#10200 - Closing Accounts Earn Outs Closed Box

1. Adjusting the Purchase Price (PP)

What Matters is what the Parties have agreed.

1.Representations and warranties made by the seller: the purpose of this to:

encourage disclosure by the seller;
allow the buyer to walk away if any are discovered to be untrue to a material extent before closing (subject to negotiation); and
provide retrospective price adjustment if any are found to be untrue after closing, through claims for breach of warranty by the buyer.

2.Closing accounts: Do not make PP fixed, instead make it subject to adjustment by reference to closing accounts (which includes, a full profit and loss account ad balance sheet or, a valuation of assets such as stock or, a determination base on financial matters such as the level of cash and debt.

3. Earn-outs: Make PP dependant on earn-outs (earn outs are security against breaches of warranty or adjustments to the PP based on the deferral of the PP by reference to future performance of the target Co.

4. Negotiate the Purchase Price and “Lock-Box” it(i.e. fix it beforehand) Most commonly used in Share Acquisitions. It is attractive for the sellers but riskier for the buyer as there will not be a chance for adjustment after completion (except by using a warranty claim).

2. Adjusting the Payment

- Deferred Consideration: The buyer could ask the Seller to agree to receive a deferred consideration. This is in line with a potential PP adjustment as a result of an agreed Earn-Out. Similarly, due to the potential IP Rights claim the Buyer will be in a good position to ask for retention of part of the purchase price as security in case the IP Rights claim arises.

3.Points to clarify with client + identify further instructions to amend the price and payment provisions in the SPA.

This is an Acquisition in Brazil, contact local counsel.
The position regarding the Earn-Out will depend on whether the sellers will manage the Co. after completion + if so, for how long + timetable to review the accounts
The accounts of the seller
The IP Rights claim
Stock Valuation + Debtor Valuation + Fix Asset Valuation
Pre-completion considerations in relation to changes to the accounts

Workshop Task 1

	Completion/Closing accounts	Earn-outs	Locked box
¿ when?	Price is determined at completion of the transaction and it is subject to the values contained in the Closing Accounts. ¿Who?S’s accountant usually drafts first set, as they are familiar with the Co, but the B may prefer to have its own accountants do it as it allows greater financial scrutiny (improve their negotiation position)	Part of the consideration is giving at completion and other depending on the success of the Co. (S’s Ds manage the Co. for a while after completion ) ¿Who?B’s accountant usually prepares the accounts for each period; payments are calculated by thresholds achieved or by a multiplier. Need to have accurate definitions e.g. “net profit” or “closing assets.	A fixed price has been agreed before completion May be paid in installments there might be a retention of the PP (perhaps because there is a threatened liability and B knows of it)
S controls after completion	No	Yes, the seller maintains control during the earn-out period.	No
¿ Why use it?	Buyer’s view: B isconcerned over accuracy of S’s accounts (stock, assets, debts valuation) thus B wants to know it is paying for what it is getting “tune up the PP”. B wants an up-to-date picture of the value of the Co. at completion (S’s accounts may be old) Bringing a claim under a warranty (e.g. because stock not in condition as warranted by S) is a lot more cumbersome and expensive than sorting this out in advance via balancing payment/refund Seller’s view: S may get a better price e.g. if the assets/shares were originally undervalued. Protects S from having to defend a warranty claim in the future. Completion = quicker. S may have a say how the assets/shares are valued	Buyer’s view: the Co. may be a new venture and B wants to make sure it is successful Prevents B overpaying for a Co. that does not live up to B’s expectations Motivates S/managers to help the Co. perform highly (also if Co.’s managers are paid in shares in Holding Co.) Private equity B’s or Private Co.’s often use this method Seller’s view: S’s want to prevent B from reducing value of Co. during the earn-out, S wants to protect profit. S wants to stay in Co. to enable profit targets to be met and prevent B from undermining short-term profit e.g. by investing in R&D, substantial asset disposal/purchase The deferred payment will affect S’s tax liability (see tax note “your lpc”) Secure Co.’s outstanding payments Restrictions on intra-group transfers Restrict material change of business after completion = prevent devaluation	it is the simplest, quickest way to valuate a Co. commonly usedin share acquisitions before SPA is signed. attractive for S but riskier for B whose only opportunity for priceadjustment after completion is by bringing a valid warranty claim. B is wise to include provisions in the SPA toprotect against ‘leakage’ –i.e. seller extracting value from the target between signing & completion. Leakage’ examples: payment of a dividend, unsanctioned transfer of assets to target SHs, or inappropriate payment of expenses by the target. S will usually be obliged to undertake to repay such ‘leakage’ to B on a pound for poundbasis.
Disadvantages	Expensive (because of hiring the accountants), Delay (waiting for the accountants to do their job and agreeing terms), Getting the accounts ready (the seller may be slow or not have consolidated accounts), agreeing on all the above (B may want X and S may want Y) uncertainty,	Delay (agreeing the terms) Only suitable when S is involved in the business after post-completion. S will want to manage the Co and have some control during the Earn-out period. S & B may want different things. Thus there will be concern as to the short-term long-term profits if the Buyer is not involved in the aims of the Co.	It is inflexible as to the price and thus the B may not be getting a fair value. The value assessment method might not be as accurate
¿ Is the PP at completion ascertained, ascertainable or unascertainable?	Ascertainable (we can give a valuation of the Co. because we have access to most information to make the valuation)	Unascertainable (It will depend on several variables which are not there yet and we will depend on future information)	Ascertained (we know what the exact PP is at completion)
TAX SEE the Note on TAX on YOUR LPC	The S will have to pay on the basis on the amount that it is likely to have to be receiving	There are two taxing points: 1. At completion, the S will have to pay the tax on: a)Money received at completion + b)The sale of the Chose in Action (which HMRC calculates at will) 2. HMRC will compare the value they calculated in b) (above) with the value that the Co. actually receives for any earn-out	Because the PP is ascertained the TAX can be calculated in a straightforward manner. Thus S pays CGT on sale and B pays Stamp Duty tax.
Consideration	Cash, electronic transfer, shares and debs securities
Valuation of a Company	The valuation of a property can be based on: The assets of the company (Buildings, machinery, stock) The overall value of the business (goodwill, knowhow, IP, and profitability) A combination of the two When valuing a Co, the accountants will consider a number of elements: The value of the stock, The value of the assets, The value of debts, The value of Goodwill, IP, Know how Accounting principles and valuation mechanisms will have to be agreed by the Accountants of both parties. It is common to agree on standard (sometimes Int. Accounting policies: GAAP or UK-GAAP)
Closing/ CompletionAccounts provisions	Determine whether it will be the B’s or the S’s accountant who will draw the accounts. Determine a fixed payment to be made at Completion, with an adjustable balancing payment/refund to be made after the accounts are prepared Agree a time table for completion and for drawing the accounts (i.e how long will it take to draw the accounts, how are the parties going to reply etc) + sanctions for delay determine the accounting policies; options: whether bespoke accounting policies and mechanisms agreed by S&B whether to use Standard international Policies GAAP or UK-GAAP But in particular the following should be considered: whether S’s accounting policies used up to this point are reasonable, accurate, reliable. Define terms e.g. “Slow Moving Stock” in order to have an accurate valuation e.g. 50% of its sale price or cost price of stock Define “bad debts” e.g. 100% of those bad debts over 18 months will be labeled as “bad” and written off. Will there be a depreciation policy for assets? Will there be restrictive covenants to prevent “improving” of the accounts e.g. S overstocking the business pre-completion, or B doing something post-completion (when it has control) to reduce value and use the representations warranties against S. Determine a Dispute Resolution Mechanism(including referral to 3^rdP) and agree on costs The parties will have to agree on the Price Adjustment Mechanisms (PAM): Upwards only?,Downwards only?, a combination of Both? Pound for pound multiplier (with relation to Co.’s net assets or Co.’s profits)(i.e. a mathematical formula usually called a “multiplier”)) to adjust the price if the assets/profits are...

#10200 - Closing Accounts Earn Outs Closed Box - Mergers and Acquisitions (Private Acquisitions)

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