Payment Mechanisms Notes

What is fixed price?

• Parties agree a price for the target company which is fixed before SPA is signed.

Is fixed price applicable on the facts?

There has been a recent trend towards fixed price transactions due to the great scope for time-consuming disputes in relation to the preparation of completion accounts, but earn-outs and completion accounts are typically more attractive options due to obtaining up-to-date and accurate information.

1. Risky for B whose only opportunity for a price adjustment after completion is by bringing a valid warranty claim.

2. May be longer negotiations which may not result in any final agreement (e.g. on the valuation of the company).

3. S may attempt to extract value from the company between the date of the agreed accounts and the completion date ('leakage') such as through dividends or inappropriate payment of expenses.

4. But this can be guarded against by obliging S to undertake to repay such leakage to B on a pound for pound basis.

What is an earn-out?

• Part of the consideration will be based on the profit earned over a specific period of time post-completion. An initial payment will be made on completion and then following payments will be made depending on the profits earned during that period.

These are most often used where S continues to manage the company post-acquisition.

For example...

• B values the company at 10m based on its past performance.

• S values the company at 15m based on projections of the company's future profit.

• If they can't agree on the fixed value of the company, they could agree that B pays the initial 10m, and then the remaining 5m if S's valuation proves true within a certain amount of years.

2. Motivates S/manager of Business to maximise the profit of the company, particularly if that person is likely to stay on and continue to play some role in running Business.

2. Possibility that B could acquire the target and sell it to a third party. If B did that, then the profit won't meet S's projections and will affect how much consideration they will receive. Restrictions can be put in place to prevent this - Sellers remain involved and spot if B does something against spirit of the agreement.

What are completion accounts?

• When negotiating, parties may have based their valuation on dated information (such as the last audited accounts).

• B will want confirmation that the figures have not altered significantly since the date of original accounts.

• The completion accounts will confirm the valuation of the target and make provisions for any necessary adjustments to price on completion date to reflect the actual net earnings and/or assets of the company.

Are completion accounts applicable on the facts?

Stock/Assets

1. Is there a concern/disagreement about the method of valuation of an asset (e.g. stock valuations, depreciation, bad/doubtful debts)?

2. Is the valuation based on management accounts (whose purpose is not the valuation of the company for sale as a going concern) or out-of-date audited annual accounts?

3. If so, then completion accounts will give an accurate and up-to-date valuation of the assets on completion date, determine the method of valuation, and impose time limits (e.g. end of season stock will be depreciated more than new season stock for a retailer)

Profit levels

1. Is there a concern about the level of profit in the target company? (e.g. very high for the most recent period but based on out of date accounts)

2. Completion accounts will be able to determine the exact level of profit from the last audited accounts (date?) to the completion date (date?)

3. Can also negotiate accounting policies for bad debts, doubtful debts, depreciation, etc.

4. Would litigation be problematic (e.g. foreign jurisdiction?) - if so, then completion accounts will be easier than pursuing a warranty claim that the out-of-date accounts are true, accurate and not misleading.

1. Accuracy

• Gives B a more accurate picture of the company as at the date of completion and so B is more likely to pay for exactly what it is getting.

2. Up-to-date audited accounts

• B doesn't have up-to-date assessment of the company before completion

• Audited accounts are not made up to value the company and may be out of date

• Management accounts may be up-to-date, but their purpose is to aid the running of business and not to value the company for sale as a going concern.

4. Agreed accounting policies in advance

• Valuations (e.g. of stock) - by what method?

• Depreciation - how much?

• Bad debts - threshold?

• Doubtful debts - "doubt" is discretionary

On P&L account, the above are expenses and will...