M&A Vocabulary – Experts explain: Permitted leakage

The reason why the buyer bears the economic risk without legally owning the target company, is the point in time at which the buyer has calculated the purchase price and at which it is determined. In corporate transactions, the purchase price can be determined at different points in time.

On the one hand, the purchase price can be determined based on an exact determination of the company value at the time of the closing, i.e. at the time the legal transfer of ownership to the buyer with effect in rem. In this case, the effective date, on which the purchase price to be paid by the buyer is determined, and the closing date coincide. As the final purchase price is calculated on the closing date, it is generally irrelevant for the buyer's purchase price calculation whether distributions are made to the seller or other outflows of value from the target company take place prior to the closing date. These are considered as part of a purchase price adjustment to the time of completion. 

On the other hand, the purchase price can also be agreed as a fixed purchase price at the time of signing the company purchase agreement. In these cases, the buyer calculates the fixed purchase price based on the company's key figures on a specific economic key date (so-called effective date) in the past (so-called locked box date). The last balance sheet date of the target company is often used (so-called lockedbox mechanism). 

The buyer only becomes the legal owner of the target company (with effect in rem) upon completion of the company purchase agreement, i.e. at a time that may be considerably after the lockedbox date. However, by agreeing the fixed purchase price, the buyer already bears the economic risk from the lockedbox date onwards and the target company has been managed by the seller for the account of the buyer since this time. The buyer must therefore contractually protect himself against outflows of value outside the ordinary course of business, which the buyer did not take into account when determining the purchase price on the basis of past company figures. If, for example, profit distributions were to be made to the seller, related parties or affiliated companies between the lockedbox date and the closing date, this would constitute a unilateral increase in the purchase price for the buyer without the buyer being able to exert any influence. Such inadmissible outflows of value can take many forms, such as the granting of transaction bonuses or payment of transaction costs by the target company, the assumption of guarantees or sureties vis-à-vis the seller or contracts between the target company and the seller and its affiliated companies that do not stand up to the at arm's length principle. 

In order to protect against unplanned outflows of value outside the ordinary course of business when agreeing a fixed purchase price based on historical company figures, the company purchase agreement must therefore contain a guarantee for the period between the effective date and the signing date, with which the seller assures that no outflows of value have taken place during this period that have not occurred in the ordinary course of business or are explicitly specified (so-called no-leakage guarantee). In addition, a so-called no-leakage clause is required, which prohibits outflows of value between the signing date and the closing date. This is an obligation of the seller (so-called covenant) to ensure that no cash outflows occur outside the ordinary course of business, unless these are permitted as permitted leakage in exceptional cases. 

It is important for the buyer that only those items are included as permitted leakage that the buyer has considered in the purchase price calculation. In addition, these items must be precisely defined to avoid disputes later, in particular by type andobject, amount and time of the outflow of funds. 

The seller should note, that a breach of the no-leakage clause can lead to compensation or indemnification obligations depending on the specific provisions in the company purchase agreement. To protect the buyer, it is also sometimes agreed that inadmissible cash outflows of which the buyer becomes aware before the closing date entitle the buyer to a reduction of the purchase price in the amount of the inadmissible outflow of value.

In summary, permitted leakage refers to an exceptionally permissible outflow of value from the target company specified in the company purchase agreement, which takes place at a time when the buyer already bears the economic risk of the target company, but cannot yet control and determine the business activities of the target company due to a lack of legal ownership. The agreement of a permitted leakage always requires the embedding of a no-leakage clause, which prohibits other outflows of funds outside the ordinary course of business between the signing date and the closing date.