Sameer Huda and Adele O’Herlihy provide a broad overview of the various price adjustment mechanisms which could be included in a share purchase agreement (“SPA”).

In brief:

  • Drafting well-structured and creative price adjustment clauses in share purchase agreements can help Buyers and Sellers bridge valuation gaps.
  • In a difficult market, valuations using historic and projected financials incur higher perceived risks so Buyers tend to build protections into pricing, which can often disrupt a normal transaction process.
  • There are a range of different mechanisms to allow for an alteration of the purchase price prior to or at various points following completion of an acquisition. The right mechanism will balance the level of post-completion pricing risk that a Buyer wants a Seller to assume, against a Seller’s preference to avoid any such price adjustment.
  • Certain adjustment mechanisms allow Sellers to benefit from the potential future success of a business related to its intrinsic value, whilst protecting the Buyer against having to pay for synergy and other post-completion improvements.

Introduction

The issue of price is generally the key obstacle to be overcome between a potential Buyer and Seller. One way of potentially addressing this is through the use of a properly structured price adjustment clause in an SPA, which is tailored and designed specifically to tackle the issues that are the cause of, or contribute in some way to, the issues that drive disagreement over price.

The main methods by which consideration clauses may be structured in share purchase agreements are set out below.

Completion Accounts

This is the most popular and common mechanism used to determine overall purchase price after signature of an SPA. It involves the target’s accounts being drawn up either soon after or at completion (“Completion Accounts”), which are then used to form the base upon which the final consideration figure is calculated.

The parties may further agree between themselves on which aspects of the target’s financial position should be measured in the Completion Accounts. We have found that, for example, focusing on obvious problematic key line entries from the relevant accounts is a very a useful method, ensuring that adjustments can be made quite efficiently, since the scope of disagreement between a Seller and Buyer is then reduced by a notable extent. Any disagreement over any part of the Completion Accounts is potentially resolved by the introduction of an accounting expert, but we have also found that this process requires careful thought to ensure it is workable, as “market-standard precedent language” is often not appropriate.

Debt Free/Cash Free Deals

Due to the fluctuating and inconsistent nature of a company’s debt and cash levels, it is common for valuations to be calculated on the basis that there is no debt or cash on the company’s balance sheet. As a result, a price is agreed on the assumption that the target has no borrowings or financial obligations as well as no cash or cash-like items which can be easily converted into cash. This mechanism is often used by corporate strategic Buyers.

The debt free/cash free price is known as the notional price, and the actual price is then an adjustment of the notional price for any debt or cash that is on the balance sheet of the target. The mechanisms to employ in determining this valuation should be less complex than those used for completion accounts, given that only levels of cash and debt are measured on the completion date. However, the definitions of what constitutes “cash” and “debt” are clearly critical, and should be specifically agreed in the SPA, rather than being assumed to be generic terms whose meaning would always be obvious. For example, debt may not just be limited to financial debt on the balance sheet. There may be other elements that could be classified as “debt” but are effectively contractual obligations that have a direct financial impact such as payables relating to accrued interest, dividends, finance or lease payments. As stated previously, the relevance will need to be established for each transaction, so ensuring that relevant finance professionals provide their input into the legal drafting is critical.

Working Capital Adjustment

As working capital reflects net short-term assets, a working capital adjustment is used to ensure that the purchase price eventually paid more accurately reflects the “working cost and value” of the business. This circumstance can come about for different reasons, such as where the target does not have enough working capital after completion and needs additional cash to function properly or where seasonal business cycles may mean the level of working capital prior to completion differs from the normal working capital position of the business.

The adjustment would normally occur by the parties agreeing a provisional working capital figure that the target should have at completion (“Provisional Working Capital Amount”). After completion, a final working capital amount will need to be agreed by the parties at a particular date (“Final Working Capital Amount”). The Final Working Capital Amount will then be compared to the Provisional Working Capital Amount, and depending on whether there is a deficit or surplus, the Buyer will either need to pay more consideration to the Seller, or the Seller will need to return a proportion of the cash already paid to it to the Buyer (subject to any retentions that might be expected if acting for the Buyer). However, this area can often lead to a number of disputes, as lawyers and accounting experts generally tend to not work closely enough together to develop a definition of “net working capital” that is acceptable and relevant. Analysing and specifying the meaning of this in sufficient detail in the SPA by tailoring this definition to the particular underlying business being purchased in a transaction actually saves time later and greatly reduces the risk of a damaging dispute. This is one of the many instances where standard definitions create unnecessary risk, or where their use fails to provide the parties with a solution that addresses their real underlying concerns that they may not address properly themselves.

Net Asset Value

Net asset value is quite simply the total book value of the target’s assets less the total book value of its liabilities.

The main advantage of using the net asset value adjustment is, in some ways, its simplicity, as well as the unequivocal protection it offers to both the Buyer and Seller, but this method is rarely used due to its simplicity.

Locked Box

This has become one of the most popular structures for many Buyers. It requires agreement of the purchase price at a specific date prior to completion, based on a pre-signed balance sheet.

The main advantage is to provide certainty of price for both parties. It does push the risk to the Buyer in some ways since the Buyer has to assume the risk of the target’s performance between signature and completion under an SPA, although this risk can be managed by ensuring that appropriate “no leakage” protections are in place during this period, such protections involving a series of Seller undertakings generally prohibiting the Seller from carrying out certain acts that could reduce the value of the business during this period. However, careful consideration ought to be applied to the practical remedies that should be made available to the Buyer if any of these undertakings are breached, since Buyers will not wish to pursue a Seller for a contractual breach of undertaking. We would tend to assess these for each particular transaction in a manner that is commercially pragmatic, but which also offers the simplest legal recourse without having to first resort to court or arbitration. A common error is to simply rely on a contractual breach of a Seller’s undertaking, but we don’t believe that this provides an adequate remedy in this region.

Earn-out

The earn-out provision is not a true price-adjustment clause (unlike the others above), as it is effectively a method of increasing the price following completion, if certain performance benchmarks are achieved by the target following completion. In the current economic climate, where Buyers are particularly careful with over-optimistic projections, or where the macroeconomic climate is uncertain, a Buyer faces too many unpredictable variables when trying to fix a reasonable price. Conversely, many Sellers now believe that valuations are unfairly low due to the past couple of years of historical accounts.

A well-structured and well-designed earn-out clause can act as a very useful bridge in these circumstances. This mechanism allows the Buyer to protect against over-optimistic financials from the Seller, but then also allows the Seller to receive additional cash after completion if the value of the business based upon its post-completion performance closely reflects the value advocated by the Seller.

Another key advantage of an earn-out clause is its use as a mechanism to tie-in managers deemed important to the future success of the target. It is also important that such managers are not permitted to “play” an earn-out in a manner where the business results align with their incentive payments rather than the best interests of the target.

The earn-out is generally triggered if the business meets certain performance benchmarks during specific periods following completion. The types of performance benchmarks that are easily measurable should be identified, but a great deal of difficulty can arise in trying to separate those performance benchmarks which are achieved due to improved efficiencies and synergies created as a result of the Buyer’s purchase of the target, from those generated as a result of the inherent underlying business itself, which are achieved independently from any added value brought in by the Buyer. A Buyer will obviously not want to pay for improved financials in a target derived from the Buyer purchasing the target, so even with careful analysis, creating entirely accurate metrics will always be a challenge. However, there are ways to capture these metrics as accurately as possible and reflect this into the drafting of the earn-out clause in the SPA.

Overall, properly devised earn-out clauses allow certain transactions to close the gap on valuation if they are properly drafted and analysed in sufficient detail by lawyers, acting creatively and commercially in relation to the issues at hand. We do appreciate that Sellers do not favour earn-out clauses, since they obviously have a direct bearing on price and push the risk of a target underperforming following completion onto the Seller, where the Seller’s level of control over the business is vastly diminished.

Conclusion

From our experience, some of the main reasons for transactions failing to complete relate to a lack of proper analysis in the initial structuring of the deal, or valuation gaps. It is essential to address the real pricing risks relating to a transaction, in order to ensure that both the Buyer and Seller are covered in a manner that assists with closing a transaction.

It is possible to minimize the risk of a transaction failing due to a valuation gap by spending time at the outset devising an appropriate valuation mechanism. The key obstacles and underlying issues facing a transaction should be identified in order to create appropriate solutions. It is important to not follow a transaction process too rigidly, since a bespoke solution is often required.