Two of the main mechanisms in negotiated M&A transactions when structuring the consideration and the deal with purchase price adjustments are (i) the locked-box mechanism and (ii) the price subject to adjustment based on completion accounts.
Locked-box mechanism
In the locked-box mechanism, a value date (the ‘locked-box date’) is established. This is usually a relatively recent date between the last annual balance sheet date and the date of signing the share purchase agreement (SPA).
When using this mechanism, the consideration is finalised and set upfront in the SPA by reference to the locked-box date and interest is usually charged from the locked-box date down to completion in order to recognise that the vendor has foregone profits.
Significant governance controls will normally be imposed on the vendor to determine how the business will need to be run from the date of signing the SPA up to the completion date. To this end, extensive and prescriptive protections will have to be included in the SPA to prevent value leakage out of the target company after signing. The vendor will have to warrant that no leakage will occur between the locked-box date and the completion date and contractual constraints will have to be imposed in order to compensate the purchaser for any leakage that cannot be deemed as ‘permitted leakage’. Agreeing to what is or is not leakage or permitted leakage will form an important part of the negotiations. ‘Leakage’ is any transfer of value from the target company to the vendor between the locked-box date and the completion date. For example, ‘leakage’ often includes payment of dividends and of management bonuses, payments to directors or to connected persons, fees and expenses incurred in connection with the sale and paid by the target company, or any waivers of amounts due from the vendor to the target company. ‘Permitted leakage’, on the other hand, includes those categories of payments which are necessary to allow the target company to continue operating in the ordinary course of business. For example, ‘permitted leakage’ will typically include intra-group payments on an arm’s length basis and on terms consistent with past practices, staff wages, and any other identified items which have been agreed by the parties and factored into the price already.
Furthermore, those profits or losses made by the target company after the locked-box date will normally arise to the benefit or detriment of the purchaser, which, by having paid a fixed price, will assume all trading risks and rewards of the target company after the locked-box date.
Price subject to post-closing adjustment based on balance-sheet
In some jurisdictions such as the US, locked-box mechanisms are rare and post-completion price adjustments are more common. Using this method, purchase prices may be subject to adjustments based on a balance-sheet as of completion, or made at closing based on the vendor’s estimate and followed by an adjustment post-completion, for instance.
In these cases, working capital adjustment is the most common adjustment metric. Other metrics, such as net debt or minimum cash, are less popular. Whatever the chosen metrics, it is crucial to focus on these financial definitions and ensure that there is no double-counting. For example, if there is a post-closing tax indemnity, but tax liabilities have also been included in the working capital calculation, there is a risk of ending end up with adjustments under both provisions.
Compared with relying on warranties and indemnification provisions, price adjustments ensure that thresholds for specific key financing variables can be specifically identified and directly addressed very quickly, without the purchaser having to incur the time, expenses and other hurdles of establishing and bringing a warranty claim against the vendor. On the contrary, price adjustments have an entirely different focus than a breach of warranties, since price adjustments are not intended to ‘penalise’ the vendor beyond the adjustments, even if at the end a variable proves significantly lower than that expected at completion.
It must be kept in mind, though, that in certain jurisdictions such as India, post-completion price adjustments are not possible for cross-border transactions, since the share valuations must always comply with certain mandatory rules set forth by the relevant Indian Authorities (which include the Reserve Bank of India), and which do not permit the parties to the SPA to freely adjust the price after completion.
On the other hand, completion accounts will normally be prepared by the purchaser’s accountants. However, determining which accounting policies and principles will be used in order to prepare these accounts will be much more critical than which party is entitled to prepare the first draft completion accounts. Furthermore, price adjustment clauses usually include specific arbitration provisions whereby accounting disputes will be resolved by an independent accounting expert, acting as an arbitrator and thus providing a final resolution to the dispute. For this purpose it is essential that the accounting criteria and references that the expert will have to use are both clear and capable of execution.
Price adjustment indemnity
When the parties agree to a holdback as an indemnity for price adjustments, purchasers will normally argue that a holdback for an adjustment and an indemnity escrow for breaches of the representations and warranties are two different devices, dealing with two separate valuation issues, and that a short term price adjustment holdback should not deplete the indemnity escrow established to address warranty claims. On the contrary, vendors will typically argue that there is no reason to have two separate escrows. In the end, the creditworthiness of the vendor is the most relevant factor to take into account when considering whether an escrow is necessary.
Sergio Sánchez Solé is a partner at Garrigues. He can be contacted on +34 93 253 3700 or by email: sergio.sanchez.sole@garrigues.com.
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