The primary goal of almost every finance director is to maximise the growth of their business, as part of a long-term strategy. One way to unlock sustainable growth is through corporate acquisitions. However, difficulties in reaching agreement on the completion mechanism and the drafting of the Sale and Purchase Agreement (SPA) can frustrate or derail an otherwise successful transaction.
The successful signing and completion of a deal is dependent on numerous factors. The most important is the agreement between principals of the price that is paid and received in a deal. Normally, this pricing focus will centre on the ‘Enterprise Value’ or ‘Headline Price’ offered, often derived from a multiple of earnings and/or from a discount of forecast future cash flows. However, enterprise value may differ significantly from what is paid or received on completion. As headline offers are typically made on a “cash-free, debt-free basis assuming a normal level of working capital”, the final ‘Equity Price’ that is paid and received for the business can be very different.
Determining the Equity Value
The signed SPA sets the terms of the transfer of ownership from Seller to Buyer, the allocation of risks and protections against them, and the contractual obligations binding them to the deal. The SPA also sets a pricing mechanism that determines the equity price at completion. Under a locked box mechanism, the final equity price is written into the SPA. With completion accounts, the SPA describes how the enterprise value is adjusted to reach the equity price, who should prepare and who should review the completion accounts, when adjustments are made, and, most importantly, the basis of deriving the quantum of these adjustments. The SPA could include an earn-out mechanism to adjust further the price based on a measure of future trading performance of the business.
Adjusting the headline price for certain assets and liabilities in the balance sheet seems a straightforward calculation, but what constitutes cash, debt or working capital, as well as what a “normal level” of working capital is, can be divisive. There is often no ‘right answer’ and their components will vary between deals.
With significant values at stake, negotiating the completion mechanism and the drafting of the SPA can be the difference between a successful and unsuccessful transaction. Parties can agree on the headline price and commercial terms of a deal, only for it to fall apart prior to completion owing to disagreements over the components of the price adjustment.
With, Parties to a transaction can cite ‘market practice’ when negotiating how the initial offer price is converted into the final equity value in the absence of definitive rules or standards for completion mechanisms. However, there has thus far been limited publicly available data to determine what is meant by ‘market practice’ internationally - until now.
What is market practice?
We obtained the views of almost 600 participants from over 400 organisations internationally in a pioneering survey. We have identified key themes and practices worldwide to help enable deal participants achieve smoother and successful transactions, they include:
- The understanding and appreciation of the Locked Box balance sheet date mechanism is rising fast: 76% of respondents used this mechanism in the last 12 months and 64% saw its usage rise over the past 5 years. It is now a common alternative to the traditional ‘completion accounts’ pricing mechanism. Despite this it isn’t always fully understood by deal participants so value can be lost during the process (such as through inappropriate calculation of the ‘value accrual’ between locked box and completion)
- It is important to identify contentious price-adjusting items and consider agreeing them early in the transaction process. Doing this at the offer stage (before exclusivity is granted) is wise to avoid transactions subsequently falling over or being delayed. It is best practice for principals and advisors to have open discussions to reach agreement and ensure that one party is not disadvantaged by a lack of awareness
- Post completion disputes over completion accounts or earn-out clauses can be reduced by identifying potentially contentious areas of accounting up front, such as areas of management judgement, and stating the required treatment in the SPA, so that provisions in the agreement accurately reflect the commercial intentions of parties and ambiguity is avoided
- Warranty & Indemnity insurance is becoming an increasingly attractive option for both buyers and sellers, allowing parties to reach an agreement faster. As the insurer deals with the defence and/or settlement of any warranty or indemnity claim, a seller avoids the administrative burden and potential cash outflow a claim might otherwise have caused. Buyers can gain additional comfort over W&I being provided, knowing they have protection. It can also help to preserve any ongoing relations between parties, allowing the buyer to get on with running the business
Sustainable growth depends on markets and deal participants working with trust and integrity. The Best Practice Guideline: Completion Mechanisms Determining the Equity Value in Transactions, written by the firm and published by the Institute of Chartered Accountants in England and Wales (ICAEW) and the International SPA Survey aims to bring parties closer together, reducing tension in the deal process and promoting more successful transactions. When considered alongside the Best Practice Guideline, the survey provides insights and tips to finance directors to help them unlock sustainable growth. Particularly when it comes to considering the purchase price mechanism, negotiating key value areas, and achieving optimum equity prices in their transactions.