance, rising nationalism and increased regulation and scrutiny of cross-border transactions to name a few.  Against that backdrop, however, sits the record-busting year that was 2021 and a cautious but notable return to optimism in the markets as we begin to press in to H2 2023. In this environment we have seen a notable increase in the use of put and call options in M&A transactions, as a mechanism to address challenges to valuation.

What is behind this trend?

It is no wonder then that one of the prevailing challenges M&A advisors and deal-doers are facing in present times is valuation – in this unpredictable market, in this national and/or global environment, what is the value of a particular business at any given time?  Multiples in some sectors have sustained, or even increased, whereas others have stagnated or fallen.  Scrutiny of equity valuations and the metrics underlying them is greater than ever, and as a result targets are on the whole undeniably slower to come to market as they wait for that perfect moment to maximise value.  M&A, however, remains at the heart of the strategic plans of boardrooms as a tool to drive a level of growth in markets which could not otherwise be so readily achieved.  So how are businesses and their advisors navigating this market and what mechanisms do buyers have at their disposal when it comes to seeking to execute their M&A strategy?  One structure in particular has seen a noticeable rise in popularity in the last 12 to 18 months – put and call options.

In a more ‘traditional’ M&A structure, a buyer might be perfectly willing to acquire 100% of the shares of a target on day 1 and perhaps – if at all – seek to mitigate valuation uncertainty by a simple hold-back of part of the purchase price or even via an earn-out style mechanism.  We have seen a noticeable pattern where buyers are moving away from a willingness to acquire 100% of a target at the outset, particularly where the buyer is paying a healthy multiple, and rather to buy a certain interest (often a majority interest, say 60%) on day 1 but then defer the purchase of the remaining 40% for a period of time (often somewhere between 2 and 5 years) pursuant to a form of share option agreement.

How do put and call options work?

A buyer will want the primary ability to choose when it exercises its option (which would be a “call” option – the ability to call on the seller(s) to sell the remainder of their shares to the buyer).  Therefore typically the buyer has control of the option process for the majority of the period during which the option is live.  However, sellers will want deal certainty and so will want the ability, should the buyer not exercise its call option during the option period, to be able to exercise their own option to force the buyer to acquire (a “put” option – to put their shares on to the buyer).  The put option is typically exercisable only at the end of the buyer’s call option window and for a much narrower period of time, and if neither option is exercised by either party then the option agreement simply lapses and terminates.   The price payable in either a call option or put option exercise  would be the same, and is often (but not always) calculated on a similar basis to the purchase price paid for the initial tranche of shares on day 1 – for example, if on day 1 a buyer paid a 10x multiple of EBITDA for 60%, then on option exercise the buyer might pay a 10x multiple of an updated EBITDA calculation (as at the option exercise point) for the remaining 40%.   There are further degrees of nuance that are often included on a deal-by-deal basis which could consist of, for example:

1. Certain conditions to an option exercise that must be met prior to exercise (i.e. perhaps the execution of a particular contract, or the registration of certain IP or development of certain technology);
2. Protections in favour of the seller whereby the buyer will not, for example, take steps to intentionally reduce the option price payable on option exercise; and
3. Expert determination provisions in the event the parties cannot agree an element of the option price at the time, so as to not frustrate the operation of the option.

What are the benefits?

There are various benefits to a buyer (and some potentially to a seller) in the use of a put and call option as opposed to other forms of purchase price deferral/contingency, such as:

1. For a buyer:
   • having control of a target business and its people and assets but not having 100% exposure to its trading losses/historic issues;
   • retaining and motivating any existing seller-managers in a manner akin to an earn-out structure;
   • certainty, and a degree of control, around the pricing of the remaining shares to be acquired;
   • potentially giving the buyer a window of time to properly integrate the target and work through teething issues without having 100% of the risk exposure associated;
   • enables the buyer to put a degree of conditionality behind it’s 100% ownership by way of conditions precedent to exercise of any of the options.
2. For a seller:
   • an ability to play a part in maximising the value of the option shares with pricing based on real-time EBITDA or other revenue or earnings bases; and
   • delaying the date of disposal of the relevant option shares for capital gains purposes.

What else do I need to know?

It is no great surprise that recent market dynamics have seen put and call options become more frequently used in M&A transactions and is a trend that feels likely to continue into the near future whilst economic and market uncertainty remains.  Great care should be taken in preparing an option agreement to ensure it (i) achieves the desired economic outcome, (ii) reflects the nuances of the deal in hand and (iii) does not give rise to unexpected tax consequences, particularly where the sellers are individuals and will be employees or directors of the buyer group following completion. 

If you would like further information on this matter, get in touch with your usual Eversheds Sutherland contact or the authors below: