Purchase price determination in company acquisitions

For the seller of a company, it is of central importance to be paid – after the end of the negotiations – the purchase price originally agreed with the buyer. To ensure this, it is in the seller's interest to agree on a fixed price that will not be adjusted later on. By contrast, the buy-side usually prefers a variable purchase price. In this scenario, a preliminary purchase price is normally paid first and is usually determined on the basis of valuation methods commonly used in practice. This is usually done on the basis of already existing annual financial statements. The seller's shares are typically transferred to the buyer upon payment of the preliminary purchase price. In order to determine the final purchase price, closing accounts (interim financial statements or annual financial state-ments) are then prepared as of the date of finalizing the acquisition agreement, i.e. the date on which the shares are transferred to the buyer. On this basis, the purchase price is then adjusted, if necessary. Factors that are taken into account for adjustment purposes include net cash (cash and debt free), often net current assets and sometimes also equity. A purchase price is adjusted if the values deviate from the items based on which the preliminary purchase price was determined. It is therefore of central importance to define cash items, liabilities and also the working capital. Whether the purchase price is later reduced or increased is a question of the negotiating position of the seller.

Purchase price adjustment mechanisms often come with disadvantages for the seller. In this scenario, the seller is still entitled to the net cash generated up until the closing date. Nonetheless, it is the buyer who controls the purchase price adjustment process because the closing accounts are prepared under his super-vision after the closing date, he determines the purchase price adjustment amount and the seller is often on the defensive if he wishes to object to the proposed adjustment amount assuming the objection is substantiated.

Regarding the issue of possible disputes, the parties usually agree on a dispute resolution mechanism, but this can be time-consuming and cost-intensive. In addition, to secure the amount to be adjusted, if any, the buyer normally does not pay the full amount of the preliminary purchase price immediately, but retains part of it. Finally, the seller bears the risk of any negative developments occurring up until the closing date, as a result of which the preliminary purchase price agreed upon when signing the agreement and the final purchase price may differ considerably to the disadvantage of the seller.

To avoid these disadvantages, the so-called locked box mechanism has been developed. With this mechanism, the parties agree on a fixed purchase price based on the last annual financial statements, which is not subject to any adjustments (locked box). In this context, it is assumed that between the last balance sheet date, on which the fixed purchase price is based, and the closing date, no funds are transferred by the company to the seller and the related parties. In economic terms, the buyer thus takes over the company with its value as from the last balance sheet date. The buyer is entitled to the profits generated during this period, but he must also bear any losses. As compensation for this, the parties often agree that interest will be computed on the purchase price as from the last balance sheet date.

A central element of the locked box mechanism in this context is that the seller guarantees or undertakes to ensure that between the locked box balance sheet date and the closing date the company only operates in the ordinary course of business and that no unpermitted liquidity is transferred to the seller and related parties and no such obligations exist (no leakage). Unpermitted outflows of funds include, for example, profit distributions, capital repayments, payments of transaction bonuses and forgiveness of debts or liabilities of the seller. The only permitted liquidity outflows are those that occur in the ordinary course of business, such as the repayment of financial liabilities to the seller or contractually agreed payments arising from service contracts.

Furthermore, in addition to general balance sheet warranties, the buyer often insists on specific covenants regarding selected individual balance sheet items, as the buyer relies on the balance sheet prepared by the seller and has no possibility to adjust the purchase price based on accounts prepared as of the closing date. Under the locked box mechanism, the fixed purchase price is usually agreed based on the last annual financial statements of the company or financial statements prepared specifically as of a date prior to the signing of the agreement.

Conclusion

The locked box mechanism is recommendable mainly for the sell-side. The main advantage is that the purchase price is not adjusted after the closing date. This ensures “price certainty”. Thus, post-completion payment obligations for the seller can still only arise from warranty or indemnity obligations or other breaches of contractual duties. Another advantage can be that no interim financial statements have to be prepared as of the closing date and this can help avoid any cost-intensive and time-consuming disputes about this issue and about the purchase price adjustment. For this, however, up-to-date and audited financial statements must be available as of the date of signing the agreement, on the basis of which the fixed purchase price can be determined.

From the buyer's point of view, it is advantageous to agree on a preliminary purchase price and adjust the purchase price in the course of the transaction. With such a flexible solution, any negative business developments taking place in the period between the locked box balance sheet date and the closing date can be taken into account. In the locked box system, it is the buyer who bears the risk of negative business developments – i.e. during a period in which he had no control over the company. However, if the seller is willing to guarantee that he has run the company in the ordinary course of business and that there have been no unpermitted outflows of funds, this risk for the buyer is relatively low and often bearable if appropriate contractual arrangements are made. In addition to the business risk, however, the buyer also bears the risk of negative market developments. Buyers sometimes try to counter this risk by agreeing the so-called “material adverse change” (MAC) clauses.

Apart from the fact that many sellers do not agree to MAC clauses, such clauses offer only limited protection, as they are usually conceptualised to address only serious negative developments. However, it should be noted that in the uncertain times of the corona virus pandemic, buyers sometimes try to minimize the risk of negative developments or let it remain entirely with the seller not least by agreeing on closing accounts and MAC clauses. Locked box systems had caught up on popularity with purchase price adjustment systems before the outbreak of the corona virus pandemic and are also frequently agreed in bidding processes. It remains to be seen whether this will continue in times of the corona virus. In the end, however, it is a question of the seller's bargaining power whether he is able to enforce the locked box system.