Turkey: Consideration Clause In Mergers And Acquisitions: Closing Accounts vs Locked Box

OVERVIEW

In mergers and acquisitions, the determination of the purchase price and payment terms are among the key concerns of the parties to the transaction. In these transactions, we encounter full payment at a predetermined price on the closing day, similar to conventional sales agreements, as well as structures that are subject to installments, profitability targets or price adjustment mechanisms. The issue of consideration depends primarily on the agreement of the parties on commercial terms, however, the implementation of this clause, which can be quite technical, into the share purchase agreement require the intervention of legal and financial teams.

In this article, we will explain closing accounts and locked box, the two most common pricing mechanisms in mergers and acquisitions involving share transfers, and discuss the advantages and disadvantages of these systems.

A. TRADITIONAL METHOD: CLOSING ACCOUNTS

The "closing accounts" is the most commonly used mechanism in practice. Typically, the parties agree on an enterprise value, on a cash-free and debt-free basis, on the signing date of the share purchase agreement, taking into account market conditions and the outcomes of legal, financial and technical due diligence. The primary objective in determining the enterprise value is to calculate the purchase price based on this value, taking into account the net debt and working capital at the closing date.

However, as companies continue to operate, their financials are constantly changing and it is not possible to calculate the closing net debt and working capital, i.e. the closing accounts, precisely on the closing date. For that reason, the enterprise value is taken as fixed, and an estimated purchase price determined based on the net debt and working capital forecast for the closing date is paid by the buyer to the seller at the closing. This payment is commonly based on (i) the financials as of a certain date that is a date before the closing or (ii) as close as possible to the closing date, the good-faith estimate of the seller, who holds the company's financials until the closing, regarding the net debt and working capital, and therefore the purchase price; and is supported by representations and warranties provisions related to the accounts to protect the buyer.

Upon the completion of the closing, a retrospective examination is conducted on the company's financials, leading to the determination of the now available closing accounts. This allows for the calculation of the final purchase price based on the enterprise value, adjusted in accordance with the closing net debt and working capital. The closing accounts are often calculated by the buyer, who gains access to the company accounts post-closing. However, the seller's approval is also required for the final purchase price, and to prevent potential disagreements on this matter, a provision for the appointment of a third-party expert to review the accounts may be stipulated.

Following the parties' agreement on the final purchase price, any difference between this price and the estimated purchase price paid on the closing day is settled by the buyer to the seller or vice versa, depending on the circumstances. This ensures that any changes, whether positive or negative, in the company's financials are reflected in the sales price.

B. NEW APPROACH: LOCKED BOX

The "locked box" is an increasingly prevalent alternative used in the UK and Continental Europe.
Here, a review is conducted on the financials (typically the last annual or interim period) of the target company prepared at a date prior to the signing of the share purchase agreement. This review is preferably performed by an independent expert, and the target company's cash-debt position and working capital, hence the purchase price, are determined as of a date before the signing date (the locked box date), based on the agreed financials. Given that this price can be included in the share purchase agreement at the signing, there is no need for any estimations regarding the closing date or post-closing adjustments.

Due to the nature of the locked box mechanism, it is not possible to reflect any positive or negative changes in the financial position of the target company between the locked box date and the closing date in the purchase price. Therefore, the buyer is exposed to the risk of value erosion and leakage occurring between the locked box date and the closing date, while the seller faces the risk of being deprived of benefiting from any value increase that may occur in the target company during this period. To protect the buyer, share purchase agreements include representations and warranties as well as indemnity provisions aimed at preventing leakage in favor of the seller or to the detriment of the target company. However, leakages necessary for the operation of the target company are permitted. To protect the seller, on the other hand, a clawback mechanism may be established based on any value increases realized in favor of the buyer during this period.

C. PROS AND CONS

Agreements containing closing accounts are lengthier and complex compared to locked box agreements. In these agreements, it is not sufficient for the buyer and the seller to agree solely on the enterprise value and the formula for the purchase price; they must also individually negotiate the definition and content of each financial item, the accounting standards under which the accounts will be prepared, and the actual purchase price calculated accordingly. Due to the possibility of some payment extending into the post-closing period, disputes may arise post-closing. Additionally, this method requires the target company's financials to be examined by professionals multiple times, resulting in a cost of time and expenses. However, since any benefit or loss until the closing moment automatically falls on the seller, it is expected that the seller will not permit leakage that would result in their detriment. Therefore, this mechanism is considered buyer-friendly.

In a locked box deal, the financials of the target company are examined in a single instance, and the agreed-upon purchase price is numerically stated in the share purchase agreement. Therefore, locked box agreements are shorter and simpler. As this price is determined prior to the signing date of the agreement, unlike the closing accounts, the parties do not need to extensively negotiate each financial item and accounting standards. However, the parties must still agree on prohibited and permitted leakage, indemnification for damages, and the seller's clawback. While this structure does not open the door to any disputes over the purchase price, the buyer should nonetheless review the accounts for leakage.

CONCLUSION

We have discussed above the advantages and disadvantages of both the closing accounts and locked box mechanisms. Ultimately, these two systems, each internally consistent, can be preferred depending on the unique characteristics of each transaction and the parties' approach. It is worth noting that both systems can exhibit considerable variability in each transaction. For instance, they can be combined with installment payments, profitability-based payment methods, or earn-out mechanisms. Therefore, it is important for the payment provision to be prepared at the conclusion of negotiations involving the legal and financial advisors of the parties involved in the transaction, in order to reduce potential disputes that may arise later on.

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.