Introduction

M&A activity in India has been on the rise for the past several years. Since valuation lies at the heart of a deal, differing expectations as to valuation of a transaction can potentially be a debilitating roadblock for parties. Valuations depends on various factors, such as cash position, net debt, working capital etc. The initial valuation exercise may not be reflective of the actual valuation of the business at the time of closing for many reasons, including a significant time lapse between signing and closing.

In this scenario, purchase price adjustments may solve for such a gap and are commonly incorporated into domestic and cross border deals. Purchase price adjustments also accommodate various transaction specific nuances, necessitating adjustments to the purchase price. The objective of this webinar was to discuss purchase price adjustments and their use in transactions.

A webinar was organised by our firm on the topic Purchase price adjustments in M&A. The speakers for the webinar were Aravind Venugopal, Purti Minawala & Nayantara Kutty. The session was moderated by our partner Sameer Sah.

You can see the recording of the webinar at this link

Share Purchase and Asset/Business Sale

The purchase price adjustments used can differ in case of share purchases and business or asset sales, as follows:

  • Share Purchase: Valuation may be comparatively simpler in case of a share purchase as it is arrived at on the basis of a balance sheet and audited accounts, which connotes a full set of accounts.
  • Business or Asset Sale: Valuation can be trickier in case of a sale of carved-out assets as the accounts do not cater exclusively to such carved-out assets and may require a review of historical data to arrive at the valuation for such these assets.

Purchase Price Adjustments and their Features

The following are standard forms of purchase price adjustments and their features:

  • Completion Accounts: The seller and the purchaser typically initially agree upon a purchase consideration based on assumed accounts. The closing date accounts are verified by the buyer during a post-closing review period (generally 60-90 days from closing) and the differences (if any) between assumptions and actual numbers are adjusted for in the purchase price. If the adjustment reveals a positive number, then usually price is increased and if the adjustments are negative, seller compensates the buyer in respect of the delta.   
  • Locked Box: The parties agree upon the purchase price and permitted leakages (i.e., the agreed outages, such as managerial remuneration, salaries of employees, day-to-day expenses, etc.). Any expenditure outside of the permitted leakages will affect the valuation at closing. Permitted leakages depend on the business, the timeline for signing and closing, ordinary business practices and so on. Therefore, a comprehensive understanding of the business and a robust diligence exercise are necessary.
  • Deferred Consideration: In this form, a portion of the consideration is deferred for an agreed period of time and depending upon the terms for payment of the deferred consideration in definitive agreements (e.g. Milestones / liabilities), the deferred consideration is released to the seller or retained by the buyer.  
  • Earn-Out: If the parties agree that the current valuation does not depict the true value of a business, they may agree upon additional payments linked to certain conditions or the achievement of milestones. These are generally deployed where the seller remains involved in the business post the occurrence of closing. From a purchaser’s perspective, a purchaser is not required to go out of pocket until the condition or milestone is satisfied.

The amounts involved in adjustments may be identified and held back by the buyer or deposited in an escrow with a third party. In each case, release occurs after threshold conditions identified in the definitive agreements (including with respect to timing) occur.

Types of Adjustments

Typically, adjustments may be made on account of:

  • Cash
  • Debt; and
  • Working capital.

Usage of Purchase Price Adjustments

The different forms of purchase price adjustments utilized for a transaction are determined on a case-by-case basis.

  • Completion accounts are the most popular form of purchase price adjustments in domestic deals. However, there is an uptick in locked box in recent deals.
  • Deferred consideration is subject to limitations under Indian foreign exchange regulations. Foreign exchange laws provide that (i) up to 25% of the consideration amount may be deferred for a period of 18 months from the signing date; (ii) pricing guidelines will apply; (iii) the fair market value must be paid upfront and the deferred amount must be computed accordingly.
  • A locked box is ideally used when there is a reasonable estimation of the business, generally pursuant to due diligence and when cash flows are not erratic.
  • Purchase price adjustments may address related party transactions, however, the approach depends from transaction to transaction.

Role of Drafting

Recent cases have underscored the importance of drafting provisions relating to purchase price adjustments (like the disinvestment by the Government of Hindustan Teleprinters and the disinvestment of Madurai Hotels) which relied on the plain text of the contractual provisions. A few key points to consider at the time of drafting are: 

  • Keep in mind the party that you are representing;
  • Understand the business and the end-goal of the transaction;
  • Incorporate clear accounting principles;
  • Define the relevant terms and provide for consequences in case of breach / deviation. So, for instance, permitted leakages should be clearly defined and remedies for deviation from permitted leakages should be built in;  
  • In case of earn-outs and deferred consideration, determine the minimum and maximum payout;
  • Delineate the roles and rights of parties;
  • For deadlocks or disputes, consider including a third-party expert, such as a recognized accounting firm, rather than a long-drawn arbitration process; and
  • Incorporate inputs from business and tax teams to properly cater to commercial considerations.

Conclusion

Purchase price adjustments are instrumental in facilitating successful completion of a deal, which can otherwise fall prey to valuation mismatches. While there are no set formulas for incorporating purchase price adjustments, these must be carefully analysed with a deal-specific approach, keeping in mind the business, commercial considerations, timeframes, residency status of the parties and so on.