A takeover, when one company acquires another, can be a lengthy and expensive process. To protect themselves, buyers often include a termination fee provision in the preliminary purchase agreement or letter of intent.
What is a termination fee?
A termination fee, also known as a breakup fee, is a fee paid by a seller to a buyer if the seller backs out of the agreement. It's common in mergers and acquisitions (M&As), where buyers invest time and money into making a deal. Termination fees are typically between 1% and 3% of the total value of the deal. Both the buyer and the seller must agree on the termination fee amount and the conditions that trigger it for the fee to be valid.
Although termination fees are paid to buyers, a letter of intent can also have a reverse termination fee. This is a fee paid from the buyer to the seller if the deal doesn't close, with common reasons being regulatory issues or the buyer being unable to secure financing.
How a termination fee affects the acquisition process
Buyers can use termination fees to encourage sellers to accept their offers and potentially reduce competition from other bidders. Because the seller will need to pay the termination fee if it backs out, it has a financial incentive to stick with that deal. Any other bid will need to be larger than the initial offer plus the cost of the termination fee to make it worth accepting for the seller.
Along with discouraging the seller from backing out, a termination fee can discourage other companies from bidding. They'll know that they need to bid more than the current offer plus the fee. A termination fee doesn't guarantee that a deal goes through, but it makes that more likely.
The impact a takeover has on investors
For shareholders in a company, the acquisition process is a turbulent time. The company's share price could increase, especially if there's a bidding war. While a termination fee reduces the likelihood of a bidding war, it doesn't eliminate that possibility entirely.
A stock's volatility may increase when an acquisition is in play. Any recent positive or negative news about the takeover could heavily influence the share price. Even if shares see an initial bump in value, they could come back down if it appears that a deal isn't going to happen.
If a company in your investment portfolio is in play, take some time to research what's happening and consider if it's still a good fit for your risk tolerance. An acquisition, including one with a termination fee, doesn't necessarily mean you need to sell your holdings. It's simply a sign that you should take a closer look at that stock so you can make an informed decision.
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Historical example of a termination fee
In February 2016, LinkedIn began entertaining purchase offers from multiple companies. Microsoft (MSFT -2.82%) and Salesforce (CRM +1.69%) were the final two bidders involved in negotiations. In May 2016, LinkedIn chose Microsoft's offer of $182 per share, all cash, and the two companies signed a letter of intent. While Microsoft wanted a termination fee of $1 billion, LinkedIn negotiated it down to $725 million.
Over the next month, Salesforce revised its offer multiple times. Even though LinkedIn would've had to pay Microsoft a termination fee, it informed Microsoft that the original offer was no longer supportable. Microsoft eventually agreed to increase its offer to $196 per share, all cash. LinkedIn's board of directors met later that day, considering the new offer, the offers from Salesforce, and the cost of the termination fee. After discussing it, they voted to approve the transaction, and Microsoft officially purchased LinkedIn.
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