Considering consideration

In an English law-governed share purchase, the price to be paid for the target entity is usually calculated by reference to a set of accounts. Whether those accounts are historic and peg valuation of the target business at some past date or are updated to value the business as at the date of completion is a key question which should be discussed at an early stage of negotiations, as it inevitably has a bearing on more than just the price paid.

Intuitively, most buyers and sellers understand the concept of completion accounts, where the consideration payable for the shares in a target company is determined by reference to the trading and financial position of the company at the date when completion of the transaction actually takes place.

However, it is also common for sellers to use an alternative mechanism, known as a locked box, whereby the price payable for the target company is based on a balance sheet as at a specified date in advance of signing (for example, the last audited balance sheet, the date of the most recent management accounts or a pro forma balance sheet prepared specifically for the purpose).

Each of these two methodologies poses different types of legal and commercial risks and, consequently, the mechanism that is used will impact on the nature of the transaction and on the way it is documented.

Completion accounts are used to value the business as of the date of completion for the purpose of determining the purchase price. Completion accounts are not statutory accounts (nor are they commonly audited) but are prepared solely for the particular transaction.

Depending on the pricing methodology, the completion accounts may consist of a balance sheet only, a full profit and loss account and balance sheet, a net asset statement or a valuation of specific assets.

Given the lead time required to draw up and prepare financial statements, completion accounts which are accurate up to the day of completion will not be available until after the completion date. Typically, the seller and buyer will agree a headline price (usually paid on completion) based on the agreed valuation metric (for example, enterprise value plus net cash, assuming normal working capital). The headline price may be based on a draft, or estimated, set of accounts agreed by the parties prior to completion or on the last audited set of statutory accounts.

The buyer or seller (as agreed) will then have a period of time after completion to prepare and deliver the completion accounts to the other party. There is a perceived advantage in being the party who prepares the first draft, although for practical reasons it is often the buyer that is best placed to do so.

If the completion accounts show that the financial condition of the target is better than expected, the consideration will be adjusted upwards and a balancing payment will be due from the buyer to the seller. If the financial condition is worse than anticipated, the seller will repay part of the consideration paid on completion by the buyer. It is worth remembering that stamp duty is likely to be payable on any additional consideration (at least in the context of an English company acquisition).

English law does not automatically impose any accounting standards or principles on the parties and the basis on which the completion accounts will be prepared must therefore be negotiated and agreed in the share purchase agreement.

Typically, this will be consistent with the accounting principles that have been applied by the target or its group prior to completion and/or UK GAAP, but it is normal to include a detailed set of specific accounting policies that will apply in the completion accounts as well as a hierarchy setting out the order of application of the relevant accounting rules where the specific policies do not apply.

In addition, the share purchase agreement will include a procedure for resolving any disputes which arise as to the content of the completion accounts. A standard clause will provide that the receiving party will have a period of time to review and verify the accounts and notify the other party if it disagrees with all or part of it.

The agreement will then allow for a further period of time for the parties to attempt to resolve the dispute, following which there is a mechanism for referral by either party to an expert. The rules for appointing the expert and the basis of his appointment will need to be set out in full.

A locked box mechanism aims to achieve the practical effect of ensuring that the buyer will take economic risk and reward in respect of the target business from the date of the reference balance sheet (the locked box date) to the date of completion. In effect, economic ownership of the business passes to the buyer as of the locked box date while legal ownership passes at completion.

The risk for the buyer is that it will not be in control of the business during the interim period and it will want to ensure that the value of the target business remains in the locked box. The buyer will therefore seek to protect itself against, for example, manipulation of working capital or other distributions or payments between the locked box date and completion which may dilute value in the business being acquired.

To mitigate these risks to the buyer, the seller will covenant that no leakage will occur between the date of the reference balance sheet and completion. Leakage is essentially the transferring of value out of the target to the seller and its affiliates and is typically defined to include:

• dividends;

• other distributions or returns of capital paid to the seller's group and any other sums paid to the seller's group which are not paid on arm's length terms and in the ordinary course of business;

• fees and expenses incurred by the seller in connection with the transaction to the extent reimbursed or paid by the target; and

• repayments of shareholder debt, other than as specifically agreed.

The buyer customarily requires leakage to be subject to indemnification so that it can be repaid on a pound-for-pound basis in the event this covenant is breached and leakage does occur.

Notwithstanding the locked box structure it is important that the target company should be free to carry on its business in the ordinary course. As such, the leakage covenants should not prevent the repayment by the target company of any financing and operational indebtedness or other payments made in the ordinary course of business, such as for goods, services, wages and tax.

Ordinary course payments of this nature are characterised as permitted leakage. Although permitted leakage should be acceptable to a buyer as it does not impair the locked box value, it is not uncommon for there to be agreed limits on the extent of permitted leakage to ensure that value in the business is not unexpectedly diluted.

The process of preparing and agreeing the completion accounts and resolving any dispute can involve significant time and expense. This can be a large concern for sellers in particular, although it will impact on both parties. In addition, if the completion accounts are to be prepared by the buyer, the seller may feel that it has lost an unacceptable amount of control over the valuation process and therefore the outcome of the agreed price payable.

Sellers sometimes concern themselves with value leakage that can occur if buyers take a contrary position on interpreting the accounting treatment of certain matters, particularly, for example, where management judgement is required to be applied to determine the level of provisioning etc.

By contrast, the locked box mechanism provides the seller with certainty of sale proceeds at completion. Although cash in hand will always be preferred by most sellers, this is particularly attractive for private equity sellers as they may be able to remit all of the sale proceeds to its investors on a more timely basis.

From a seller's perspective there are also some disadvantages to the locked box mechanism. In particular, the seller will not benefit from the continued operation of the business in the period between the reference date and completion (although this can be an advantage if the business takes a turn for the worse during this period).

The seller will also have to be comfortable not to receive consideration for the sale of the company at the time of the valuation but some time later when completion takes place. For this reason, sellers often seek to provide for interest on the agreed purchase price from the locked box date to the date of completion or, alternatively, for a daily earnings amount to be added to the agreed purchase price in order to reflect the earnings of the target company between the locked box date and the completion date.

This is not always accepted, and recently there has been increasing reluctance on the part of buyers to pay interest on the purchase price in a locked box structure.

Buyers are sometimes sceptical about locked box mechanisms. The fact that buyers are expected to be economically responsible for the financial performance of the target during a period where they have no control is a perceived risk.

A locked box mechanism does not provide the buyer with as much general comfort as completion accounts potentially do, as there is no opportunity to adjust the purchase price after completion if the business is in worse shape than anticipated. A buyer will therefore usually only agree to a locked box mechanism if it is in a position to carry out full due diligence on the target, including in particular on the reference balance sheet.

Whether this is possible will depend on the buyer's resources, the seller's willingness to give it access to management and time, which means that a locked box mechanism may be unsuitable if the parties intend on an aggressive timetable for signing and/or completion.

In contrast, buyers will generally be comfortable with completion accounts as it affords them an opportunity to properly value the assets of the business after the date on which they were acquired and on which they took economic risk on them.

If a buyer does agree to a locked box rather than completion accounts, it will seek as much contractual protection which may include increased covenant protection between signing and completion (for example lower monetary thresholds on disposals of assets requiring buyer consent) and warranty protection as regards the conduct of the business between the locked box date and signing.

It will also likely seek to reduce the risk of relying on a balance sheet which it has not prepared by obtaining additional warranties, in particular on the reference balance sheet. The buyer may also ask to be able to rely on any due diligence reports prepared by the sellers' advisers, although these advisers are likely to insist on material limitations on their liability.

The locked box approach does have one advantage for a buyer, namely certainty as to the amount of the purchase price. This certainty avoids the complications of their having to raise additional funds after closing, which can arise where there is an unforeseen upward purchase price adjustment under a completion accounts procedure (for example, in the event the business has been particularly profitable between signing and closing).

That said, this advantage will hardly outweigh the risks for the buyer if it cannot be fully satisfied as to the quality of the reference balance sheet.

Locked box mechanisms originally arose out of sellers' desire to capitalise on increasing competition amongst buyers to acquire attractive investment opportunities and it remains generally true that buyers tend to prefer completion accounts while sellers value the certainty provided by the locked box mechanism.

As a result, locked boxes tend to be prevalent in a bull market and less prevalent in distressed markets. A return to health in the M&A arena is likely to see locked boxes become more common and anecdotal evidence suggests that this trend has already commenced.

By partner Ronan O'Sullivan and associates Ross McNaughton and George Weston of Paul Hastings Janofksy & Walker in London