Germany: News From the Locked Box

Last Updated: 29 November 2010
Article by Martin Schulz

GERMAN M&A AND PRIVATE EQUITY NEWS - 4TH QUARTER 2010

In German share deals, two types of purchase-price clauses predominate: on the one hand, the adjustment of a base purchase price by the net debt of the target company and variations in its working capital as of the closing; on the other hand, the calculation of the purchase price on the basis of the latest audited balance sheet of the target company and interest payments on such purchase price for the period between the balance-sheet date and the closing ("locked box"). In recent times, a combination of both mechanisms has been used as an alternative: the calculation of the purchase price as of an effective date between the date of the last audited financial statements and the closing and interest payments for the period between such effective date and the closing. This article briefly discusses the established mechanisms and then explains the new alternative.

Determination of the Purchase Price as of Closing

In recent years, the most common purchase-price mechanism used in share deals—on a simplified basis—is as follows: base purchase price plus cash less financial debt plus excess or less shortfall in working capital equals final purchase price.

The reason for this mechanism lies in the valuation of the target company. Buyers typically value target companies using the discounted-cash-flow method and/or an enterprise- value multiple, such as a multiple of the target company's EBIT or EBITDA. Both types of valuations have in common the fact that the value of the target company—and thereby the purchase price—is determined in two steps. First, the so-called enterprise value is determined, which is the present value of the target company's expected payments to its equity and debt holders. In order to determine the target company's equity value and thereby the purchase price, the market value of the target company's debt, which normally equals its book value, then has to be deducted from the enterprise value. Furthermore, nonoperating assets, particularly excess cash and cash equivalents, are compensated separately and therefore have to be added to the purchase price. Second, the target company's working capital is compared to a certain target workingcapital figure. To the extent the target company's working capital exceeds or falls short of such target, the purchase price is increased or decreased, respectively.

The advantage of this purchase-price mechanism is that the balance-sheet items required to calculate the equity value and thereby the purchase price are determined as of the closing. Therefore, this mechanism is more accurate than the locked-box approach discussed below, which through the interest component contains a certain lumpsum element.

However, in practice this mechanism has several disadvantages. First, it is often difficult for the parties to agree on the individual items constituting the financial debt, cash and cash equivalents, and working capital, as well as on the target working capital. Since the items have to be determined on the basis of an interim balance sheet as of the closing, the parties are usually forced to close at the end of a calendar month, which might delay the closing. Second, as the balance sheet can be prepared only after the closing, there often is a significant time period between the closing and determination of the final purchase price, particularly if a dispute between the parties develops concerning the accuracy of the closing balance sheet. Finally, from the perspective of the seller, the mechanism has the disadvantage that the purchaser controls the target company postclosing and therefore often only the purchaser will be able to prepare the closing balance sheet. The seller then only has the opportunity to review the balance sheet prepared by the purchaser.

Locked Box

In order to avoid the problems described above, private equity sellers in particular have increasingly been using a different purchase-price mechanism in recent years, the so-called locked-box mechanism. In that mechanism, prospective purchasers are requested to submit a purchase- price bid on the basis of the target company's latest available financial statements. Such purchase price then bears interest between the effective date of the financial statements and the closing.

The economic rationale behind this mechanism is as follows: the balance-sheet items required to derive the equity value from the enterprise value as of the latest balancesheet date are available in the latest financial statements. Therefore, prospective purchasers are able to determine the purchase price as of the latest balance-sheet date on the basis of the available data. Since the purchase price was calculated as of an effective date in the past, it bears interest until the closing date.

The practical advantages are obvious. Since the bidders are requested to calculate the purchase price from an economic perspective retroactively on the basis of available data, they can (and have to) offer the equity value of the target company they consider appropriate as the purchase price. Therefore, there is no need to determine the equity value as of the closing based on an interim balance sheet. Furthermore, there will be no discussions as to the balance-sheet items by which the enterprise value has to be adjusted in order to obtain the equity value.

Despite these advantages, the parties nevertheless are often unable to agree on this mechanism, particularly if there is a substantial period between the last balancesheet date and the closing and if the target company is (very) profitable. The main reason for this is that the parties are often unable to agree on an appropriate interest rate for the period between the balance-sheet date and the closing. The seller, which will argue that the reason for the interest is to get a lump-sum compensation for the profits generated by the target company between the balancesheet date and the closing, will therefore demand a corresponding interest rate. The purchaser, on the other hand, will argue that it has borne the economic risk of the target company since the last balance-sheet date because the purchase price was calculated as of that date. Therefore, it should be entitled to the profits. The interest rate thus should be that of a secure alternative investment, e.g., for fixed-term deposits.

The Combination of Both Mechanisms

In order to avoid at least some of the problems discussed above, parties in recent times have started to combine both mechanisms. For that purpose, the parties agree to determine the purchase price in the form of the target company's equity value as of a balance-sheet date between the date of the latest audited financial statements and the closing and on the interest on such purchase price until the closing. The appropriate effective date for the determination of the purchase price depends on the circumstances of the transaction, e.g., whether the target company requires some lead time for the preparation of the interim balance sheet (e.g., in order to prepare a physical inventory), the expected time period between signing and closing, and whether there is a profit-and-loss pooling agreement to be terminated. Typically, the effective date will be either shortly before or after signing.

The share purchase agreement then provides that the equity value (purchase price) of the target company shall be determined as of such effective date. To that end, the mechanics described above in the section "Determination of the Purchase Price as of Closing" are used; i.e., starting with a base purchase price (enterprise value), the target company's cash and cash equivalents, financial debt, and working-capital excess or shortfall are determined on the basis of an interim balance sheet, and then the final purchase price (equity value) is derived from the base purchase price. The interim balance sheet is prepared by the seller because the seller still controls the target company. In addition, an appropriate procedure for the review of the balance sheet needs to be agreed upon. The purchase price bears interest for the period between the interim balance- sheet date and the closing.

Even though this mechanism, in contrast to the pure locked-box approach, requires the parties to agree on the individual positions of the cash, cash equivalents, financial debt, and working capital and to prepare an interim balance sheet, the mechanism has several advantages. From the perspective of the seller, a major advantage is that it can prepare the interim balance sheet. Furthermore, there is no longer any need to close at the end of a month in order to be able to prepare a closing balance sheet. Since the effective date for the interim balance sheet is prior to the closing so that there will be time to start preparing and reviewing the balance sheet prior to the closing, the procedure is considerably faster than if the balance sheet had to be prepared postclosing. Compared to the pure lockedbox approach, the mechanism has the advantage that the equity value (purchase price) is determined as of an effective date later than the date of the last audited financial statements. Therefore, the profits generated by the target company until the interim balance-sheet date are directly taken into account in the calculation of the purchase price rather than being compensated on a lump-sum basis through interest payments. At the same time, the period during which the purchase price bears interest is much shorter, so the relevance of the interest to the total purchase price decreases and the parties are more likely to determine an interest rate acceptable to both of them.

Conclusion

This new approach is a combination of established mechanisms. Applied correctly, it leads to an expedited determination of the final purchase price and to greater flexibility regarding the timing of the closing. Furthermore, from the perspective of the seller, it has the advantage that the seller, rather than the purchaser, can prepare the balance sheet required for the determination of the final purchase price. Due to the relatively short period between the interim balance- sheet date and the closing, the parties will be more likely to agree on an interest rate for the purchase price.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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