In the realm of M&A and private equity (PE), pricing a deal is not an exact science. Despite in-depth financial, business and legal due diligence, the buyer can never be certain that they are not overvaluing or undervaluing the target. Add a pandemic to the mix, and this uncertainty as to valuations is further magnified.
Locked-box versus closing accounts adjustment
Traditionally, the two preferred pricing models in M&A deals were the locked-box mechanism and the closing accounts adjustment mechanism.
Under the locked-box mechanism, parties freeze the purchase price at signing based on the last available balance sheet and there is no adjustment to the price after closing. As an exception, parties may agree price reductions in respect of a few specific pre-agreed items that are likely to cause 'leakage' of the target's value between signing and closing.
By contrast, under the closing accounts adjustment mechanism, parties agree a tentative purchase price at signing based on a value of the target's business (eg, enterprise value) and adjust the purchase price after closing based on a 'true up' of actual cash, debt and working capital.
While both models have their proponents and opponents, the locked-box model is generally seen as seller friendly, while the closing accounts model is seen by some as neutral and by others as buyer friendly. Those who favour the locked-box mechanism highlight that it is more efficient and simpler and brings certainty to the pricing of the deal. However, the closing-accounts adjustment mechanism is more precise than the locked-box mechanism since it captures the true value of a business at closing and is suited to deals of all levels of complexity, including:
- deals involving start-ups that may not have many historical balance sheets;
- 'hiving-off deals', where an undertaking is hived off from another company; and
- deals in which there is a long gap between signing and closing due to unavoidable circumstances, during which the target's valuation could change.
The 2008 financial crisis fueled caution in deal making and led traditional PE and M&A players to lean towards the closing accounts adjustment mechanism. However, in the four-to-five-year period immediately preceding the COVID-19 pandemic, the ease and efficiency of the locked-box mechanism attracted investors, especially in deals that did not involve serious valuation uncertainties. However, the pandemic has introduced several factors to the valuation process and, as a result, there is a renewed interest in the closing accounts adjustment mechanism and other post-closing adjustment mechanisms.
While the closing accounts adjustment mechanism is one variant of the post-closing purchase price adjustment, there are other forms of post-closing adjustment, not all of which are adjustments to the purchase price. If the trends since March 2020 are anything to go by, many of these post-closing adjustment mechanisms may come out of the woodwork in the coming months. In the Indian context, post-closing adjustment in cross-border deals is regulated and such mechanisms should be carefully crafted within the contours permitted by the applicable regulations.
This article takes a closer look at various post-closing adjustment mechanisms used in PE and M&A deals involving Indian private companies.
Deferred consideration is typically implemented in India through a 'holdback' structure, where the seller is paid less than the full purchase consideration at closing and the balance is paid subsequently on the fulfilment of certain conditions or the achievement of certain milestones by the seller or the target. Until 2016, deferred consideration was prohibited in India in cross-border share transfers. At present, the Foreign Exchange Management Act (FEMA) permits deferred consideration in share transfers between a person resident in India and a person resident outside India (cross-border transfer), subject to the following three riders:
- no more than 25% of the total consideration may be deferred;
- the deferral cannot be for more than 18 months from the execution date of the share purchase agreement (SPA); and
- the total consideration finally paid should be compliant with the applicable pricing guidelines.
According to the pricing guidelines, in relation to shares of an unlisted Indian company, the reference price is the price of such shares based on an arm's-length valuation carried out in accordance with any internationally accepted pricing methodology (fair market value). Where the buyer is the foreign party, the purchase price should not be less than the fair market value of the shares; where the seller is the foreign party, the purchase price should not be more than the fair market value. This third rider leaves little elbow room for foreign parties, even when the deferral of consideration is linked to a genuine performance milestone or condition subsequent. The flexibility allowed for any internationally accepted pricing methodology cannot always accommodate parties' full commercial intent in a cross-border transfer. This has led to certain creative structures.
One post-closing adjustment mechanism used in M&A transactions is where specific sources of the target's value depletion are identified as indemnity events. A portion of the purchase consideration in the deal is parked in an escrow account at closing so that it can serve as a source of recovery for the buyer towards any indemnity claims against the seller or the company. Unused amounts are released to the seller after a certain period. Under FEMA, the above three riders apply to indemnity holdbacks with or without escrows in cross-border transfers. In such deals, if the original purchase consideration does not substantially vary from the fair market value, there would be little scope to enforce indemnity payouts even if an escrow arrangement were to be created since the total consideration finally paid would not meet the fair market value requirement. There are two mainstream views in the Indian market about how the three riders should be implemented:
- One view suggests that in SPAs, indemnity in favour of the foreign party should be capped at a maximum of 25% of the total consideration and indemnity obligations cannot be enforced beyond 18 months from the SPA's execution date.
- The other view is that the SPA can legislate for indemnity payouts beyond the cap of 25% of the total purchase consideration and for enforcement of such indemnity even beyond the 18-month period, but any such action beyond what is explicitly allowed requires specific regulatory approval before it can be effected, which can be obtained at such time.
Arbitral tribunals seated outside India may often give effect to indemnity arrangements by recognising the primacy of the contracting parties' intention. However, in the absence of any known instance in the public domain of regulatory approval being granted for payment of indemnity amounts to foreign parties in excess of the cap, the latter view remains untested.
Earn-outs are a popular mechanism typically used to bridge the differences between the buyer's and seller's valuations of a business. In theory, most earn-outs follow the model under which the initial purchase consideration is less than the agreed purchase price and the remainder is linked to certain milestones or the target's achievement of certain performance metrics during a fixed period following closure. The most common earn-out structure used in India consists of the buyer acquiring the control of the target and retaining the seller as a consultant, key employee or minority shareholder. Under this structure, the earn-out is a cash payout linked to the target achieving revenue milestones such as:
- earnings before interest, taxes, depreciation and amortisation (EBITDA) multiples;
- sales targets;
- the creation of intellectual property in the target; or
- other performance metrics.
Parties should agree and provide for mechanisms to ensure that during the run-up to the milestone due date, the party in control of the target cannot take actions that frustrate the seller's ability to ensure that the earn-out milestones are achieved.
Another rarer alternative involves the issuance of redeemable preference shares (RPS), a class of instrument not included in the definition of 'equity instruments' under FEMA, which are thus issued to Indian and not foreign parties. In a typical structure involving RPS, at closing, a majority or the entire shareholding of the target is acquired by the purchaser and RPS are issued to the seller or the erstwhile promoter. The terms of the RPS will state that if the seller meets certain milestones, the RPS will be redeemed by the company by paying a redemption premium and that if the seller fails to meet the milestones within a specified period, the RPS will be redeemable at face value.
PE deals often contain earn-out structures referred to as 'upside sharing'. The contracts will stipulate a share in profits or 'upside' for the promoter-seller based on the return on investment received by the PE investor at the time of its exit and the timing of such exit (the faster the exit, the higher the upside). The earn-out structures may have an upside waterfall with different upside percentages linked to various exit periods and an internal rate of return ranges. Such arrangements can alternatively be implemented through a put or call option on permitted equity instruments held by Indian promoters. If the promoters meet the performance targets, the option price will be higher than the fair value. The strong financial incentive for promoters in this structure often helps to co-opt them into facilitating an early and profitable exit for the investor.
Sometimes the 'upside' in a deal is a higher shareholding for the promoter instead of a cash component. This can be structured by using compulsorily convertible preference shares or debentures. If these instruments are issued to investors, their conversion ratios will be such that they will convert into a higher number of equity shares if the promoters fail to meet certain performance milestones or into fewer equity shares if the promoters meet the performance milestones. This ensures an upside in terms of a higher shareholding in the company for the promoters if the milestones are met and a lower shareholding in the company if they are not. When issuing convertible instruments to persons resident outside India, it should be ensured that even in a scenario in which the maximum number of shares results in conversion, the price at the time of conversion should not be less than the fair value when the convertibles were issued.
Buyers' risk aversion in PE and M&A deals, the regulatory strictures on escrow and indemnity holdbacks, the growing popularity of seller-led and banker-led sales processes through bids and sellers' reluctance to have their consideration deferred or locked in led to the creation of warranty and indemnity (W&I) insurance. A seller or buyer may take out a W&I insurance policy, which offers cover to the indemnified party against any breaches of warranties that were not disclosed or discovered through the buyer's due diligence. W&I insurance is tailored to situations in which a sale happens through an auction and in trade-sale exits by PE funds that are principally opposed to offering warranties when selling their stake. Despite the advantages that it offers, due to the high cost of the product, W&I insurance continues to be an exception rather than the norm in small to medium-sized deals in India. However, this may be set to change.
The process of closing-accounts adjustment is rarely a pleasant experience for either party to a deal. Nonetheless, depending on factors such as the relative bargaining strengths of the parties to the deal and which party will retain control over the target after closing, adjustments and earn-outs are often necessary. When drafting contracts which provide for post-closing adjustments and earn-outs, the need for clarity in computing metrics, defining milestones and detailing mechanisms to ascertain the achievement of the milestones cannot be overemphasised. The flexibility that is allowed under accounting standards in computing metrics such as EBITDA and a buyer's ability to disrupt the seller's attempts to achieve earn-out milestones can often lead to disputes between parties. Post-closing adjustments currently seem to be the flavour of the day among investors, but it is unclear whether this too is a passing phase.
