Cheque-in-a-Box: Purchase Price Mechanisms in M&A Transactions

Choosing the right purchase price mechanism is a significant aspect of structuring an M&A transaction.  Importantly, how purchase price is structured, and the mechanisms used to establish the purchase price, directly impact the final consideration amount in the deal as well as the risks allocated between the deal participants.

There are several purchase price mechanism options in M&A transactions – this article focuses primarily on completion accounts and locked box mechanisms, being the two most common mechanisms in an M&A transaction.  Whilst the general inclination for each deal participant is, naturally, to select the mechanism which enables them to maximise their respective value out of the deal, there are ultimately a number of factors that can practically impact whether a completion accounts or locked box mechanism is selected.  These factors are such as:

  • The seller’s leverage and bargaining power – e.g., a seller engaging multiple prospective bidders on a competitive process is likely to have greater leverage to seek locked box mechanism, which is more seller-friendly;
  • The risk appetites of respective deal participants – e.g. the extent of risks that an acquirer is willing to assume with respect to the target company and its actual / final value, having regard to the nature of the target company’s business, level of certainty / uncertainty of the target company’s financial position and future performance, etc;
  • Complexity of the deal structure – e.g., completion accounts may be more appropriate in respect of high-complexity deals involving multiple business units, intercompany transactions or complex tax issues;
  • Deal timeline – e.g., if there is time pressure for both parties to complete the deal, locked box mechanism may be more appropriate to deliver efficient deal completion.

In identifying and negotiating the best purchase price mechanism, deal participants ought to carefully consider the specifics of their respective deal and their positions with respect to the above factors.  Ultimately, regardless of the purchase price mechanism selected, deal participants can also seek implementations of appropriate safeguards in a Share Purchase Agreement (SPA) entered into between the parties to reduce risks and enhance their positions with respect to the transaction.

We briefly summarise the purchase price mechanism options as follows.

Completion accounts

Completion accounts mechanism involves the adjustment of purchase price on basis of the actual financial position of the target company (this typically occurs post-completion), as determined by an agreed-upon financial principles and conditions between the deal participants.  In such transactions, deal participants will agree to an estimated financial position of the target company at completion (also known as the ‘enterprise value’), which would subsequently be “trued-up” against the target company’s actual financial position post-completion by way of adjustments.  On this basis, in an acquirer’s perspective, purchase price established via completion accounts offer a more accurate and fairer reflection of a target company’s value on basis of the company’s actual financial circumstances.  Further, given the adjustable nature of the purchase price, risks in relation to changes or volatility in respect of the target company’s financial position post-completion are also distributed between deal participants (rather than primarily on the acquirer in a locked box mechanism).  Completion accounts are therefore more acquirer-friendly, but it can introduce a curveball into the transaction in a seller’s perspective if the target company’s actual financial position results in significant adjustments against the seller.

The downside to completion accounts is that they are complex and time-consuming to negotiate and execute.  At the SPA-negotiations stage, deal participants would need to negotiate and work towards a mutually agreed position in respect of accounting principles and financial metrics to be used in preparing the completion accounts as well as the scope of the completion accounts (e.g. what constitutes as cash and debt in the target company), given that any adjustments would impact the scope and value of the final purchase price.  In addition, deal participants should also seek to implement relevant warranties and indemnities in the SPA in the context of their respective risks in connection with the completion accounts.  Deal participants are also required to work together post-completion to prepare and finalise completion accounts.

Locked Box Mechanism

Locked box mechanism involves deal participants agreeing to a fixed purchase price without undergoing any post-completion adjustments, determined on basis of the target company’s historical financial statements.  Thus, the purchase price is “locked” on basis of the target company’s financial position at a point in time, making the mechanism more seller-friendly given the certainty around purchase price.

Whilst locked box mechanism offers simplicity and efficiency with respect to deal completion, the mechanism presents certain risks in an acquirer’s perspective.  Relevantly, given that historical financial statements of the target company are relied upon to derive the purchase price, risks of changes or volatility to a target company’s financial position after the locked box date are not appropriately accounted for in the mechanism.

In a locked box transaction, acquirers can seek to minimise their risks with respect to the transaction in a number of ways, such as:

  • Undertaking careful due diligence of the target company, particularly financial due diligence;
  • Negotiating comprehensive warranties around the conduct of the target company’s business pre-completion to ensure preservation of the target company’s profitability;
  • Implementing protective terms surrounding “leakages” with respect to the target company’s value to guard against any value erosion in the target company at completion;
  • Seeking seller’s indemnities in respect of substantial value “leakages” in the target company.

 Conclusion

The selection of purchase price mechanism directly impacts consideration value for each deal participant.  Therefore, it is important that deal participants carefully consider the specifics of the deal and their respective positions to select the mechanism appropriate for their transaction (having regard to economic interests and risk appetite).   In addition, regardless of the chosen mechanism, deal participants must take care to negotiate and seek implementation of protective terms to address risks against them under an SPA.

 

This article was prepared with the assistance of Elvira Limpid.

 

Contact our Corporate & Commercial Law Team for any queries regarding purchase price mechanisms in M&A transactions.

 

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