One of the most important areas of regulation in acquiring a business is purchase price provisions. This is an extremely complex issue in which various aspects must be taken into account. In addition, the opposing perspectives of the buyer and the seller must be reconciled. In this regard, various basic models and approaches have become established in M&A practice. These vary in complexity, so the corresponding complex procedures should only be applied in larger transactions, while others are more suitable for mid-sized business sales. A distinction must be made between the regulations which govern the determination of the purchase price and those which define the terms of payment.
In the following article, we give you an overview of the four most important purchase price clauses and adjustments when acquiring a business:
1. Fixed purchase price
The fixed purchase price is simple, at least in the first step. In this regard, an economic benchmark date in the past is set, and the seller and buyer agree on a specific enterprise value at that time. A fixed purchase price for the business is then determined based on the value of that business. In determining enterprise value, parties generally rely on the most recent annual financial statements available.
The costs of preparing interim financial statements are often uneconomical in small transactions and should be avoided. It is clear that this approach, while simple, has certain limitations and risks. The economic deadline should not be too far advanced before the actual transfer of the business to the buyer. Otherwise, the value at the time of transfer may already have deviated from the value determined on 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 away in the time of their preparation.
If a fixed price is used, the acquirer must also avoid any exit between the economic deadline and the sale of the business which would reduce the value of the business. As such, the purchaser is contractually bound by strict behavioral requirements for the period between the economic reference date and the sale of the company. These are the so-called “representations” relating to the past and the so-called “alliances” relating to the future. These forward-looking requirements create a legal framework within which the seller can operate until the economic close date and which aims to prevent manipulation at the expense of the buyer until he can control the business himself. business. In the practice of transactions in the United States, the term “locked box” is in place for this purpose.
Purchase price adjustment clauses – overview
The background to purchase price adjustment clauses is that contracting parties do not have the data necessary for a concrete calculation when negotiating the purchase price. These are often the result of a balance sheet that has not yet been established. In transactional practice, 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 corresponding balance sheet is available based on the balance sheet values contained therein. Which purchase price formula should be used as a basis is a matter of negotiation, and in this regard, there is no generally applicable procedure; the different methods are presented below.
In practice, agreement on the purchase price mechanism must be found as early as possible, i.e. already in the preparatory documentation for the basic economic agreement in the letter of intent (LoI) or the term sheet. Otherwise, there is a risk that the business acquisition will fail at this fundamental stage after considerable time and costs have already been invested in the sales process.
2. Equity guarantee
One method that has dominated in Germany, at least in the past, is the adjustment of the purchase price on the basis of equity. Here, a fixed purchase price is first set on the basis of the balance sheets already available. This is then subsequently adjusted according to the increase or decrease in equity determined in the final decisive balance sheet. The seller thus provides a “capital guarantee” on the fixed purchase price. This method is rarely used today, especially in transactions involving private equity investors.
3. Without money – without debt
A purchase price adjustment under the keyword “cashless – debt free” is usually only useful in larger business transactions, as it is usually expensive and complex. The company is treated as if it had neither cash (“cash free”) or debt (“debt free”). The value of the company is then regularly determined on the basis of a so-called “discounted cash flow” or “DCF” method or on the basis of a revenue capitalization approach recognized by international accounting standards.
The aim of the “cash free – debt free” assumptions is to help neutralize the influence of the different characteristics of the liquidity and financing situation of each company. Any manipulation of the seller to the detriment of the buyer is then regularly prevented by a contractual adjustment of the purchase price according to the variation in net working capital (known as “working capital adjustments”). Thus, the seller should not be able to “artificially” increase his cash flow with an effect on the purchase price, such as late payments from suppliers or the assignment of trade receivables through factoring. In this regard, there are many circumstances that need to be taken into account when negotiating the purchase contract, and their handling should be contractually stipulated. The resulting complexity is generally not justifiable for sales of small and medium-sized enterprises, so an adjustment of the purchase price on this basis is excluded.
4. Earn-out – the variable purchase price
A variable purchase price adjustment using earn-out clauses can help reconcile the different price expectations of a seller and a buyer in a business acquisition. The purchase price is then made up of a fixed part and a variable part. However, the variable part must first be acquired. Otherwise, it is canceled without replacement. This is particularly applicable in situations where the selling entrepreneur remains linked to the business, such as the managing director or the consultant.
Example: The selling shareholder-manager will remain in the company after the sale of the shares and will continue to manage his fortune. He will only receive part of the purchase price if he achieves the defined economic objectives.
The reference framework of these economic objectives can be for example the turnover, the gross margin, the EBIT, the EBITDA or the net result, but also the number of newly acquired customers or the quantities of production. In practice, EBITDA is widely used. In any case, the mechanism must be well thought out and regulated as precisely as possible to avoid litigation. If disagreements arise, an accountant is usually called in as the arbitrator.
Earn-out clauses – good for the buyer
Earn-out clauses mainly serve the buyer because:
- He transfers part of his economic risk to the seller as the new owner of the business.
- Earn-out clauses give the buyer the option to defer 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 purchaser (financing by current profits).
Earn-out clauses are particularly advisable from the buyer’s point of view when acquiring companies whose future performance is difficult to assess. This is especially true for start-ups but also for companies whose success depends heavily on individuals.
Price supplement clauses – not so good for the seller
The joy of one man is the pain of another. For the seller, a price supplement involves many risks that are difficult or uncontrollable. The seller bears the economic risk even if he is no longer a shareholder or only a minority shareholder. In addition, it 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 be particularly careful to ensure, for example, that he is granted extensive rights over the information with which he can counter manipulation in an emergency.
However, residual risks for the seller cannot be totally excluded, even if detailed clauses are agreed. A seller should therefore always approach an earn-out clause with skepticism. Here it is worth negotiating with special persistence.
On the other hand, it should be noted that the seller may increase the potential for additional purchase price vis-à-vis a skeptical buyer resorting to a earn-out clause, especially if he, as manager general, can continue to exert a decisive influence on the achievement of objectives.
Final purchase price
As soon as the balance sheet at the corresponding closing date is available, the variables specified in the agreed purchase price formula are applied and the actual purchase price is agreed. This is not fixed either at the time of signing the contract or at the time of closing. A refund of part of the purchase price or an additional payment by the buyer takes place only afterwards, depending on the necessary adjustment based on the determination of the purchase price.