How to Negotiate an ESG M&A Transaction

This blog post is co-authored with Amy Wojnarwsky, an attorney at McDonald Hopkins, a Cleveland-based business advisory and advocacy law firm. Amy is a leader in McDonald Hopkins’ Social Corporate Governance & Impact Investing practice and has a strong passion for helping entrepreneurs and businesses on ESG matters.

In this third co-authored blog post of this series, EPOCH Pi and McDonald Hopkins highlight how environmental, social and governance (ESG) principles have an increasingly prevalent impact on the negotiation of M&A transactions. 

In our previous blog, we discussed how buyers and sellers can prepare for mergers and acquisitions with an internal review of a company’s performance on ESG metrics as well as methods to improve ESG performance. This emphasis on ESG early in the diligence and preparation stages can continue in the actual negotiations of an M&A transaction.

As we mentioned in our first blog post of this series, the most successful companies develop an M&A strategy that focuses on their business objectives, and ESG considerations are becoming an increasingly important aspect of these goals. 

After completion of ESG diligence, counsel should document the relevant ESG findings identified during the due diligence process and provide an analysis of potential legal risks and exposure associated with any ESG-related issues. Once completed, this analysis can assist the buyer in evaluating the transaction as a whole and negotiating certain representations in the deal. 

As an initial matter, some red flags identified during due diligence may lead to a reassessment of the potential value and price of a transaction. In a recent PRI/PWC study, 69% of companies assess potential acquisitions for compliance with local regulations and will proceed if only minor non-compliance issues are identified that can be tackled post-acquisition. However, a large proportion of the interviewees stated that they would refuse a target if there were serious implications to non-compliance and poor performance on ESG factors and would create a substantial risk or cost to the acquirer. 

Rather than walking away from a deal when substantial risk factors relating to ESG are identified, parties and their counsel can negotiate alternative deal structures that may have an economic impact on the transaction. 

In negotiating the economic impact that ESG factors can have on a transaction, 1/3 of the companies surveyed indicated that they consider the cost of compliance for ESG factors for up to two years, and more than half of respondents consider the cost of ESG compliance for up to five years post-deal. This consideration may result in negotiations for a reduction in the purchase price, a change in transaction structure (equity versus asset), increased holdback for risk factors, allocation of funds as transaction expenses to improve ESG performance, transition services relating to the same, or earn-outs or contingent consideration based upon meeting certain ESG metric thresholds. While each of these negotiated structures may differ from the original deal and have an economic impact on both buyer and seller, these strategies can be effective to complete a transaction and provide the selling entity with the resources needed to improve ESG performance of the company on a going-forward basis. 

Additionally, ESG factors can influence the negotiation of certain representations in purchase agreements. Over 80% of deals include some aspects of ESG representations and warranties in their purchase agreements. Specific ESG-focused representations and warranties may include:

1. Standard representations and warranties regarding legal and regulatory compliance, environmental and employee matters; 

2. The target’s compliance with applicable ESG metrics (SASB, UN Sustainable Development Goals, etc.);

3. The target’s past disclosures relating to positive or negative ESG performance;

4. Privacy and data security;

5. So-called “Weinstein” clauses or “MeToo” representations that require disclosure of sexual harassment or misconduct allegations; and 

6. Other social, labor, health and safety, security or environmental incident, accident, or circumstances with respect to the target’s business and operations could be expected to have a material adverse effect on the business or its community reputation. 

We expect ESG considerations in M&A transactions to continue to develop and become an increasingly prevalent component of negotiations. New ESG-related opportunities and risks to each seller and buyer will continue to emerge and corporate and acquisition strategies will need to adapt as these opportunities and risks are identified.