As well as agreeing the consideration to be paid for a target company’s shares or business assets, a key issue to be agreed between the parties is how the purchase price is to be structured. This will depend on many factors, such as the bargaining power of the parties, tax considerations and how the buyer will be funding the transaction. This blog highlights the most common pricing structures used in the acquisition of shares in a target company (many of which will also be relevant to asset purchases).
Fixed cash sum
Paying an immediate fixed cash sum to the seller in full at completion of a transaction is the most straightforward pricing arrangement, and will often be the more favourable option for the seller. This is because it results in the agreed price for the shares being paid in full at completion, providing certainty and eliminating the potential costs and delays surrounding any post completion pricing adjustments or other pricing structures which may be used. From the buyer’s perspective, a fixed cash sum may not be the most accurate way of assessing the value of the target as at the completion date. For this reason, post completion price adjustment mechanisms are often used, as outlined further below.
Price adjustment mechanisms
The purchase price will likely have been negotiated and agreed based on certain financial assumptions and the expectation that a certain financial position will be delivered at completion. This is often based on the most recent audited annual accounts for the target. The buyer may therefore require this position and assumptions to be tested following completion by the production of completion accounts, and for the purchase price to then be adjusted if the completion accounts show a departure from the assumed position. This is traditionally viewed as being a more buyer-friendly pricing mechanism, as the seller continues to bear the economic risk of any fluctuation in the target’s value in the time period up to completion. The use of completion accounts can add a significant amount of time, complexity and negotiation to the transaction process.
Locked box mechanism
A “locked box” price adjustment mechanism is traditionally a more seller-friendly alternative to completion accounts. It involves fixing a price for the target based on a balance sheet prepared before completion. Although there will be no post-completion adjustment to the price, the buyer will be protected from any “leakage” (e.g. transfer of value to the target’s shareholders) from the target between the date of the locked box balance sheet and the completion date – this is usually structured by way of a pound for pound indemnity being provided to the buyer for any leakage (other than “permitted leakage”, the scope of which will be negotiated). There are advantages from a seller’s perspective in using a locked box approach as it provides more certainty as to price and the buyer bears more of the economic risk to the target business in the period between the locked box date and completion.
For various commercial reasons, it is not always possible for the purchase price to paid in full at completion. In addition to the above pricing mechanisms, the following are also often used:
- Deferred Consideration – payment by instalments is typically used where the buyer has not been able to raise sufficient funds to pay the purchase price in full at completion. The parties may then agree a structure for the buyer to pay deferred elements of the consideration at certain date(s) in the future. Whilst there is the risk that the buyer may not be able to meet these payment obligations in future, the seller will likely seek various contractual protections to address this (which may include security for the deferred consideration, for example).
- Earn-outs – if the parties cannot agree the value of the target company, it may be possible for an earn out structure to be used. This traditionally involves part of the purchase price being paid at completion, with the remainder being paid at a later date(s) during an earn-out period based on the post-completion performance of the target. The earn-out provisions will need to be carefully drafted and negotiated, specifying the duration of the earn-out period, the relevant targets to be met, and the attributable earn-out payments, for example.
- Escrow / Retention arrangements – in certain circumstances, the buyer may request that part of the purchase price is withheld at completion and deposited into a separate escrow account – this may be to secure certain post completion obligations of the seller, for example in relation to any post completion price adjustments in relation to completion accounts, or the seller’s potential liability for warranty or indemnity claims. The retention (or escrow) arrangements will need to be carefully documented and negotiated in order to provide for the specific retention amount, time period, terms regarding access and control of the retention account, which party is entitled to the accrued interest and how the funds can be withdrawn, for example.
- Anti-embarrassment – an anti-embarrassment provision is a seller-friendly pricing mechanism which allows the seller to receive an additional payment in specified circumstances if the buyer sells the target company at a higher price within a set amount of time following completion. It is essentially an on-sale protection, which manages the risk of the seller being “embarrassed” for selling their business at a price which does not reflect the true value of the company, allowing the seller to participate in any increase in value achieved by the buyer in a future sale.
The total amount of the purchase price paid for the target company does not need to be paid in cash. If the buyer is not willing or able to pay in cash, they may satisfy all or part of the price by way of non-cash consideration, such as the issue of loan notes or consideration shares to the seller(s). There will be different pros and cons for the buyer and seller(s) in each situation depending on the circumstances, together with tax implications for the parties to consider if structuring any of the purchase price in this way.