The complexity and multitude of factors and external requisites which are not under the control of either party in an M&A transaction mean that significant time can pass between:
- the company's valuation;
- the finalisation of the financials;
- the signing of the share purchase agreement (SPA); and
- the deal's completion.
How the target operates during this time will affect its value. However, several adjustment and pricing mechanisms are available to amend this situation, including completion account, locked-box and novel hybrid mechanisms. This article examines these mechanisms in light of recent developments.
In SPAs with completion account mechanisms and post-closing adjustment clauses, parties agree a provisional price based on:
- an account prior to closing; or
- an estimation of the target's accounts at the closing date, generally on a debt-free, cash-free basis, or at some point on an assumed debt and cash amount.
The price is then adjusted according to the agreed method, which is generally either a working capital, net asset or capital or revenue expenditure adjustment.
As the final price is not certain at signing and further negotiations will occur, the parties (particularly the seller) must give special consideration to the determination of the adjustment method and a clear agreement as to a comparison of the financials. As the final price may be negotiated after the SPA, changes in the target's net financial position may become the subject of renegotiations and possibly a dispute. As much as this fact strengthens the hand of the buyer in terms of nabbing a potential bargain, a seller that is confident of a value hike between signing and completion may also opt for this mechanism.
An alternative to completion accounts is the locked-box mechanism. Under this mechanism, parties agree the precise price at signing, based on accounts of the target which were prepared before the locked-box date and the SPA. As the target's working capital and net financial position is known at signing, there will be no price adjustments. Value extractions, other than those permitted by the buyer, will be deemed leakage and entitle the buyer to reimbursement. Value extraction may come in the form of:
- dividends;
- distributions;
- ex gratia payments to the directors and associated persons; or
- intragroup transactions of a non-commercial nature.
As the parties agree a fixed price, renegotiation of the price is impossible – save for in the event of leakages not permitted by the buyer. This price certainty might be sought after by both the seller and the buyer and protects the seller against 'price chipping' (ie, last-minute bargaining in order to obtain a price reduction) in particular. Because the target's financial structure is locked in and the price is set, the buyer may ask for contractual protections such as:
- representations and warranties on interim accounts; and
- a material adverse change clause if the target's value significantly reduces and the transaction becomes unacceptable.
Further, under the locked-box mechanism, the buyer assumes the risk of overpaying for the company and the seller assumes the risk of underselling.
Parties may combine the appropriate features of the locked-box and completion account mechanisms to create a more expedient process that better suits their particular transaction. An elementary example of such a combined mechanism is when the parties agree a completion account mechanism from signing until an interim account and a locked-box mechanism thereafter. This hybrid mechanism proves useful where parties agree a locked-box mechanism in principle, but specific events or measures are unforeseeable and the opportunity to renegotiate the price before 'locking the box' provides reassurance to both parties.
Transfer of risk and economic interest
Transfer of risk and reward is particularly important in the context of the COVID-19 pandemic where risks abound and the prospect of a substantial reward is slim. The risk and reward passes to the buyer on the locked-box date under the locked-box mechanism and on the date of the initial payment at closing under the completion account mechanism. As the locked-box date is prior to the handing over of the target and the seller resumes management of the operations, the parties may agree to pay the seller compensation until closing by charging interest on the fixed price or by making periodic fixed payments.
As the COVID-19 pandemic has resulted in the closure of facilities, the halting of business operations and market disruption, parties may agree guarantees under the locked-box mechanism that permit extraordinary indebtment (ie, not in the ordinary course of the target's business) to a certain point, but provide that the buyer will be compensated for any further increase in the target's net financial position. Buyers will likely be inclined to use the completion account mechanism as the risk passes later on in the process and balance sheets might not be robust or reliable enough for a locked-box mechanism during the pandemic. However, the locked-box mechanism provides for the target's swift integration into the buyer's other operations. The same perspective also holds true for sellers, as it sellers which assume the risk of value deterioration in completion accounts. A locked-box mechanism would be more favourable to the seller as the price is set and the buyer bears the risk of impaired trade interests.
In choosing a pricing mechanism, careful consideration must be given to the characteristics of the target, the financing of the transaction and the legalities and peculiarities of the market. The use of further warranties and protective measures during the pandemic is highly advised. Regardless of the chosen mechanism, its application requires experience in the relevant country's legislation and careful diligence both when drafting the agreement and executing the transaction.
Mert Ceylan, legal intern, contributed to the preparation of this article.
