Break-up Fee

What is a break-up fee?

Break-up fee (German Abbruchgebühr, also break fee or termination fee) refers to a contractually agreed payment in the event that a planned company transaction fails for a previously specified reason. In the narrower sense, the seller side or the target company, that is, the company to be sold, pays the prospective buyer. A payment in the opposite direction is called a reverse break-up fee. The idea resembles a cancellation fee: whoever cancels a firmly planned service compensates the other for part of the wasted effort.

A break-up fee is agreed at two points in the transaction process. In a letter of intent (a declaration of intent), it secures the exclusivity period in which only this prospective buyer negotiates and spends considerable amounts on examinations and advisers. In the signed purchase agreement, it can secure the period until closing, that is, until shares and purchase price actually pass, where a party may withdraw from the contract under certain conditions.

Purpose and effect of a break-up fee

The break-up fee serves two purposes. It compensates the prospective buyer for effort that becomes useless if the deal fails. This includes the costs of the financial, legal and tax review of the company (due diligence), costs for financing commitments and the tying up of its own resources. At the same time, it increases transaction certainty, because switching the seller side to another buyer costs money.

The second effect has a downside. Any payment obligation that arises when another offer is accepted raises the threshold from which a competing offer is worthwhile for the sellers. A moderate fee protects the prospective buyer from serving merely as a benchmark; a high fee deters competitors from making their own offers.

Typical triggers

The payment obligation arises only for reasons that the contract names exhaustively. Common ones are:

• the sellers' break-off of negotiations during exclusivity, although the prospective buyer adheres to the agreed key terms,
• a breach of the no-shop clause, for example by talks with another prospective buyer,
• the refusal to sign a fully negotiated purchase agreement,
• missing consents from the sellers' sphere, such as the approval of the assignment required under the articles of association (Section 15(5) of the German Limited Liability Companies Act, GmbH-Gesetz, GmbHG),
• for listed target companies under US practice, the withdrawal of the recommendation by the governing body or the acceptance of a superior offer through a fiduciary out.

As a rule, circumstances outside the sellers' sphere are not triggers, such as a clearance denied by the competition authority or a failed financing on the buyer's side. The reverse break-up fee exists for these risks.

Legal classification in Germany

Starting position without an agreement

Until signing, each party can in principle end contract negotiations without consequences and bears its own costs. An exception is formed by the principles of fault in contract negotiations (culpa in contrahendo; Section 311(2), Section 280(1) of the German Civil Code, Bürgerliches Gesetzbuch, BGB). Under them, whoever has aroused in the other party the justified expectation of a certain conclusion and then withdraws without good reason owes damages. For contracts subject to formal requirements, such as the purchase of shares in a GmbH (German limited liability company), the case law sets particularly high standards. A prospective buyer who wants to be protected therefore needs an express agreement.

Reimbursement of costs, lump-sum damages or contractual penalty

The agreement can be designed in different ways. A cost reimbursement replaces documented external costs up to a maximum amount. A lump-sum damages clause fixes a set amount as the estimated loss; depending on the wording, the party obliged to pay may prove a lower loss. A contractual penalty (Sections 339 et seq. BGB) is additionally meant to exert pressure to honour the contract. Which form is present follows from the wording and purpose of the clause, not from its heading.

The classification has consequences. A court can reduce a disproportionately high contractual penalty on application (Section 343 BGB). This does not apply if a merchant promised it in the operation of its commercial business (Section 348 of the German Commercial Code, Handelsgesetzbuch, HGB), such as a selling holding GmbH. Alongside a contractual penalty, further damages generally remain possible, against which the penalty is credited (Section 340(2), Section 341(2) BGB). Contracts therefore clarify whether the payment settles the claims conclusively.

Sometimes a purchase agreement that has already been signed grants a party the right to withdraw from the contract against payment of an amount. This corresponds to the statutory figure of withdrawal against payment of a forfeit sum (Reugeld; Section 353 BGB). If the forfeit sum is not paid at the latest with the declaration of withdrawal, the other party can reject the declaration without delay, and the withdrawal is then ineffective.

Drafting example for a break-up fee clause

A cost reimbursement in the letter of intent can be worded roughly as follows: "If the sellers break off negotiations before the end of exclusivity although the buyer adheres to the key terms of this letter of intent, they shall reimburse the buyer's documented external advisory and due diligence costs. The reimbursement is limited to EUR 250,000. Further claims arising from the break-off are excluded to the extent permitted by law." The last sentence makes the reimbursement a conclusive settlement.

Notarisation questions in a share purchase

Obligations to assign shares in a GmbH require notarisation (Section 15(4) GmbHG). A payment obligation for the case that the sellers do not sell can create indirect pressure to sell. A reimbursement of costs actually incurred is generally regarded as uncritical. A lump sum that goes well beyond the effort, by contrast, can mean that the agreement itself is subject to formal requirements and would be ineffective without notarisation.

Payment by the target company

If the target company itself is to pay, limits under company law come into play. If a GmbH assumes a payment that economically falls on the selling shareholders, the ban on payments that preserve the share capital must be observed (Section 30(1) GmbHG). For a stock corporation, the stricter rules of capital maintenance under stock corporation law apply (Section 57 of the German Stock Corporation Act, Aktiengesetz, AktG), and the management board must measure the commitment against its duty of care and the interest of the company. In public takeover offers, takeover law also sets limits. Payment commitments by listed German target companies are therefore rare and usually limited to a capped reimbursement of costs.

Amount of the break-up fee and reference base

In the US market, break-up fees in takeovers of listed companies are often around 2 to 4% of equity value. The courts there examine whether a fee in effect excludes competitors. For German transactions in the Mittelstand (mid-sized companies) and in the venture environment, there is no comparable benchmark; what is more common is the reimbursement of documented costs up to a fixed maximum amount.

The reference base matters. Equity value is the value of the shares and thus the purchase price that the shareholders receive. Enterprise value additionally includes net debt, that is, financial debt less liquid funds. For indebted target companies, the same percentage applied to enterprise value therefore leads to a higher fee.

Worked example: break-up fee as a cost reimbursement in a letter of intent

The shareholders of a GmbH sign a letter of intent with a prospective buyer for the acquisition of all shares. A purchase price for the shares of EUR 24 million and ten weeks of exclusivity are agreed. The company has net debt of EUR 6 million, so the enterprise value is EUR 30 million. If the sellers break off negotiations during exclusivity without a factual reason, they reimburse the prospective buyer's documented external costs up to 1% of equity value.

• Maximum amount: 1% of EUR 24 million = EUR 240,000
• Based on enterprise value, it would be 1% of EUR 30 million = EUR 300,000, that is, EUR 60,000 more
• External costs of the prospective buyer: financial review EUR 110,000, legal review and contract draft EUR 95,000, tax review EUR 40,000, commercial review EUR 35,000, together EUR 280,000
• Reimbursement: EUR 240,000, because the maximum applies; EUR 40,000 is borne by the prospective buyer
• Alternative lump sum of 2% of equity value: EUR 480,000, that is, EUR 200,000 more than the actual costs

The cost reimbursement largely compensates the effort without building up additional pressure to close. The lump sum contains a surplus of EUR 200,000, which acts like a contractual penalty and, depending on the individual case, can create a formal-requirements risk. In both variants, the prospective buyer's internal effort remains uncompensated.

Distinction: break-up fee, reverse break-up fee, no-shop and go-shop

• Reverse break-up fee: payment by the buyer to the seller side if the transaction fails for reasons in its sphere, such as financing or a regulatory clearance.
• No-shop clause: creates the obligation not to negotiate with third parties. The break-up fee governs the payment consequence of a breach or a break-off.
• Go-shop provision: allows a US target company, after signing, to search actively for better offers. If it switches to a bidder from this search, a reduced fee is often payable.

Common mistakes

• Open triggers. Wording such as "if the transaction fails" leaves open whether reasons from the prospective buyer's sphere are also covered.
• Lump sum without a link to costs. A fixed amount far above the expected effort increases the risk that the agreement is subject to formal requirements or, if private individuals promised it, is reduced by a court.
• Unclear reference base. A percentage without stating whether it refers to equity value or enterprise value leads to disputes over the amount for indebted companies.
• One-sided provision. If only the seller side has a payment obligation, there is no compensation for the case that the prospective buyer breaks off without a factual reason.

Frequently asked questions

Is a break-up fee common in Germany?

Less so than in the US market. In sales of mid-sized companies, a limited reimbursement of the prospective buyer's costs is, if anything, usually agreed. Percentage fees on the US model are found mainly in large transactions with international buyers.

Are there break-up fees in funding rounds too?

Rarely. Term sheets usually provide instead that the company bears the legal and due diligence costs of the lead investor up to a maximum amount, often only if the round is completed.

Who bears the break-up fee if another bidder is awarded the deal?

Legally, the party that has committed to pay, that is, the sellers or the target company. Economically, a new buyer often prices the fee into its offer; it is, however, obliged to pay only if it assumes it contractually.

Can damages be claimed in addition to the break-up fee?

That depends on the agreement. If the payment is structured as a contractual penalty, further proven loss generally remains recoverable. Many contracts therefore provide that the break-up fee settles the prospective buyer's claims conclusively.

How is a break-up fee treated for tax purposes?

For the recipient company, it is generally operating income. If a company pays, a deduction as an operating expense may be possible; for private individuals as sellers, the treatment depends on the individual case. For VAT purposes, it has to be clarified whether it is non-taxable damages or consideration for a service.

The Roemer Capital view

In company sales that we accompany on the seller side, we generally propose, instead of a percentage fee, a reimbursement of documented external costs with a fixed maximum amount. It takes account of the prospective buyer's legitimate effort and preserves the sellers' freedom of decision until notarisation. We derive the maximum amount from an estimate of the review costs, not from a percentage of the purchase price.

If a buyer demands a lump sum, we work through with the client what threshold it sets for other offers and how it fits the timetable of the process. Whether the agreement has to be notarised and how it affects taxes is clarified by the client's law firm and tax adviser.