M&A and COVID-19: Purchase price mechanisms in times of the coronavirus
The effects of the coronavirus (Covid-19) on the global economy are becoming increasingly clear. The Dutch government has presented a comprehensive emergency plan with the aim of "not only protecting our health, but also our jobs and income and cushioning the consequences for self-employed persons, SME entrepreneurs and large companies". This package provides support to entrepreneurs and businesses for as long as necessary. Various sectors, such as the hotel and catering industry, the travel industry and the flower industry are already suffering from the consequences of the coronavirus.
The consequences are also noticeable within the Dutch M&A practice. The central question in this article is how the buyer of a company should deal with the future uncertainties of the current crisis. To what should the buyer pay extra attention, and are there ways to limit the future uncertainty for the buyer as much as possible?
In times of economic uncertainty, and especially now with the enormous uncertainty as a result of the corona crisis, it is important for the buyer to pay extra attention to the due diligence investigation in an M&A project. In the current situation, for example, additional research into the entire supply chain of the target company or a thorough check of the target company's insurance policies and coverage and possible exceptions for cases such as the Corona virus can be considered. Also, the contracts to which the target company is a party will have to be reviewed in order to determine to what extent the target company will be able to either perform its contractual obligations, suspend its contractual obligations or whether there are possibilities for termination of the contract as a result of the corona crisis. In addition to the due diligence investigation, the buyer will want to formulate the conditions precedent, warranties and indemnities in such a way that the consequences of the corona crisis will also be covered by these provisions. The wording of the so-called MAC clause will also deserve extra attention.
In addition, it is important for the buyer to determine which mechanism will be used to determine the purchase price for the shares in the target company. In this article, I will discuss two purchase price mechanisms commonly used in the M&A practice: the "locked-box mechanism" and the "closing accounts mechanism". In this context, I will pay attention to the effects of the corona crisis on a purchase price determined by the “locked-box mechanism”, and a purchase price determined by the “closing accounts mechanism”. In addition, I will discuss the possibility of making the purchase price dependent on the outcome of the uncertain (economic) times by means of an “earn-out”. This may also offer the buyer some extra security where the future results of a target company will be extremely uncertain.
Purchase price mechanisms: “locked-box” and “closing accounts”
The coronavirus will have a major impact on the revenues of businesses, including target companies in M&A transactions. In an M&A transaction, the purchase price is often based on a forecast of the target company's revenues after the transaction. In the current circumstances it will obviously be difficult to make a good estimate of the revenues of the target company.
The purchase price for the shares in a target company is generally determined by using either the "locked-box mechanism" or the "closing accounts mechanism". Both mechanisms have advantages and disadvantages. Below, I will discuss which purchase price mechanism is the most beneficial for the buyer given the current circumstances.
If the “locked-box mechanism” is used, the purchase price will be determined by looking at the financial status of the target company on a date several months prior to the date of the transfer of the shares. The purchase price is often determined on the basis of the most recent financial figures of the target company, usually its most recently (audited) annual accounts. The economic risk of the target company is transferred to the buyer as per the same date as the date of such financial statements or accounts. This date is called the effective date. However, the purchase price is only paid upon transfer of the shares and will in principle not be adjusted after transfer. The parties agree that the target company will continue its operations on a normal course of business basis from the effective date and stipulate that only any withdrawals of value of the business (other than resulting from normal operations), also referred to as "leakage", between the effective date and the transfer date must be reimbursed by the seller.
When the “closing accounts mechanism” is used, provisional closing accounts of the target company, including an acquisition balance sheet, are drawn up as per the time of the transfer of the shares in the target company. These provisional accounts reflect the target company's expected financial position on the date of the transfer: the closing. The provisional purchase price is determined on the basis of these provisional closing accounts. The provisional purchase price is paid to the seller at the closing. From that moment on, the target company is operated for the account and risk of the buyer.
Some weeks after the closing, the final closing accounts will be drawn up. On the basis of a comparison between the provisional closing accounts and the final closing accounts, the definitive purchase price is determined. It is possible that the final purchase price differs from the provisional purchase price. In that case, either the seller will have to repay part of the purchase price to the buyer, or the buyer will have to pay an additional part to the seller.
The parties may also agree on a so-called "earn-out". If an “earn-out” is agreed, part of the purchase price will be paid on the date of transfer. This part is called the basic purchase price. The parties also agree that another, additional part of the purchase price, the so-called "earn-out", will not be paid on the transfer date but will only be payable by the buyer after certain conditions agreed between the parties have been met within a certain period of time.
There are several reasons to agree on an "earn-out". One reason may be that the future results of the target company are difficult to estimate. In the case of such an “earn-out”, the payment of part of the purchase price is made conditional to the future results of the target company.
Influence of the coronavirus-crisis
In times of uncertainty, it seems more favorable, at least for the buyer of a company, to opt for the "closing accounts mechanism". If the “closing accounts mechanism” is used, the final purchase price will be determined only after the transfer, and the provisional purchase price already paid will be subject to adjustment. As a result, the purchase price will better reflect the state of the target company purchased on the date that the buyer obtains the operational risk of the business of the target company than in the case of the “locked-box mechanism”. In that case, the purchase price will be set at a value of the target company on a date in the past (the effective date), which may no longer correspond to the value of the target company at the time of the acquisition. The "locked-box mechanism" may have an even bigger detrimental effect on the buyer when the effective date is set before or at the beginning of a crisis. The potentially negative result between the effective date and the date of transfer of the shares in the target company is for the account and risk of the buyer.
As indicated above, agreeing on an “earn-out” will provide additional security for the buyer. In case of economic uncertainty, as is currently the case due to the corona crisis, the future results of the target company are difficult to predict. An “earn-out” can then be a solution, as it can take the possible future negative consequences of the corona crisis into account which will result in a lower purchase price to be paid.
The effects of the corona crisis are widely felt. This is also the case in the M&A practice. In these times of uncertainty, it is very important for the parties involved to consider certain specific aspects of an M&A transaction. In this contribution, I have discussed the consequences of choosing a particular purchase price mechanism, concluding that in an uncertain economic climate it is beneficial for the buyer to use the "closing accounts mechanism" to determine the purchase price. In addition, by agreeing on an “earn-out” with the seller, the buyer can make part of the purchase price to be paid dependent on future results to be achieved by the target company.
If you have any questions about the above, please do not hesitate to contact our corona helpdesk team (firstname.lastname@example.org / +31(0)20 312 2800).