When buying or selling a business, the way in which the purchase price is structured and paid is as important as the base price agreed on. There are various ways to structure the deal to bridge the gap between what price a seller is willing to sell at and what perceived value a purchaser is willing to pay.
Aside from a simple transaction that states the purchase price without any adjustments, closing accounts is a regularly used purchase price adjustment. The parties agree a base value, usually a ‘cash free debt free’ basis (meaning that the asset value is assessed on the basis that all debt will be settled and any excess cash will be extracted by the seller). This base value is then adjusted to take into account the remaining cash or debt, inventory or net assets when the deal is closed. This mechanism is purchaser friendly because it gives the purchaser an opportunity to interrogate the financials of the target enterprise, resulting in an adjustment of the purchase price. It protects a purchaser against any decrease in the value of the target pending conclusion of the transaction.
The parties negotiate how the adjustment will be calculated, what will be taken into account in the financial statements, and how to deal with any dispute over the financial statements. The sale agreement will regulate the process of how and when the closing accounts are finally agreed upon, which may involve expert determination.
The closing accounts mechanism leaves room for disputing the figures and drawing out the process of reaching a final purchase price. In an attempt to limit this process we have seen deals being completed under a locked-box pricing mechanism.
In its simplest form this is still a fixed price transaction. A fixed price is negotiated based on a historical balance sheet is locked in at a particular date. This protects the purchaser against any potential leakage of value of the target between the locked box date and the closing date of the transaction. Leakages may be permitted (such as dividends to the shareholders prior to closing) which do not affect the purchase price. These permitted leakages may become an issue for negotiation but provides certainty to both the parties as to the purchase price.
The locked box mechanism is a seller friendly pricing mechanism because there is no opportunity to adjust the purchase price, except as specifically provided for. However, the risk increases where the Locked Box Date and the closing date of the transaction are significantly far apart. The parties would have committed to a price based on the financial statements at the locked box date. Circumstances could have changed during this period, despite the protections in place against any leakages, and the target could be performing differently in the ordinary course of its business cycle. This is a risk both the seller and purchaser need to assess when agreeing the locked-in price.
This is also known in South Africa as an ‘agterskot’. This type of clause is not about how the purchase price is calculated. It is about the manner in which the purchase price is discharged. There may be a misalignment between a seller and a buyer on what the value of a business is. This purchase price structuring allows the parties to bridge this gap and still get the deal done.
An earn-out provides that the owners are paid for the sale of the business but are required to remain with the company for a period of time. Within this period the sellers are required to achieve a certain level of performance or financial performance target, and in return a further payment will be made by the purchaser. An earn-out is an adjustment to the purchase price dependent on whether the desired targets are reached or not. If the target is not reached the additional payment is not due and the purchase price is considered fully discharged. There may be other agreed provisions should the target not be reached.
An earn-out is also sometimes viewed as a form of delayed gratification and an incentive to reach the desired performance target. This purchase price mechanism results in the expectations of the purchaser for the business being met.
Other purchase price adjustments
There may be adjustments based upon the occurrence or non-occurrence of an event, such as securing a contract that is anticipated to increase cash flow. The adjustment would be an increase or decrease by a fixed amount on an agreed date, after closing.