The primary goal of almost every CEO 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.
A myriad of factors will determine the successful signing and completion of a deal. The most important of which is typically the agreement between principals of the price to be paid and received in a deal. Normally, this pricing focus will centre on the ‘Enterprise Value’ or ‘Headline Price’ offered, which is often derived from a multiple of earnings and/or from a discount of forecast future cash flows. However, this enterprise value may differ significantly from what is actually 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 actually paid and received for the business can be very different.
Determining the Equity Value
The signed SPA sets out 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 will also set out a pricing mechanism that determines the equity price at completion. Under a locked box mechanism, the final equity price will be written into the SPA. With completion accounts, the SPA will describe how the enterprise value should be adjusted to reach the equity price, who should prepare and who should review the completion accounts, when these adjustments are made, and, most importantly, the basis of deriving the quantum of these adjustments. The SPA may also 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 may seem like a straightforward calculation, but the agreement of 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 come together on the headline price and commercial terms of a deal, only for it to fall apart prior to completion due to disagreements over the components of the price adjustment.
With the absence of definitive rules or standards for completion mechanisms, parties to a transaction will often cite ‘market practice’ when negotiating how the initial offer price is converted into the final equity value. 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?
In our pioneering survey we obtained the views of almost 600 participants from over 400 organisations internationally to identify key themes and practices worldwide including:
- The understanding and appreciation of the Locked Box mechanism is rising fast: 76% of respondents had used this mechanism in the last 12 months and 64% had seen its usage rise over the past 5 years. It is now a common alternative to the traditional ‘completion accounts’ pricing mechanism, yet despite this it isn’t always fully understood by deal participants and 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 to consider agreeing them early in the transaction process. Doing this as early as the offer stage (before exclusivity is granted) may be 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.
Our team at Grant Thornton combines completion mechanism adjustment and dispute specialists to help principals and advisers to reach an agreement on the SPA that protects real monetary value, whilst reducing the risk of disputes. Grant Thornton offers clients this specialised expertise, for both domestic and cross-border transactions, across a full range of sectors.
We are the only integrated specialist SPA team with a focus on mid-market transactions. Our team brings together their insights and experience of well over 1000 deals to support clients on the full range of issues that can arise during the deal process: from negotiating ‘locked box’ or completion mechanisms and accounting warranties, to finalising completion accounts and earn outs, advising and acting as accounting experts in resolving disputes and undertaking independent expert determinations.