Termination agreements in M&A contracting

Abstract

This paper extends information economics research on M&A by examining the difficulty acquirers encounter when seeking to purchase targets that have the option of selling to other bidders. We use signaling theory to develop theoretical arguments on the dual effects of signals in M&A markets: Signals are beneficial to an acquirer in reducing its risk of adverse selection, but have the drawback of offering similar benefits to other potential bidders. This creates a contracting problem for the focal acquirer that risks losing any deal-specific investments it makes in due diligence, negotiations, and post-acquisition planning if the target would sell to another firm. Under these conditions, acquirers can secure the deal by negotiating termination payment provisions (TPPs) in the form of termination fees and lockup options. Our empirical analyses focus upon acquisitions of newly-public firms and reveal that market signals available during and after the IPO increase the usage of TPPs in acquisition contracting.