You have identified a business that you want to buy, you have identified what the value of the business is and how much you are willing to pay, and have a rough estimate or figure in mind, but how do you narrow down that amount to a specific figure to include in the purchase agreement?
Buyer’s often focus on the ‘Enterprise Value’, often linked to a multiple of historic EBITDA or some other industry specific basis but the finances of a business change daily in terms of money in the bank, debtors, creditors, taxes etc so how do determine the price payable by reference to the actual financial position of the business at completion, or at least the expectation as to the financial position of the business at completion?
Buyers and sellers generally use, three methods to fix the figure in the purchase agreement:
- Agreed price;
- Completion accounts; or
- Locked box accounts.
Agreed price
An agreed price is exactly that. There is no mechanism of adjusting the price depending on the performance and working capital requirements of the company. It is an arbitrary figure that is agreed between the parties. It offers certainty and can quickly be implemented if there is a short transaction timeframe, but it fails to consider working capital requirements of the business or any cash that is left in the business following the transaction. This option is often only used if there is a desire to complete the transaction quickly, there are no issues with working capital or excess cash in the business.
Where parties agreed a fixed price deal, it is sensible that the agreement sets out the expectation as to the financial position of the business at completion. For example, is there an expectation as to a specific amount of retained cash or net assets?
As there is no adjustment mechanism to adjust the purchase price based on the exact financial position of the business at completion, it is important from a buyer’s perspective to ensure appropriate financial covenants to avoid a situation whereby, for example, a seller takes all cash in the business and leaves a series of liabilities and taxes outstanding.
Completion Accounts Mechanism
Some parties require certainty as to what the actual financial position is of the company at the date of the sale as this will affect the price that they would be willing to pay.
Completion Accounts is the most common mechanism to adjust the price based on the exact financial position of the business at completion. Broadly, the mechanism involves parties agreeing to a headline price or enterprise value and then adjusting that price based on whether the actual financial position of the business is better or worse than a ‘target’ position.
To calculate the financial position of the company on completion, there will be completion accounts and a completions account mechanism included in the purchase documentation.
Completion accounts are financial statements prepared after the sale completes, based on the actual position of the company’s finances at the completion date of the sale. These are usually prepared by the buyer’s accountants based on the completion accounts mechanism. However, it is not uncommon for these to be prepared by the sellers, taking into account the completion accounts mechanism but based on existing financial policies that they will have operated the business on prior to completion.
The completion accounts mechanism adjusts the overall price up or down depending on the position of the cash and liabilities in the company in the completion accounts. There are competing interests between the buyer, who wants to ensure that there is enough money left in the business to cover the liabilities and working capital, and the seller who wants to ensure they receive the maximum amount of money for the business.
Calculation
Depending on the exact policies in the Completion Accounts, broadly the Completion Accounts will calculate the following:
- Cash in the bank
- Plus debtors (being money owed to the Company)
- Plus tangible assets or stock if applicable to the deal and agreed between the parties
- Less creditors, being money owed by the business for example to suppliers
- Less Debt, for instance finance debt
- Less accrued taxes
The above is a simplistic summary and more specific policies are required for each business.
The parties will also need to agree what the ‘target’ or expected position will be and what is included in the assessment. For example is the deal on a ‘cash free, debt free’ basis whereby the assumption is that the above calculation would be Nil and anything above Nil will be paid to the seller.
Alternatively is the expectation that the seller will leave a minimum level of working capital or net assets in which case any adjustment is linked to whether the calculation above results in a figure which is higher or lower than this expectation.
The amount from the completion accounts is then added or subtracted from the initial purchase price to reflect the true price of the company, taking into account the financial position of the company on the day of completion and whether this is higher or lower than expectations. If the purchase price has increased then this is an amount that the sellers are owed by the buyers, however if there has been a reduction in the purchase price this is an amount that would be owed to the buyers.
Advantages
It provides certainty as to the price, taking into account the actual financial position of the company at completion. It can also remove risk to the buyer when the financial performance of the company is volatile or uncertain as the price is fixed by the accounts compiled at completion. More crucially the sellers can benefit from the upside of any cash fluctuations up until the day of completion.
Disadvantages
It can be costly to prepare completion accounts and the calculation of the price occurs after the transaction has been complete as it an adjustment of the purchase price after the transaction has occurred. This process can often take between 30-90 days post-completion and can cause disputes between the parties as to the calculation of figures in the completion accounts.
Locked Box Accounts Mechanism
This process operates differently in that a specific set of accounts are prepared which underpins the valuation of the business and have a date which is prior to completion. Once prepared, the sellers provide warranties around the accuracy and the validity of the accounts and that they represent a fair and accurate picture of the financial performance of the company.
Essentially, the parties are fixing the price based on the financial position of the company at the locked box date. The calculation is similar to completion accounts but as the date for this is prior to completion, the parties also need to agree restrictions on costs and expenditure which a seller can incur between the locked box date and completion. The sellers and buyers agree to specific agreed adjustments to the locked box accounts through a mechanism called leakage.
The sellers largely agree that they will not incur expenditure other than normal operation expenditure, such as paying wages, and agree not to take dividends or similar exceptional expenditure unless agreed by the buyer.
Post completion, if the accounts of the company do not match the locked box accounts (factoring in any leakage), then the buyer will have a claim against the seller for breach of warranties for the difference.
Advantages
It provides certainty as to the price of the transaction as this price is fixed upfront by reference to the financial position as at the locked box date. It also removes the possibility of dispute around the calculation and preparation of the completion accounts.
Disadvantages
There is no adjustment for the price of the business following the locked box date. Should the business perform better than expected then the seller will not be able to benefit from any future uplift in value. Conversely, if the business under performs then the buyer will not be able to seek a price reduction.
The mechanism also relies heavily on the accuracy of the locked box accounts and the time frame between the date that these are prepared and the day of completion. The greater amount of time that passes after the locked box date, the greater the chance of the accounts being unreliable or there being a dispute between the parties. It also requires additional drafting and strong anti-leakage provisions and warranties to protect the integrity of the locked box accounts.
Which should I choose?
In determining the optimum pricing mechanic, consideration must be given to time, historic performance of the company and parties’ intentions. A completion accounts mechanism is appropriate where accuracy outweighs speed, the balance sheet is variable, or the buyer requires comfort that the final price will reflect the company’s true position. Conversely, a locked‑box mechanism is suited to transactions requiring pricing certainty and minimal post‑completion involvement of advisors.
If you are considering purchasing a business and would like some advice, contact our Commercial team. You can call us on 0113 284 5000 or e-mail us at companycommercial@isonharrison.co.uk.
