Acquisitions: Purchase price mechanisms

The most common purchase price mechanisms

At one business acquisitions the choice of the purchase price mechanism is an important factor that affects how the payment for the acquisition is structured. Two common principles used are fixed purchase price (in English locked box) and preliminary purchase price with subsequent adjustment (in English completion accounts). Depending on the approach chosen, the purchase price can be managed in different ways, which has consequences for buyers as well as sellers.

Fixed purchase price (locked box)

The locked box mechanism is a popular purchase price mechanism, especially in Europe, where the purchase price is set and negotiated based on a historical date. This mechanism offers both buyers and sellers predictability and clarity, as it avoids subsequent adjustments and ensures that the purchase price does not change after access. The locked box mechanism includes the following main components:

• Locked box date: This is a specific historical date agreed upon by buyers and sellers. At this date, the target company's financial position is determined and documented in a locked box balance sheet that provides a snapshot of the target company's assets, liabilities and equity as of the locked box date. Based on this financial statement, the purchase price is determined.‍
• Initial purchase price: The determined purchase price based on the financial position as of the locked box date. ‍
• Interest rate: Some transactions using the locked box mechanism include an interest rate (sometimes called a “ticking fee” or “interest charge”) calculated on the financial position as of the locked box date. This interest is a way of compensating the seller for effectively accessing the target company's cash flows from the locked box date until the date of access, even if ownership formally transfers only upon access. The interest rate is a matter of negotiation between buyer and seller and shall reflect the return the seller would have received if the cash flow had been available to the seller in the period leading up to the access.

On the day of access, the buyer pays the initial purchase price along with the interest. Beyond the initial purchase price and interest, there is no further adjustment to the purchase price, which means that the parties know exactly how much is due at the time of access. In the locked box mechanism, it is often defined which transactions must not be executed between the locked box date and the access date and these transactions are called leakage (in English). Examples of this could be dividends paid to the seller, excessive bonus payments, or other payments that reduce the value of the target company without the buyer's approval. To protect against leakage, the share transfer agreement should contain specific write-ups prohibiting such transactions, and if they occur, the corresponding amount should be deducted from the purchase price or returned to the buyer. Permitted Leakage Transactions between the locked box date and access may include ongoing business expenses or contracted payments and do not affect the purchase price.

Advantages of the Locked Box mechanism include:

• Predictability: Since the purchase price is determined in advance, both parties know the exact size of the purchase price which reduces uncertainty.
• Simplicity: This mechanism avoids complex subsequent adjustments that can lead to disputes and delays.
• Time saving: Since no subsequent asset accounting and adjustment is required, the transaction can be completed more quickly and with fewer administrative steps.

Disadvantages of the Locked Box mechanism include:

• Risk for the buyer: The buyer assumes the risk of any adverse changes in the target company's financial position between the locked box date and the date of access. Therefore, it is important to carefully monitor the activities during this period.
• The weight of the review: A careful due diligence and review of the locked box balance sheet is central as the buyer does not have the opportunity to adjust the purchase price after the locked box date.

In conclusion, the locked box mechanism is an efficient and predictable method for managing the purchase price in a business acquisition. By locking the purchase price at an earlier date and preventing subsequent adjustments, it gives both buyer and seller a clear picture of the financial condition of the transaction. But it also requires rigorous scrutiny and strict adherence to contracted rules to ensure both parties are treated fairly.

Preliminary purchase price with subsequent adjustment (completion accounts)

The principle of preliminary purchase price with subsequent adjustment is more dynamic and adjusts to the actual financial position of the target company at the date of access. This ensures that the purchase price reflects economic reality and reduces the risk of either party paying too much or too little. To understand how this mechanism works in practice, it is important to break down the process into a few key steps:

1. Preliminary purchase price

On the date of access, a preliminary purchase price is paid based on a preliminary access statement. This is an estimate of the financial position of the target company and serves as an initial reconciliation between the parties.

2. Preparation of access accounts

After the access, a final access statement is drawn up which gives a detailed and accurate picture of the financial position of the target company at the time of the change of ownership. This financial statement is crucial in determining the final purchase price.

3. Review and Approval

Both parties are reviewing the final access accounts. Any discrepancies or disagreements regarding the content of the financial statements are discussed and resolved before both parties give their consent.

4. Final settlement

Once the access accounts have been approved by both buyers and sellers, a comparison is made between this and the preliminary financial statements. Any differences are adjusted, leading to the final settlement of the purchase price. This step ensures that the purchase price accurately reflects the target company's financial position at the date of entry.

The choice between fixed purchase price and preliminary purchase price with subsequent adjustment is an important decision where fixed purchase price offers simplicity and predictability, while preliminary purchase price with adjustment provides a more flexible and fair pricing based on actual financial data. By carefully following the important steps of the chosen mechanism, both buyers and sellers can ensure that the deal is executed in a fair and correct manner.

At FLB Partners, we offer expertise and support throughout the acquisition process, from strategic planning to integration. Contact us today to discuss how we can help your company with the acquisition process.