An alternative purchase price mechanism for M&A transactions
16 Sep 2019
This article examines an alternative to the two predominant purchase price mechanisms used in M&A transactions in South Africa. When applied correctly, it leads to an expedited determination of the final purchase price and allows for flexibility regarding the timing of closing. In order to explore this alternative mechanism, a brief discussion of two traditional pricing mechanisms and their pitfalls are set out below.
Completion accounts and the locked box are the two predominant mechanisms used to determine a purchase price in relation to an acquisition. The completion accounts mechanism involves the adjustment of an agreed base purchase price by the net debt of the target and variations in its working capital as at the closing date. The locked box mechanism, on the other hand, involves the calculation of the purchase price on the basis of the latest (audited) balance sheet of the target and interest payments on such purchase price for the period between the locked box date (balance sheet date) and the closing date. The locked box mechanism is perceived as a “seller friendly” pricing mechanism as there is no opportunity to adjust the purchase price, save for breaches of warranties and/or anti-leakage provisions. The completion accounts mechanism is perceived as a “purchaser friendly” pricing mechanism as it affords the purchaser an opportunity to interrogate the financials of the target and thereafter adjust the purchase price after closing.
Completion accounts mechanism
A purchase price, as determined by completion accounts, is, on a simplified basis, understood to be calculated as follows: base purchase price, plus cash, less debt, plus excess or less shortfall in working capital. The advantage of this mechanism is that the balance sheet items required to calculate the equity value and thereby the purchase price are determined as at the closing date. This mechanism is more accurate than the locked box approach (discussed below), which, through the interest component, contains an element of approximation/estimation of value growth in the target between signature and closing.
The disadvantages of this mechanism are that:
- it is often difficult for the parties to agree on the individual items constituting the debt, cash (and cash equivalents), working capital, as well as the target working capital. Given that these items are to be determined on the basis of a balance sheet as at closing, the parties are typically required to close the transaction at the end of a month, which may delay closing;
the balance sheet can only be prepared after closing.
- Consequently, there is often a substantial time period between closing and determination of the final purchase price, which may prove even longer in the event that the parties dispute the accuracy of the closing balance sheet; and
- from the perspective of the seller, the disadvantage is that the purchaser controls the target post-closing of the transaction and therefore only the purchaser is able to prepare the closing balance sheet, albeit that the seller has the opportunity to review and dispute the balance sheet.
Locked box mechanism
Given the disadvantages of the completion accounts mechanism, the locked box mechanism has become increasingly popular. Under this mechanism, a purchaser submits a purchase price bid on the basis of the target’s latest available financial statements. The seller is compensated for profits made by the target between the date of the locked box balance sheet and closing, in the form of interest.
As the purchaser calculates the purchase price retrospectively on the basis of available data (most recent financials), it can offer, as a purchase price, the equity value of the target it considers appropriate. As such, there is no need to determine the equity value as at the closing date based on an interim balance sheet. Furthermore, there will be no discussions as to the balance sheet items by which the enterprise value must be adjusted in order to obtain the equity value.
Despite these advantages, the parties are often unable to utilise this mechanism, particularly if they perceive that there will be a substantial period between the last balance sheet date and the closing date (and if the target is highly profitable). The primary reason for this is that the parties are often unable to agree on an appropriate interest rate for the period between the balance sheet date and the closing date.
A seller could argue that the basis for the interest charge is to receive compensation for profits generated by the target between the balance sheet date and the closing date, and could therefore demand a corresponding interest rate. The purchaser could argue that it has borne the economic risk of the target since the last balance sheet date because the purchase price was calculated as at that date, and therefore, the purchaser should be entitled to the profits. Consequently, the interest rate should be that of a secure alternative investment (e.g. fixed-term deposits).
An alternative to the above pricing mechanisms is that the parties agree to determine the purchase price in the form of the target’s equity value as of a balance sheet date between the date of the latest audited financial statements and the closing date and on the interest on such purchase price until the closing. The appropriate effective date for the determination of the purchase price depends on the circumstances of the transaction (whether the target requires some lead time for the preparation of the interim balance sheet, the expected time period between signature date and closing date etc.).
The sale agreement would then need to provide that the purchase price of the target be determined as of the appropriate effective date. In order to do this, the target’s cash and cash equivalents, financial debt, and working-capital excess or shortfall are determined on the basis of an interim balance sheet, and thereafter the final purchase price (equity value) is derived from that base purchase price (enterprise value). The interim balance sheet will be prepared by the seller, as the seller still controls the target, which will be coupled with an appropriate procedure for the review of the balance sheet by the purchaser. The purchase price then bears interest for the period between the interim balance sheet date and the closing.
Despite this mechanism requiring the parties to agree on the individual positions of the balance sheet items (i.e. cash, cash equivalents, debt, and working capital) and to prepare an interim balance sheet, it has several advantages. An advantage to the seller is that it can control the preparation of the interim balance sheet. This mechanism eliminates the need to close the transaction at the end of a month. With effective date for the interim balance sheet being prior to the closing date there is sufficient time to start preparing and reviewing the balance sheet prior thereto. Consequently, the procedure (and thus the determination of the final purchase price) is considerably quicker than if the balance sheet had to be prepared post-closing.
The purchase price is determined as of an effective date later than the date of the last audited financial statements. Therefore, the profits generated by the target until the interim balance sheet date are directly taken into account in the calculation of the purchase price rather than being compensated on a lump-sum basis through interest payments. At the same time, the period during which the purchase price bears interest is much shorter, so the relevance of the interest to the total purchase price decreases and the parties are more likely to determine an interest rate acceptable to both of them.
In summary, the alternative pricing mechanism set out above provides an advantage to the seller in that the seller, rather than the purchaser, can prepare the balance sheet required for the determination of the final purchase price. Further, due to the relatively short period between the interim balance sheet date and the closing, the parties will be more likely to agree on an interest rate for the purchase price.
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