Hybrid Purchase-Price Mechanisms – Where Heavens Collide?
The locked box mechanism and the completion accounts mechanism are two separate methods used to determine purchase price in M&A transactions. Parties may require a combination of the two to tailor a transaction to their needs. This may be the case where a big gap in time exists between the date of the available audited accounts and the signing date, the buyer is not comfortable using management accounts, and the parties agree to a locked box mechanism per a future accounts date. Such a hybrid mechanism requires careful drafting. This blog post briefly touches upon the characteristics and pitfalls of such hybrid mechanism.
In a standard locked box mechanism (LBM), a buyer assumes the benefits and risks of the target company as per an “effective date,” typically 1 January. The enterprise-to-equity bridge (Bridge) is negotiated between the parties and determined without any contractual framework other than a non-binding Term Sheet, using the most recent audited financial accounts. If parties can’t agree on the purchase price, then either the transaction will be aborted, or parties can bridge the gap in a different manner, e.g., by deferring part of the purchase price via an earn-out. In a standard completion accounts mechanism (CAM), parties use estimates of cash, debt and a target working capital per the (future) closing date to determine the estimated purchase price and include a mechanism for a post-closing true-up based on the actuals. LBM is typically preferred by sellers, especially private equity, as it will cater for price certainty and a clean exit, whilst CAM may give buyers more comfort that the business was conducted in a profitable manner in the period prior to the closing date.
In a hybrid mechanism, parties will use audited financial accounts (like a standard LBM) which are, however, not yet available when the purchase agreement is signed. Parties should then agree on the Bridge, and thereby the purchase price, once the audited financial accounts become available (like a standard CAM) after the signing date. Negotiation and determination of the Bridge occurs in the interim period between signing and closing when a contractual framework, in the form of a purchase agreement, for those negotiations is already in place.
Such hybrid mechanism may be desired if there’s a big gap between the date of the available audited accounts and the signing date, and a buyer has insufficient confidence in using management accounts. The audited accounts available at signing may no longer realistically reflect the net debt and working capital position of the target company at closing. Also, a buyer may not be willing to pay the seller a daily interest rate over a long interim period. The contractual provisions, such as leakage, conduct of business, warranties, and indemnities, are generally insufficient to protect parties.
Close cooperation between the parties and their respective lawyers, accountants and corporate finance advisers is required to carefully draft a hybrid mechanism. Parties should ask themselves the following questions:
Type of accounts – are the accounts audited or compiled, as typically used for SMEs?
Timing – what’s the timing for preparing the accounts, and when are they envisaged to be furnished? What’s the period for the buyer to review these? This must be discussed with the other advisors.
Bridge items – which items will qualify as cash, cash-like, debt and debt-like items to get from Enterprise Value to Equity Value pre-closing? Parties may attach a Bridge based on the most recent available accounts to tackle any qualification discussion prior to signing.
Working capital – what will be the sufficient level of working capital to be maintained by the target company at closing? Any seasonality or wind-down of a target company should be considered.
True-up mechanism – what are the consequences if parties can’t agree on the purchase price pre-closing? A buyer may want to walk away. Can the buyer be forced to participate in an independent expert procedure?