If you are looking to sell or buy a business the most important issue will usually be the purchase price (or ‘consideration’). Understandably, in corporate acquisitions this is often heavily negotiated and will form the backbone of the transaction.
The consideration arrangements will be at their simplest where the price is comprised of a fixed cash sum paid in full by the buyer to the seller at completion, with no adjustments required. However, this is not always possible or appropriate. Often, the parties will instead look to subsequently adjust the price following completion, or make some of the payment conditional upon the post-completion performance of the business. Of course, each corporate transaction is different and will turn on its own individual legal and commercial issues. However, generally, one of three ‘consideration adjustment mechanisms’ will be used by the parties to determine the purchase price of the target business.
In this article we consider the three most common ‘consideration mechanisms’ used in corporate acquisitions – ‘completion accounts’, ‘the locked box’ and ‘earn-outs’. The first two are used to calculate the amount payable by the buyer at completion, whereas earn-outs are different in that they relate to future sums payable by the buyer.
Completion accounts are a set of final accounts produced after the completion of a business sale to show the financial position of the acquired company as at the completion date (or another agreed date). When completion accounts are used, the buyer will usually pay the seller an estimated purchase price amount on the completion date (based on the target company’s historical accounts and management accounts). The completion accounts (prepared post-completion) then allow the estimated valuation of the target company to be finalised (and adjusted) by reference to the actual accounts of the company as at the completion date.
Following agreement of the completion accounts (which can take some time to prepare and agree) the purchase agreement will include the mechanism for the purchase price to be adjusted. This will take account of the difference between the estimated figures used to calculate the consideration paid by the buyer on the completion date (the estimate) and the final amounts confirmed in the completion accounts. The purchase price will then be increased or decreased to reflect the updated position. Such adjustments will usually be subject to limitations (i.e. a maximum amount).
Completion accounts are normally used where there are likely to be substantial changes in the financial position of the target between the terms of the deal being agreed and completion, or where there are regular variations in the assets, profits or working capital of the target business.
Advantages and disadvantages?
An advantage of completion accounts is that they can be used to defer valuation questions until after completion. Where the parties are struggling to agree on a valuation, or if there is a tight deadline, completion accounts can be a good way of getting a transaction across the line in a timely manner. They also allow the purchase price to be based on the actual financial position of the company as at the completion date.
On the other hand, completion accounts can still leave room for dispute. There are certain key provisions that will need to be agreed in the sale agreement, including who prepares the accounts and the accounting methods used to compile the accounts. There can also be disagreement between the buyer and seller when it comes to agreeing the completion accounts themselves (and by extension, the purchase price payable) which can result in delays and an increase in legal and accountancy costs involved in preparing and agreeing the completion accounts.
An alternative to using completion accounts is to use the locked box approach, whereby the parties will agree the consideration based on historical accounts of the target company (the ‘locked box date’). In other words, the parties value the target at a specified date (which is usually a short time before the completion date). Cash, debt and working capital are fixed as at the locked box date and can’t be adjusted unless there is ‘leakage’ – see below.
The seller will give covenants and promises to the buyer to protect the buyer against the risk of cash or assets being removed from the target (or debts being incurred) from the locked box date until completion (‘leakage’). Leakage will typically include the payment of dividends, management bonuses, inter-group payments or returns of capital. A buyer will typically be given a defined period of time within which to make a leakage claim against the seller.
Advantages and disadvantages?
An advantage for both the seller and the buyer is that there can be a greater measure of certainty with the locked box method in that the price is fixed prior to completion to ensure the accuracy of the locked box valuation. Similarly, this approach can lead to some cost savings when compared to the preparation of completion accounts.
A disadvantage for the buyer is that enhanced due diligence will usually be required, particularly on the financial records of the target company. Buyers will also be forced to rely on the various covenants and warranties given by the seller to ensure that value is not stripped from the business between the locked box date and completion. A consequence of this is that negotiations to agree and document these provisions can be lengthy.
The locked box approach is becoming increasingly popular and is often used in a sellers’ market. Where a seller is in a strong commercial position then using a locked box allows them to realise all of the completion payment at completion; when completion accounts are used then some of the completion payment may be held back or put in escrow by the buyer pending agreement of the completion accounts.
Unlike the previous two consideration adjustment structures, an earn-out mechanism calculates an element of the purchase price by reference to the performance of the target company following completion. Traditionally, the buyer will pay a fixed amount of the consideration at completion and the remainder in future instalments once agreed targets (financial or otherwise) have been achieved.
An earn-out arrangement is often used when the seller will remain involved in the business following completion. The seller will thus be motivated to maximise financial performance of the business to in turn maximise their sale proceeds. The buyer will however restrict the seller’s control of the business to ensure that profits cannot be artificially manipulated to increase earn-out returns. Similarly, the seller will want to have certain covenants and promises as to how the buyer will run the business during the earn-out period as it will be in the interests of the buyer to limit profits during the earn-out period.
The formula for calculating the earn-out – and the provisions regarding the conduct of all parties – will need to be carefully considered and included in the sale agreement.
Advantages and disadvantages?
Earn-out arrangements can be attractive to buyers as they can effectively enable the buyer to finance part of the acquisition through future profits generated by the target business. This approach can also allow a buyer to value a target more accurately based on the actual performance of the business following completion.
From a seller’s perspective, earn-outs allow sellers to realise the benefit of selling a profitable business (assuming the profitable business continues to perform well post-completion). This can be particularly useful where the profitability of the business is disputed, or where the sellers think that the business is well positioned to significantly increase profitability (i.e. to mitigate against the risk of effectively selling the business at the wrong time).
However, earn-outs prevent the parties from achieving a ‘clean break’ on completion. Negotiating the precise terms of the earn-out mechanism can be lengthy and costly. The buyer will usually be restricted from running the business un-inhibited due to the sellers continued involvement. This can lead to cultural tensions where a seller is used to making unilateral decisions but having sold the business is now required to collaborate with or even defer entirely to the buyer, especially given that there are potentially large sums of money on the table under the earn-out. The seller will also want to ensure the mechanism is properly structured to ensure that any capital gains tax liability is deferred.
This is a brief, non-exhaustive summary of three common ‘consideration adjustment mechanisms’ used in corporate acquisitions. As stated above, each corporate transaction turns on its own facts and issues, and so it is important that professional legal and financial advice is sought to determine the most appropriate method/s for calculating the purchase price.
If you have any queries in relation to buying or selling a business, please feel free to contact a member of the Michelmores’ Corporate team..
This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.