A key decision for seller and buyer: Purchase price clauses for company acquisitions
By Matthias Kasch and Dan Kessler
White & Case, Frankfurt am Main / New York
Purchase price clauses are the central interface between economic and legal aspects in the negotiation of company acquisition agreements. It is necessary to carefully weigh the advantages and disadvantages of differing purchase price adjustment mechanisms, with a view to market conditions and the economic motives pursued by the respective parties. In connection with any company acquisition, the most important business decision will be what the purchase price should be. However, since there is regularly a time gap between the signing of the purchase agreement and the closing of the transaction, the parties must also agree on the legal mechanics necessary to take into account changes between signing and closing. As a result, finding the right method to determine the final purchase price also becomes a significant business decision. It is common for the enterprise value of a target company to be calculated on the basis of a multiple of EBITDA. To determine equity value, however, the parties must subtract the company’s debt and add the amount of cash held by the company. Additionally, in connection with this valuation, the parties often agree on a “normal” level of working capital for the company. How these elements are determined and potentially adjusted will affect the proceeds ultimately paid by the buyer and received by the seller.
Locked box mechanism
When a “locked box” purchase price adjustment mechanism is used, the parties define the purchase price with reference to existing financial statements dated prior to the date the purchase agreement is signed. There is no adjustment to the purchase price to reflect changes in the business between the date of the existing financial statements (the “locked box date”) and the date on which the acquisition is closed. As a result, a buyer essentially takes on the risk of the acquired company on the locked box date, while not legally owning the company until the closing date. The buyer, however, does have some protection in the form of anti-leakage covenants. These covenants generally prevent the seller from extracting value (such as dividends, payment of transaction expenses) from the target company during the period between signing and closing. The locked box mechanism is simple, quick and cost-efficient for both parties and provides price certainty, particularly to the seller. It also allows the seller to easily compare offers, as potential buyers are all valuing the company as of a fixed prior date. With a buyer’s recourse limited to claims that anti-leakage covenants were breached, the locked box mechanism is generally viewed as seller favorable.
In contrast to the locked box approach, a purchase agreement which provides for a post-closing purchase price adjustment allows the final purchase price to be determined as of the actual date of closing. Under this approach, parties often agree that the purchase price paid at closing will be calculated based on estimates of the target company’s debt, cash and working capital as of the closing date. The seller most often prepares these estimates. Following the closing, the buyer will have the possibility to review these amounts and have the opportunity to object. If a dispute arises, the parties can come to a settlement or submit the dispute to a neutral arbitrator, often an accounting firm. The purchase agreement will contain detailed procedures for this process. With the ability to review the debt, cash and working capital amounts post-closing, this approach is generally considered pro-buyer as compared to the locked box approach.
Debt and cash definitions
With the ability to increase (in the case of cash) and decrease (in the case of debt) the actual purchase price paid to the sellers of the target company, the definitions of such terms in the purchase agreement take on significant importance. Buyers may try to expand the definition of debt to include items for which it believes the sellers should be responsible (such as change of control payments to employees). Buyers may also try to exclude certain items, such as deposits that are not easily accessible (“trapped” or “restricted” cash), from the definition of cash. Understanding of, and agreement on, the definitions of these terms is therefore essential to understanding what the ultimate purchase price will be.
Net working capital
As previously mentioned, valuation of the target company will often assume an agreed upon “normal” working capital amount. The parties agree that the purchase price will be increased or reduced to the extent the actual working capital at closing differs from the agreed target. Net working capital is generally composed of the sum of inventories and current receivables less current liabilities. Again, the parties may negotiate for specific items to be included or excluded in the definition of working capital so that adjustments to the purchase price will be made in their favor. On balance, there are two good reasons for such a purchase price adjustment. Firstly, the inclusion of net working capital limits the possibilities to manipulate the purchase price. Secondly, the mechanism ensures that the target will have a minimum of liquidity or funds available at short notice safeguarding a continuation of the target’s business.
Risk of manipulation
A post-closing purchase price adjustment mechanism may encourage a seller to generate additional free liquidity so as to increase the purchase price. These effects could result from sale and lease-back transactions, factoring, de facto debt financing due to extended payment dates for supplies, advance payments from customers or a failure to make investments that are necessary for the business. In order to protect against this risk, a buyer will typically ask for a past practice clause requiring the seller to run the target company in accordance with past practices during the period between signing the purchase agreement and closing.
Relevance of the valuation method
Adjustments to the purchase price for cash and debt are not appropriate to the extent such amounts are taken into account in the valuation of the target company, such as when a capitalized earnings value method such as, the German IDW S1 standard, for instance, or a discounted cash flow method in a net approach/ equity approach (“Nettoansatz”) is used.
The choice of the purchase price calculation and its potential adjustment method is one of the key decisions to be made at the start of a transaction by both seller and purchaser.
Since the regulatory and economic capital is a crucial factor for the seller and the buyer, a net equity purchase price adjustment may be more recommendable for the acquisition of banks and insurance companies than a cash-free/debt-free adjustment.
Equity guarantees—in particular those exploiting the sensitivity of IFRS equity to changes in assets—in combination with a guarantee on the correctness of the financial statements may provide adequate protection against a potential accounting mismatch. The efficiency of an equity guarantee is driven by the level of detail of its wording. The broader the wording, the greater its reach.
The parties may decide in certain situations to make a portion of the purchase price subject to the future performance of the target company. The parties may establish for this purpose certain thresholds that must be reached. This “earn-out” approach is most often taken in cases where the seller and the buyer fail to agree on a middle ground regarding their respective assessments of the future earnings of the target company. Earn-out clauses typically have a specific term during which the contractually defined goals or ratios must be reached in order to trigger a payment of an additional purchase price component. The seller faces the risk that the buyer will attempt to influence the achievement of these goals or ratios by postponing positive developments to a time after the earn-out period. As a result earn-out provisions often contain extensive covenants with respect to how the buyer may operate the target company following the closing. These covenants seek to attain a balance between allowing the buyer to run its business as it sees fit and providing a fair opportunity for the seller to achieve its earn-out targets. In light of their complex structure and high potential for disputes, earn-out clauses are recommended only if reasonable in terms of the target’s expected future enterprise value.
The purchase price clause in a private company acquisition should fit how the parties value the target company. The choice of the purchase price calculation and its potential adjustment method is one of the key decisions to be made at the start of a transaction by both seller and purchaser. Careful drafting of the purchase price clause, particularly regarding a potential purchase price adjustment calculation, is essential to avoiding unintended disadvantages for either party. Transaction certainty is of great value to all parties. This is best achieved by using mechanisms that are as simple and unambiguous as possible. The path to complexity is fraught with the risk of an arrangement that is either incorrect or fails to cover matters that may arise in the future and are difficult to predict.