Authors: Gamze Çiğdemtekin and Sinem Sena Gültekin
gcigdemtekin@cdcalaw.com
Price adjustment mechanisms are a sine qua non to establish the equity price in every M&A transaction. There are various purchase adjustment mechanisms that each have advantages and disadvantages. In order to assist our readers in selecting the optimal working mechanism for their individual M&A transactions, this article seeks to provide a brief comparison of the two widely accepted mechanisms i.e., Closing Accounts Mechanism and Locked Box Mechanism.
Closing Accounts Mechanism
Closing Accounts Mechanism has long been the primary method for determining acquisitions, and it continues to be the most often used price adjustment mechanism in the United States. According to this process, when determining the purchase price, two crucial dates must be taken into account. At the signing of the Share Purchase Agreement, the buyer and seller agree on an enterprise value, which is mostly determined based on the data provided by the financial, legal and tax due diligence. After the closing, the parties calculate the equity price based on the Closing Balance Sheet and ultimately, it varies significantly from the enterprise value. The definitions of Cash, Debt, and Working Capital as well as the procedure for creating, evaluating, and agreeing Closing Accounts are all stated in the Share Purchase Agreement, which also contains the parties' agreement on the exact calculation method for the equity price. According to this procedure, the closing accounts will not be finalized in accordance with the specific requirements outlined in the SPA until sometime after completion, at which point the degree of any price adjustment will become apparent. In this scenario, economic risk will not be passed to the buyer until the completion and the buyer will only pay for the actual level of assets and liabilities of the target that the seller delivers on completion. On the other hand, the adjustments for Cash, Debt and Working Capital takes an inordinate length of time and causes the loss of energy.
Locked Box Mechanism
In contrast to the Closing Accounts Mechanism, the Locked Box Mechanism is mostly applied in the European mergers and acquisitions transactions to cope with this uncertainty of the equity value. The Locked Box Mechanism's primary goal is to offer certainty on the cash consideration at the time the SPA is signed. In its most basic form, a Locked Box transaction is a fixed price deal. This mechanism fixes the equity price based on a historical balance sheet, also known the Locked Box Balance Sheet, as of a time prior to the signing. The Locked Box Balance Sheet serves as the basis for the negotiation of this fixed price for the Target Company's shares and the negotiation is done at the signing of the Share Purchase Agreement (“Locked Box Date”). This also means that neither the preparation of the Closing Accounts, nor the adjustment to the purchase price after closing is needed. Between the Locked Boxed Date and closing date, the seller is limited in cash payouts. Since the economic risk of the target company has passed to the buyer on the Locked Boxed Date, there is high the risk of the leakage for the buyers. What a leakage is, is defined under the Share Purchase Agreement. Leakage is defined as unpermitted extraction of value from the target business. But in every case, there are also permitted leakages, which are a must to carry on the work such as salaries, expenses, and agreed dividend pay-outs. Share Purchase Agreements contain warranties and indemnity constructed on a Euro for Euro basis to provide protection to the buyer. The warranty and indemnity insurance will reimburse the buyer for the loss value in excess of the seller's agreed-upon liability cap if any unpermitted leakage occurs.
Conclusion
Each of these price adjustment mechanisms has benefits and drawbacks that must be assessed in light of the unique characteristics for every case.