In a competitive M&A bid process, prospective purchasers are often required to enter into a term sheet and formulate an indicative purchase price without having had the opportunity to conduct thorough due diligence on the target business. The purchaser must instead rely on the limited information provided in the seller’s information memorandum or presentation deck. Prudent purchasers will accordingly seek to incorporate scope to adjust their price, either prior to or post entering into the purchase agreement. This article aims to summarise typical price adjustment mechanisms purchasers may seek to incorporate into sale terms, as well as some tips for both parties when formulating and negotiating the purchase price.
Purchase price - what is it and how is it calculated?
The purchase price can comprise cash, shares in the purchaser (also known as ‘scrip’) or a combination of these. Some of the purchase price may be deferred or may be adjusted, retained or released upon certain conditions. The purchase price is commonly offered on a ‘cash-free, debt-free basis assuming a normal level of working capital’. In simple terms this means that the seller keeps all surplus cash and pays out all financial debt in the target group at the time of the sale, but leaving adequate working capital in the business to preserve maintainable earnings at the level that underpinned the offer.
In calculating the purchase price, common valuation techniques include:
- average multiples derived from comparable companies (commonly used multiples include the enterprise value-EBITDA ratio (EV/EBITDA) or price-to-earnings ratio (P/E))
- using historic M&A transactions to determine multiples paid in the relevant industry (adjusted for control premiums and assumed synergies)
- discounted cash flow valuation models (likely subject to optimistic projections), or
- market-based valuations, for instance those applicable for publicly traded companies.
Choosing which valuation model to use will be dictated by the type of business being acquired, its asset composition, predictability of cash flows and other factors specific to the purchaser. In many instances, the purchaser’s own valuation is subjective and will have regard to strategic considerations, such as predictions around future market share, growth rates, business cycle conditions, the cost of capital, expenditure and investment in new technology, and control premiums.
In formulating a purchase price, purchasers typically have three adjustment mechanisms available:
- completion accounts
- locked box, and
The main features of these follow.
- Completion Accounts
What are they?
Completion accounts are used to confirm whether the actual financial position of the target on the completion date (i.e. the date the purchase price is paid and legal title of the target is transferred from the seller to purchaser) is reflective of the company’s financial position at some agreed point in time, such as the time the term sheet was originally entered into or the date of the most recent audited financial statements. The purchase price is then adjusted up or down depending on the difference between the position in the completion accounts as at completion or at the reference date.
How is the adjustment made?
There are generally two adjustment options available – a working capital adjustment or a net asset adjustment. Sometimes a hybrid of both.
In a working capital adjustment, the purchase price will be adjusted so that there are sufficient circulating assets to carry on the business of the target at completion without the need for additional funding from the purchaser. It is most appropriate where the precise value and amount of the fixed assets is either known with a sufficient degree of certainty or is not crucial to the acquisition.
In a net asset adjustment, the purchase price is adjusted by reference to a comprehensive list of assets and liabilities of the target at completion, excluding intangible assets such as goodwill and intellectual property rights. These items have subjective values and should be agreed separately by the parties.
The above adjustments are generally made dollar for dollar and not on a de minimis basis.
Who prepares the completion accounts?
Since the seller is typically more familiar with the accounts, they usually prepare them (but not always). Timeframes for preparing the completion accounts vary, however within a month of completion is a rough guide. This is followed by a specified period, often a similar timeframe, for the purchaser to review the accounts. If however the purchaser prepares the accounts, the seller is often required to provide reasonable assistance.
Key considerations for the parties
Purchasers need to consider whether they can finance the higher purchase price if an upwards adjustment is required to be made or whether a cap will be applied on the value of specific assets. Parties may also want to consider not adjusting the purchase price at all in circumstances where the working capital or net assets figures fall within a specified range.
The parties should also agree on whether a specific accounting treatment applies. For example, whether such line items as equipment leases are classified as finance leases (and therefore capitalised) or operating leases (and therefore expensed) may differ depending on accounting principles applied. To avoid the apples vs oranges issue, the completion account clause and accounting policies to be applied should be reviewed by the parties’ financial advisers.
Completion accounts are an important protection mechanism for purchasers as they allow the purchaser to review the target’s accounts in the period after the completion date for fluctuations in working capital (or in some cases, the full balance sheet). They are particularly useful if the target is part of a consolidated group or if stand-alone accounts have not previously been prepared. The purchaser can then bring a claim if the final position has changed from the assumed financial position that underpinned the agreed purchase price.
- Locked Box
What is it?
Unlike completion accounts, a locked box is a fixed price mechanism that does not involve a formal review of the target’s financial position on completion. Instead, the target is sold at a fixed price calculated by reference to specified financial accounts made available during the due diligence process, usually audited financial statements to the prior half or full financial year end.
Because the purchase price is fixed, the purchaser will ask that in addition to the usual indemnities and warranties, the seller also indemnify the purchaser for any value that they extract from the target business in the period to completion (known as ‘leakage’). The purchaser will also typically require that the seller give undertakings as to how the business may be conducted between signing and completion. Covenants will include not issuing new securities, varying voting rights, maintaining insurance of key assets, not entering into or varying material contracts, limits on the hiring or rewarding of key staff, commencing material litigation or incurring material capital expenditure.
The seller on the other hand will want to ensure that the definition of ‘value’ when defining leakage is clear, and that it only captures matters that are clearly within the seller’s control and the relevant benefits are actually received by them.
The purchaser customarily allows certain permitted leakages necessary to keep the target operating in the ordinary course of business. This may be extended to agreed pre-sale dividends (to achieve a cash free target) and other agreed amounts.
It is also customary to limit the time for bringing leakage claims to between 3 and 6 months, however purchasers should insist that sellers notify them immediately upon any leakage occurring.
Locked boxes are typically viewed as a seller-friendly mechanism because they give greater certainty regarding the purchase price, with more limited opportunity for the purchaser to make claims after completion.
Subject to warranties, conduct of business undertakings and leakage indemnities, the fluctuations in the value of the business between the reference date and completion are largely at the purchaser’s risk (and reward). Since the purchaser bears the risks and enjoys the upside from conduct of the target business during this period, the purchaser will often conduct a more rigorous financial due diligence to determine the purchase price to be included in the sale agreement.
What are they?
Earn-outs are mechanisms for allocating between the parties the risk and reward of the target business’ performance post-completion. They can take any form agreed between the parties and are usually structured so that a proportion of the purchase price owing by the purchaser is subject to the achieving certain financial benchmarks within specified time frames (usually 12-36 months).
Earn-outs are often revenue-based, but sometimes profit-based – although, the latter complicates things significantly. However, they can be tailored to any criteria capable of being objectively measured. We have seen such criteria include the winning of key contracts post-completion or obtaining a key licence or accreditation, as well as industry-specific criteria, for instance gross written premium levels as measured criteria for earn-outs in the insurance industry deals.
Who benefits and who loses?
Both the seller and purchaser. A seller can potentially achieve a higher sale price whilst a purchaser has the comfort of knowing that it will only pay for what it actually buys. However, a party’s gain is often the other’s loss, and vendors are often disappointed at not achieving headline purchase price levels anticipated at the original offer stage by virtue of underperformance of the business after its control has transferred to a purchaser.
Unlike completion accounts or locked box mechanisms, earn-outs are determined by reference to the performance of the target post completion. This means the seller will want contractual assurances in the SPA from the purchaser in terms of how the purchaser operates the business for the duration of the earn-out period. A seller will seek to achieve this by including an ‘operate the business like the sellers did’ covenant, or by setting objective parameters in relation to how the business can be operated and how the purchaser calculates performance incentives. An example might include setting a cap on capital expenditure or ensuring that internal resourcing of the target group remains consistent with historical levels.
A seller must be mindful that such limitations may have the unintended consequence of stifling new ideas and initiatives from management. A private equity investor will typically resist such limitations since they require flexibility in order to transform an acquired business and incentivise management. On this basis, it is uncommon to see financial buyers accept earn-outs with significant vendor protections, instead opting for a clean break to keep the necessary alignment of interests with management.
Other key considerations
The parties should further consider:
- whether the deferred consideration will be secured in some way. For example, a seller may request that funds be held in escrow or that a purchaser parent company guarantee a deferred instalment of purchase price
- whether the purchaser’s obligation to pay a higher price will lapse automatically or be offset against a breach of warranty or restraint
- whether the obligation to pay an earn-out is accelerated upon certain circumstances such as a change of control, an insolvency event or a failure to operate the business like the seller did;
- whether the earn-out calculation will be based on normalised financial accounts so that one-off costs associated with the implementation of the deal are removed, and
- whether accounting standards will remain unchanged. Earn-outs usually straddle several future accounting periods and purchasers typically account differently for their own group to the way the seller historically prepared accounts for the target business, particularly where the buyer is an overseas company. An option here is for the parties to freeze the standards used in the first year, or to agree to discuss fair adjustments to the earn-out in the circumstances. In the case of the latter, a dispute resolution mechanism such as expert determination will be necessary to enforce the arrangement.