M&A Purchase Price Mechanisms - Overview & Best Practices

Nothing is more important than the purchase price! - This is what many sellers in M&A transactions might think. Even if this is certainly not entirely true, the purchase price is of central importance to the transaction as the buyer's main obligation. This makes it all the more important to think about the purchase price mechanism at an early stage. When agreeing on a particular method of determining the purchase price, commercial considerations are naturally leading. However, the choice of purchase price mechanism also has legal implications and has a significant influence on the M&A process.

Over time, certain purchase price mechanisms and associated best practices have become established. The following is an overview from a legal perspective.

M&A Purchase Price Mechanisms - Overview & Best Practices

I. Fixed purchase price

Probably the simplest way to determine the purchase price is to agree on a fixed purchase price. Even if traditional company valuation methods are often used to determine the purchase price, the purchase price can be determined completely arbitrarily. The method used to determine the purchase price is ultimately irrelevant here and has no further effect on the purchase agreement. The buyer pays the seller a fixed euro amount on the closing date and the seller transfers ownership of the company to the buyer in return.

The main advantage of this method of determining the purchase price is that it is simple. However, this is also its biggest disadvantage. A company is "alive" and the key financial figures are always in flux. A fixed purchase price will regularly not be able to accurately reflect the enterprise value and financial position of the company at the time of completion. This can penalise either the buyer or the seller.

Best Practice

This form of purchase price determination is justified and is particularly suitable for smaller transactions (up to approx. EUR 10m enterprise value) if the seller and/or buyer are not experienced M&A players. Complicated purchase price mechanisms would possibly confuse the parties or even cause mistrust. This can burden the process and jeopardise the successful completion of the transaction.

II Locked box concept

In the case of the locked box concept, the purchase price is calculated by determining the enterprise value on the basis of a suitable company valuation method (e.g. discounted cash flow method). This enterprise value is then converted into the equity value by deducting financial debt items, adding cash items and making working capital adjustments.

The equity value is calculated on a date in the past (locked box date). As the calculation of the equity value requires a reliable basis of figures on the locked box date, the end of the financial year is usually a suitable reference date. The calculations can then be made on the basis of the (audited) annual financial statements. The cut-off date also serves to delimit the spheres of seller and buyer. In other words, everything before the locked box date is at the expense and in favour of the seller. Everything after the locked box date is at the expense and in favour of the buyer.

The demarcation of the seller and buyer spheres on the locked box date also has legal implications for the purchase agreement. As changes in cash and financial debt positions as well as changes in working capital from the economic closing date are in favour of or to the detriment of the buyer, it must be ensured that these positions only change in the ordinary course of business. In addition, it must be ensured in particular that the buyer no longer withdraws any cash from the company that is attributable to the period from the locked box date. As the name "locked box" suggests, the box must remain closed from the lock-in date. An outflow of value in the direction of the seller or a person close to the seller is referred to as "leakage".

As the economic closing date is in the past and the purchase price is often not paid until months later, it is often agreed in practice that the buyer pays the seller an additional amount as interest on the purchase price for the period between the closing date and closing. In economic terms, such interest can be justified and measured in various ways. For example, the seller's weighted cost of capital could be used, i.e. the costs the seller would have incurred if he had had to generate liquidity in the amount of the purchase price. In practice, however, a so-called "profit ticker" is more frequently agreed, i.e. a locked box interest rate that is based on the expected profits of the target company over the locked box period, i.e. the period between the closing date and closing. Due to the natural asymmetry of information, the seller will regularly succeed in presenting an optimistic earnings forecast. A buyer will therefore always scrutinise this forecast carefully. In addition, the buyer will often argue that the profit expectation for the current financial year is already reflected in the enterprise value and will therefore not be paid again.

The M&A process is indeed more complex and due diligence on the part of the buyer may even lead to the buyer having sovereignty of knowledge with regard to one or other aspect of the target company. However, this is no reason to categorically deny the validity of the principle of making a statement in the blue. The question of fraudulent misrepresentation will not have to be examined across the board for the M&A process, but rather in relation to the specific statements made by the seller. There may well be constellations that fulfil the requirements of fraudulent misrepresentation due to statements made in the blue.

Best Practices

• The locked-box concept is generally recognised, but its popularity varies from region to region. In US deals, purchase price adjustment mechanisms are seen almost exclusively. In UK deals, price adjustment mechanisms seem to predominate. In Germany, we see more fixed-price and locked-box contracts than purchase price adjustment mechanisms. A seller should bear the different customs in mind when targeting national or international buyers.
• The locked-box concept is particularly suitable if the last annual financial statements have been audited and still provide a reliable basis of figures when the transaction is finalised. This is typically not the case if the company has changed significantly since the annual financial statements (change of business model, strong external influences, personnel changes, etc.). If the transaction is planned for November/December, the last annual financial statements were published quite some time ago. In this case, you should consider using the next annual financial statements as a basis (conceivable: Locked box concept for a future reporting date (see below)). The locked box concept is also difficult in carve-out situations if there is not yet a separate company code for the target. In this case, the cash flows cannot be easily deferred.
• If the seller wants a "profit ticker", they should communicate this as early as possible in the process. If this request is made too late, negotiations on this point will most likely put a strain on the M&A process. In favour of a smooth M&A process, a ticker is often dispensed with altogether and the period between locked box date and closing is played out solely on the basis of enterprise value.
• With regard to the demarcation of the seller and buyer spheres on the closing date, the purchase agreement contains the following regulatory regime:
• The period between the locked box date and signing is covered by guarantees. Typically, guarantees are given (i) that the seller has not made any unauthorised cash withdrawals or comparable measures and (ii) that the business operations of the company have been conducted in accordance with the ordinary course of business. If there has already been an unauthorised outflow of value at the time of signing, this is either repaid before the closing or deducted from the purchase price. As the past annual financial statements form the basis of the locked box concept, the balance sheet guarantee should also be designed to be correspondingly robust.
• The period between signing and closing is then covered by so-called covenants, i.e. behavioural obligations of the seller. The seller undertakes (i) not to make any unauthorised cash withdrawals or comparable measures until closing and (ii) to ensure that the company is managed in accordance with normal business operations until closing.
• Unauthorised value outflows must be settled euro for euro. Any de minimis, basket, deductible or cap regulations must not be applied here. This applies to both covenants and breaches of guarantee. Moreover, the guarantees and covenants are typically part of the general regulatory regime of the purchase agreement.

III. Purchase price adjustment mechanisms

When the term "purchase price adjustment" or "purchase price adjustment mechanism" is used in M&A, it usually refers to a "closing accounts" or "completion accounts" concept, whereby "closing accounts" and "completion accounts" are synonymous. However, the possibility of adjusting the purchase price is by no means limited to such a concept. A classic "earn-out" clause also basically represents a subsequent adjustment (increase) of the purchase price.

The following is an overview of the most common concepts.

Closing accounts concept

With the closing accounts concept (on a cash/debt free basis), the seller and buyer agree that the final purchase price will be determined on the basis of the company's financial statements on the day of closing. Specifically, the equity value at closing is initially calculated on the basis of an estimate. The buyer initially pays a provisional purchase price. After the closing (and therefore after payment of the provisional purchase price), a company financial statement is then prepared as at the closing date in order to validate the estimated figures. Any discrepancies are subsequently settled between the seller and buyer. In contrast to the locked box concept, the economic closing date is not the date of the previous annual financial statements, but the date of closing.

As these are not ordinary annual financial statements, the parties are free to determine how these company financial statements should look. This concerns both the components of the financial statements (complete balance sheet or only the items relevant for the adjustment?) and the principles on the basis of which the closing accounts are to be prepared (HGB or IFRS, interpretation rules, any deviations from these standards?).

As the closing accounts provide the basis for determining the final purchase price, their preparation and verification is of central importance for the transaction. The purchase agreement specifies whether the closing accounts are to be prepared by the buyer or seller. They are then reviewed by the other party. The interests of the seller and buyer could not be more opposed in this constellation. This, combined with accounting and discretionary leeway that can be utilised to affect the purchase price, creates considerable potential for conflict. The aim of the purchase agreement is to prevent typical conflicts as far as possible.

Best Practices

• Unclear definitions of cash, financial debt and working capital are a reliable recipe for post-M&A disputes. It is in the buyer's interest to include as few balance sheet items as possible in the definition of financial debt, while aiming for the broadest possible definition of cash. Vice versa for the buyer. The negotiations on the categorisation of the various items as financial debt, cash and working capital are varied and depend heavily on the individual case. With regard to some items that are regularly discussed, regulatory trends have developed in practice. For example, liabilities from finance leases and tax provisions are usually recognised as part of the financial debt definition. The same applies to pension provisions, even if they are not debt capital in terms of the valuation system and are not interest-bearing. In order to avoid double recognition here, capital costs and current pension liabilities must be disregarded in the cash flow at enterprise value level. Reimbursement claims against tax authorities are usually accepted in the definition of cash. The reimbursement of losses carried forward, on the other hand, is always a question of the individual case.
• Once the parties have agreed on a common understanding of the definitions of cash, financial debt and working capital, it is advisable to make specific reference to the company's chart of accounts. The allocation of all accounts and sub-accounts from the target's chart of accounts to the definitions of cash, financial debt and working capital provides clarity and avoids disputes when preparing the closing accounts. In the event of contradictions between the abstract definitions of cash, financial debt and working capital on the one hand and the "mapping" of the chart of accounts on the other, the abstract definition of the purchase agreement provides guidance. It also comes into play if further accounts are added between signing and closing that could not yet be assigned to any definitions.
• The reference value for the working capital adjustment is generally determined on the basis of historical values, whereby dealing with any seasonal fluctuations is a question of the individual case. An individual reference value may be appropriate for each month. In some cases, the parties also agree on a corridor within which no working capital adjustments should be made. However, this is not the rule.
  In the event that the seller and buyer are unable to agree on a provisional purchase price before closing, it is advisable to provide for a purchase price in the contract to which the parties can then fall back. This protects each party from an arbitrarily high or low estimate and the associated liquidity disadvantages.
• The preparation of the closing accounts is more often the responsibility of the buyer than the seller, as the buyer has material control over the company after closing. However, there are also situations in which it is appropriate for the seller to be responsible for preparing the closing accounts. As the closing accounts are not drawn up on the basis of statutory but rather contractual requirements, the purchase agreement should specifically and in detail stipulate the regulations according to which the accounts are to be drawn up. In practice, it is advisable to draw up the closing accounts in hierarchical order in accordance with the following principles:
  • If there are specific principles agreed between the parties, these must be prioritised. These include, in particular, the definition of financial debt, cash and working capital.
  • Subsequently, the principle of accounting and valuation continuity applies and
  • the applicable principles of proper accounting and financial reporting (HGB or IFRS).
• The non-providing party is then given the opportunity to review the closing accounts. Any differences of opinion are clarified by means of a conflict resolution mechanism specified in the purchase agreement. This regularly results in the appointment of an independent auditor, whose audit is ultimately final for the parties. It is also possible to involve the auditor in the preparation of the accounts. However, this is generally not particularly useful. On the one hand, the buyer's financial adviser regularly accompanies the preparation of the accounts. On the other hand, the buyer and seller may not disagree at all or only on a few points, so that the costs for the auditor can be saved completely at this point.
• To secure the purchase price adjustment, a partial retention of the provisional purchase price or payment into an escrow account can be agreed. However, this is usually only done if there is a justified need for protection with regard to the identity of the parties. The scope of application is often given, for example, if there is a majority of persons on the seller's side. In this case, the buyer wants to protect himself from having to enforce his potential purchase price adjustment claim against each individual seller.

Combination of locked box and closing accounts

As already indicated above, it is also possible to combine the locked box concept and the closing accounts concept. In this case, the locked box date is either (i) in the future or (ii) in the past but the relevant financial statements are not yet available.

In the first case, the time axis is in October/November, for example. As the last annual financial statement (if the financial year is the same as the calendar year) is too far back, the next annual financial statement should be used as the basis. The locked box date is then in the future. In the second case, you are more likely to be in January/February, perhaps even March. The locked box date should be 31 December of the previous year, but the annual financial statements are not yet available.

As with the classic closing accounts concept, the provisional purchase price is estimated first. As soon as the annual financial statements are available, this purchase price is adjusted to the locked box date. As the closing date and the economic closing date are different, the "leakage" and "conduct of business" protection mechanisms typical of a locked box concept are also required here. The closing accounts considerations also apply.

Earn-out

Strictly speaking, the earn-out is also a purchase price adjustment mechanism. However, the thrust is different. The earn-out is an instrument that helps to find a compromise when seller and buyer disagree on the value of the company. The company valuation is dependent on the future development of the company. In other words, it is not a matter of adjusting the enterprise value for net financial liabilities, but, put simply, of a subsequent increase in the enterprise value itself.

Contractually, the following aspects, among others, are important here:

• The most precise possible definition of earn-out parameters
• Determination of the threshold values and the influence on an additional purchase price
• Definition of the measurement period
• Regulations to prevent manipulation by the buyer or to incentivise the buyer correctly
• Information rights of the seller
• Payment modalities
• Details of the special features to be observed when regulating an earn-out agreement are reserved for a separate article.

Conclusion

The methodology used to determine the purchase price has a significant influence on the M&A process as a whole, but above all on the purchase agreement. Buyers and sellers should seek legal and commercial advice at an early stage in order to weigh up the pros and cons and avoid potential conflicts. Familiarising yourself with the various concepts is essential. Only then can the parties agree on a consistent and contradiction-free contract that balances the interests of both parties appropriately.