Purchase Price Provisions in M&A Transactions

One of the most important areas of regulation in the acquisition of a company is the purchase price provisions. This is an extremely complex issue in which various aspects have to be considered. In addition, the opposing perspectives of buyer and seller have to be reconciled. In this respect, various basic models and approaches have become established in M&A practice. These vary in complexity so that correspondingly complex procedures should only be applied in larger transactions, while others are more suitable for medium-sized company sales. A distinction must be made between regulations that govern the determination of the purchase price and those that define the payment modalities.

1. Fixed purchase price

The fixed purchase price is straightforward, at least in the first step. In this respect, an economic reference date in the past is defined, and the seller and buyer agree on a specific company value at this point in time. A fixed purchase price for the company is then determined based on this company’s value. In determining the enterprise value, the parties are usually guided by the last available annual financial statements.

The costs of preparing interim financial statements are often not economical in smaller transactions and should be avoided. It is clear that this approach, while simple, has certain limitations and risks. The economic cut-off date should not be too far in advance of the actual transfer of the business to the buyer. Otherwise, the value at the time of transfer may already have moved far away from the value determined at the economic reference date. Therefore, if the annual accounts are to be used as a basis, as is usually the case, the transaction should not be too far removed in time from the preparation of the same.

If a fixed price is used, the buyer must also prevent any outflows between the economic cut-off date and the company’s transfer that would reduce the value of the company. In this respect, the buyer is contractually bound by strict behavioural requirements for the period between the economic reference date and the transfer of the business. These are the so-called “representations” relating to the past and the so-called “covenants” relating to the future. These future-related requirements create a legal framework within which the seller may operate until the economic closing date and which is intended to prevent manipulation at the buyer’s expense until he can control the company himself. In US transaction practice, the term “locked box” is in place for this purpose.

Purchase price adjustment clauses – overview

The background to purchase price adjustment clauses is that the contracting parties do not have the data necessary for a concrete calculation at the time of negotiation of the purchase price. These often only result from a balance sheet that has yet to be drawn up. In transaction practice, the annual financial statements are preferably used to avoid the costs of preparing interim financial statements.

The parties then negotiate a purchase price formula and a provisional purchase price in the abstract, which is calculated or adjusted in concrete terms after the relevant balance sheet is available based on the balance sheet values contained therein. Which purchase price formula is to be used as a basis is a matter of negotiation, and in this respect, there is no generally applicable procedure; the various methods are presented below.

In practice, agreement on the purchase price mechanism should be reached as early as possible, i.e., already in the preparatory documentation of the basic economic agreement in the letter of intent (LoI) or term sheet. Otherwise, there is a risk that the company acquisition will fail at this fundamental point after considerable time and costs have already been invested in the sales process.

2. Equity guarantee

A method that dominated in Germany, at least in the past, is the adjustment of the purchase price based on equity. Here, a fixed purchase price is first set based on already available balance sheets. This is then adjusted later by how the equity capital determined in the final decisive balance sheet is higher or lower. The seller thus provides an “equity guarantee” on the fixed purchase price. This method is rarely used today, especially in transactions involving private equity investors.

3. Cash-free – Debt-free

A purchase price adjustment under the keyword “cash-free – debt-free” is usually only useful in larger corporate transactions, as it is typically costly and complex. The company is treated as if it had neither cash (“cash-free”) nor debt (“debt-free”). The company’s value is then regularly determined based on a so-called “discounted cash flow” or “DCF” method or based on an income capitalisation approach recognised by international accounting standards.

The assumptions “cash-free – debt-free” are intended to help neutralise the influence of the different characteristics of each company’s liquidity and financing situation. Any manipulation by the seller at the expense of the buyer is then regularly prevented by a contractually stipulated adjustment of the purchase price in relation to the change in net working capital (so-called “working capital adjustments”). Thus, the seller should not be able to “artificially” increase cash with an effect on the purchase price, such as delayed payments from suppliers or the sale of customer receivables by way of factoring. In this respect, many circumstances have to be considered during the purchase contract negotiations, and their treatment has to be stipulated contractually. The resulting complexity is regularly not justifiable for smaller to medium-sized company sales so that a purchase price adjustment on this basis is ruled out.

4. Earn-out – the variable purchase price

A variable purchase price adjustment using “earn-out” clauses can help to reconcile different price expectations of a seller and buyer in a company acquisition. The purchase price is then made up of a fixed and a variable part. However, the variable part must first be earned. Otherwise, it is cancelled without replacement. This is particularly applicable in situations where the selling entrepreneur remains connected to the company, such as managing director or consultant.

Example: The selling shareholder-manager is to remain in the company after the transfer of the shares and will continue to steer its fortunes. He will only receive part of the purchase price if he achieves the defined economic goals.

The reference framework for these economic goals can be, for example, turnover, gross profit, EBIT, EBITDA, or net profit, but also the number of newly acquired customers or production quantities. In practice, EBITDA is widely used. In any case, the mechanism should be well thought out and regulated in as much detail as possible to avoid disputes. If disagreements do arise, an accountant is usually called in as an arbitrator.

Earn-out clauses – good for the buyer

Earn-out clauses primarily serve the buyer because:

• He shifts part of his economic risk to the seller as the new owner of the company.
• Earn-out clauses give the buyer the possibility of deferring the purchase price because at least part of the purchase price does not have to be paid until a later date.
• Earn-out clauses have a positive effect on the financing of the buyer (financing through current profits).

Earn-out clauses are particularly recommendable from the buyer’s point of view when acquiring companies where future performance is difficult to assess. This applies above all to start-ups but also to companies whose success is heavily dependent on individual persons.

Earn-out clauses – not so good for the seller

One man’s joy is another man’s sorrow. For the seller, an earn-out entails numerous risks that are hardly or not controllable. The seller bears economic risk even though he is no longer a shareholder or only a minority shareholder. In addition, he is at the mercy of structural changes (such as a merger with another, loss-making company). When negotiating the purchase price, the seller must therefore pay particular attention to ensuring that, for example, he is granted far-reaching rights to information with which he can counter manipulation in the event of an emergency.

However, residual risks for the seller cannot be excluded entirely, even if detailed clauses are agreed upon. A seller should, therefore, always approach an earn-out clause with scepticism. Here it is worth negotiating with particular persistence.

On the other hand, it should be noted that the seller can raise additional purchase price potential vis-à-vis a sceptical buyer employing an earn-out clause, especially if he, as managing director, can continue to exert a decisive influence on the achievement of the objectives.

Final purchase price

As soon as the relevant closing date balance sheet is available, the variables specified in the agreed purchase price formula are applied, and the actual purchase price is agreed upon. This is neither fixed at the time of signing the contract nor at the time of closing. A refund of part of the purchase price or additional payment by the buyer occurs only afterward, depending on the adjustment necessary based on the purchase price determination.

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