Pricing Mechanisms in M&A Deals: to Adjust or to Lock?
The purchase price which a potential investor would be willing to pay to a seller for its business is an essential element of any M&A deal, and it always requires significant effort for the parties to agree how such a purchase price should be determined. This article aims to analyse the two most common mechanisms of price determination — “completion accounts” and “locked box”.
In a completion accounts deal, the parties agree a price which is subject to post-completion adjustment on the basis of various adjustment criteria (usually, actual cash/debt and working capital adjustment, but there may also be a net assets adjustment). In a locked box transaction, the parties agree on a “fixed” price based on a recent historical balance sheet drawn up to an agreed date prior to the signing of the transaction (“locked box date”), whose price is not subject to any post-completion adjustment.
The main difference between the two mechanisms is the date of transfer of the economic risk. When the completion accounts mechanism is used, the economic risk transfers to the buyer on the completion date. By contrast, when using the locked box mechanism, the economic risk and benefits of the business pass to the buyer from the locked box date, i.e. while the target company or the business remains under the seller’s control.
Each mechanism has its own advantages and disadvantages, some of which we analyse below. The ultimate choice of the mechanism by the parties will, however, depend on many factors, including the identity of the parties and their bargaining power, market conditions, financial position of the target, the timing and value of the deal.
The completion accounts mechanism has been traditionally regarded as buyer-friendly. In particular, it gives an opportunity to the buyer to verify the purchase price post-completion and pay for what is actually received. It also gives more comfort and control to the buyer, as the buyer is typically entitled to prepare the first draft of the completion accounts showing the target company’s financial position as at completion, and such preparation takes place post-completion, i.e. at the time when the buyer is already in full control of the business.
At the same time, this mechanism may also be beneficial to the sellers. For example, it may speed up the negotiation of the transaction since the buyer in deals with the price adjustment provisions in the SPA usually requires less extensive financial due diligence pre-signing. Also, it allows the seller to avail itself of the economic benefit of its business up until completion of the deal, since in price adjustment deals the economic benefit passes to the buyer only at completion.
The completion accounts mechanism makes the transaction generally more complicated since it requires agreeing on and drafting a complex set of interlinked provisions in the SPA. Also, it creates a potential for a post-completion dispute between the parties when the seller (or the buyer, if the completion accounts are prepared by the seller) challenges the figures in the completion accounts, and when (absent from the parties’ agreement on the matter) the matter is further referred to an independent dispute resolution forum (most often, a reputable accounting firm). At the end of the day, it may result in additional transaction costs for both parties.
Additionally, the completion accounts structure delays the determination of the final purchase price and may, therefore, be a considerable disadvantage for some sellers (for example, private equity funds or other financial investors) who wish to get certainty on the economic parameters of the deal and complete it as soon as possible.
The two key specific features of the completion accounts structure which require the special attention of the parties are the criteria for the price adjustment and the accounting policies applicable to the preparation of the completion accounts.
The parties should agree on the principles for drawing up and agreeing the completion accounts pre-signing and include those in the SPA. The cash/debt and working capital are the most common criteria for the price adjustment, although the parties may sometimes agree on a full net assets adjustment. The latter involves determining the net asset value of the target company at completion (i.e. deducting the aggregate liabilities of the target company from its aggregate assets). Subject to the criteria chosen for the adjustment, the parties need to make sure that the relevant categories (“cash”, “debt”, “working capital”, or “net assets”) are defined in the SPA in an unambiguous manner. The parties should also ensure as much clarity as possible on the accounting policies applicable to the preparation of the completion accounts.
This approach should maximise certainty and reduce the risk of subjective interpretation, thus preventing post-completion disputes of the parties regarding the treatment of certain completion accounts items.
In a locked box deal, transaction costs are lower compared to deals with price adjustment and, therefore, cost-sensitive parties may find it more beneficial. Also, the locked box gives price certainty at an early stage of the transaction, since the parties agree on the final and fixed purchase price pre-signing and reflect it in the SPA, and allows the parties to avoid the potential complications associated with the post-completion adjustment. These advantages make the locked box structures increasingly popular in recent years.
The locked box structure may be especially attractive to the seller, as it better controls the pricing process due to it being in full control of the target company during the preparation of the locked box accounts.
Finally, in an auction scenario, bidders offering a fixed purchase price payable on the completion date will have a significant competitive advantage.
Given that in locked box deals most of the distributions by the target company (including dividend) will be restricted in the SPA, so as to prevent the extraction of value from the company, the main disadvantage for the seller is that it may lose out financially if the target company generates significant profits after the locked box date.
From the buyer’s perspective, prior to agreeing to a fixed price in the SPA, the buyer must engage in a more extensive financial due diligence compared to the completion accounts structure to get comfortable with the locked box balance sheet based on which the purchase price was actually calculated. Reliance on the sellers’ good faith in the preparation of the locked box balance sheet without conducting proper due diligence may sometimes result in less informed decisions by the buyers (given the lack of information access).
In a locked box transaction, the following key considerations should be carefully thought through by the parties: a) concept of “leakage” and “permitted leakage”; b) limitation of locked box claims; and c) possible interest on the purchase price.
As the economic risk will pass to the buyer, while the target company or the business remains under the seller’s control, the buyer will expect an extensive set of contractual protections in the SPA aimed at preventing the extraction of value from the target company after the locked box date — the so-called “leakage” provisions. The concept of leakage is absolutely crucial to each locked box transaction and is, therefore, always heavily negotiated by the parties. Leakage is commonly coupled with a concept of permitted leakage constituting exceptions to the general rule and outlining, in as much detail as possible, all permitted payments/distributions/etc., the making of which would not be considered a breach of the SPA.
As part of the leakage provisions, the buyer will often expect a “pound-for-pound” indemnity for any leakage occurring after the locked box date, robust warranties (especially in relation to the accuracy of the locked box accounts and/or strict pre-completion covenants). It is common, however, that the buyer’s ability to bring a claim for breach of the locked box provisions is more limited in time than other SPA-related claims (and may typically range from 3 to 18 months post-completion). Furthermore, the locked box claims are usually carved-out from de minimis (the minimum level at which a claim can be made) and may be subject to special liability caps (however, this is agreed by the parties on a case-by-case basis).
Also, in a seller-friendly environment, the sellers sometimes may seek additional compensation by demanding interest on the purchase price accruing from the locked box date to completion. However, such compensation is not common and, therefore, the locked box structure may not be ideal to the sellers of consistently profitable business in deals with a significant gap between the locked box date and completion.
Price adjustment deals are in an absolute majority in the US (in 2016, 86% of all US M&A deals included price adjustment).
In Europe, on the other hand, in the same period 47% of deals contained the price adjustment, and within the remaining 53% of deals made without price adjustment, the use of the locked box mechanism constituted 40%-58% depending on the value of the deal. In European deals with a value of over EUR 100 million, the use of the price adjustment mechanism remained quite popular and constituted 67%.
Tetyana Dovgan is a senior associate and Corporate/M&A practice coordinator at CMS Cameron McKenna Nabarro Olswang,
Vitalii Mainarovych is an associate at CMS Cameron McKenna Nabarro Olswang