Material adverse effect as an opportunity to withdraw from an already signed deal — a column by REVERA
It turns out that some venture contracts contain a loophole that allows a party to unilaterally exit the deal. Lawyers from REVERA, Diana Kryltzova and Alexandra Kovaleva, explained what this loophole is.
Diana Kryltzova and Alexandra Kovaleva
In venture and M&A deals, there is often a significant time gap between the signing of binding documents and the closing of the deal (sometimes several months). During this period, there is a risk of events occurring that may adversely affect each party to the deal. Can either party withdraw from the deal in such a case? Material adverse effect clauses provide such an opportunity.
Let's delve into what MAE clauses are, how they work, and when they can be applied.
Material Adverse Effect (MAE) refers to a significant adverse change that could affect a party's ability to fulfill the terms of the deal.
In deal documents, you might encounter the term "material adverse effect (MAE)" or "material adverse change (MAC)."
The MAE condition allows parties (more often, the investor) to unilaterally withdraw from the deal or revise significant terms of the binding documents (SPA, SHA) if such a significant change occurs between the signing and closing of the deal. Usually, MAEs are included in the section with representations and warranties or are one of the conditions precedent to the completion of the deal.
Most deal documents define MAE as an event, change, circumstance, or fact that either individually or collectively significantly and adversely affects (or can affect) the business, assets, obligations, or financial condition of a party to the deal, and consequently, its ability to fulfill the deal's conditions. For a startup, this could be the loss of key clients, a decrease in profits, or a significant compliance breach by the target. Negative events from the investor's (buyer’s) side might include a sharp deterioration in financial status, or a change in control/management.
Thus, the main goal of the MAE clause is to allocate between the parties the risks of unforeseen events that occur after the signing of binding documents but before the deal’s closing date.
Criteria for Determining MAE
There are no clear criteria for determining what constitutes an MAE. The parties agree on these themselves and record them in the deal documents. In case of disputes when implementing an MAE, courts and business practice outline several criteria to qualify changes as MAE.
1. Long-term Effect
The changes must be enduring rather than temporary. For example, based on judicial practice, a decline in revenue for one quarter is not considered an MAE.
2. Materiality of Changes
The circumstances must go beyond ordinary business fluctuations. A 5–10% drop in profit or revenue is often not considered significant, whereas a decline in key financial indicators by 50% or more could justify recognizing an MAE.
3. Comparative Nature
The court considers how the change affected the industry as a whole. For a change to be recognized as an MAE, it must specifically impact the target company or affect it more than other companies in the industry. If negative changes affect the entire industry and not just a particular company, they are generally not considered MAE.
4. Unknown Event
Typically, the event cited by a party as the basis for invoking the MAE clause should not have been known to them at the time of entering into the deal. If a party knowingly assumes a certain risk, they should not later be able to withdraw from the deal just because the risk has materialized against their favor.
Exceptions to MAE
As noted earlier, MAE provisions are a subject of active negotiation between the parties. To minimize risks and misinterpretations, deal documents often specify circumstances that will not constitute an MAE. Investors aim to agree on as few exceptions as possible, while startups prefer more. These are usually not related to the actions/inactions of the parties:
- circumstances known to the parties prior to the signing of the documents;
- significant changes in the securities markets;
- general macroeconomic changes;
- force majeure circumstances (pandemics, natural disasters);
- changes in applicable laws (new restrictions or licenses in a specific industry, tax reforms).
Important: Even if an event falls under an exception, it can still be considered an MAE if it disproportionately affects a party compared to similar businesses (disproportionate impact).
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The material adverse change clause is not a panacea or a guaranteed way out of a deal, but with the correct drafting of terms and exceptions, this tool allows parties to allocate risks between signing and closing the deal. In certain cases, it can indeed play a crucial role in protecting the interests of a party facing unforeseen developments. For the investor, it reduces the risk of investing in a company whose financial or operational state significantly deteriorates after signing the documents; for the seller, it offers the chance to agree in advance on exceptions and evaluation criteria for such changes, reducing the likelihood of an unwarranted withdrawal from the deal.