Determining the price when buying and selling a business
When buying or selling a company, the purchase price will be a key consideration and there are a number of mechanisms which can be used to determine this. Two of the most common methods are completion accounts and locked box.
The mechanism which is chosen depends on the preference of the parties, their bargaining power and the particular circumstances of the transaction. This insight summarises the two mechanisms and highlights the advantages and disadvantages to sellers and buyers if these mechanisms are adopted.
When completion accounts are used, the buyer pays a set purchase price on completion but this amount is later adjusted upwards or downwards based on a set of accounts produced after completion which show the position at completion. These accounts are used to test certain metrics, such as cash, debt and working capital. As completion accounts are produced following completion and are based on actual metrics at the completion date, they provide a more accurate picture of a company’s performance.
- Adopting the completion accounts mechanism can help to speed up the transaction process: the parties may be able to reach completion more quickly as there is no need to negotiate the exact purchase price up front. For the seller, there is no risk of being underpaid because actual metrics of the target, at the date of completion, are being measured.
- Because the price is based on these actual metrics, the buyer will be paying a more accurate price and is not likely to pay more than is reasonable for the target. The figures used to compile completion accounts are based on current data. Historical data, where the performance of the target may have changed in the interim, will often not reflect the target’s current situation.
- The buyer will usually produce the first draft of the completion accounts and will be in control of the company during this process. The accounts are used to value the business and so the buyer can focus on the metrics it believes are key to the business of the target.
- Producing completion accounts can be costly and both the buyer and the seller will need to engage an accountant to assist in the negotiation of the accounts.
- The seller will have less control over the adjustment process post-completion as the buyer is in control of the business at the time the completion accounts are drafted. There is a potential for disputes following completion when the buyer, who has already acquired the shares, has no incentive to compromise on price. The seller takes on the economic risk up to completion so should the target underperform its value may decrease once the completion accounts are drawn up – if the target performs well, this is good news for the seller who may then receive more consideration.
- There may be considerable delays in finalising and agreeing the completion accounts and there may be disputes as to the scope and basis on which the accounts are to be prepared.
A locked box deal is essentially a fixed-price deal which is based on a historical set of accounts. The buyer will assume both the risk of a fall in value and the reward of an increase in value between the date of those accounts and completion. In order to achieve certainty as to price, the buyer needs to ensure that the ‘box’ is tightly locked meaning that the sellers cannot extract value from the company between the date of the accounts and the date of completion.
- Locked box allows for certainty of price – the buyer knows exactly what it will pay and the seller knows exactly how much consideration it will receive at completion. The parties will agree actual values for each item in the accounts, rather than a mechanism for determining those accounts (which can leave open the possibility of disputes).
- For the seller, the risk of deterioration passes to the buyer at the locked box date and so any fall in value of the target between that date and completion is borne by the buyer. The flip side of this is that the seller does not benefit from any profits earned by the target in the interim period up to completion although the buyer may be required to pay interest on the purchase price to cover this.
- The buyer can be safe in the knowledge that the purchase price will not fluctuate and this should make sourcing funding more straightforward.
- Enhanced due diligence will be required to establish any risk of the business deteriorating between the locked box date and completion. This can be costly to the buyer and it will have an increased reliance on warranties.
- It may take longer to get to completion if the locked box mechanism is adopted because more negotiations will be required earlier in the process around items such as debt and working capital to agree the locked box accounts.
- There is always the possibility of ‘leakage’ from the locked box where the seller looks to extract value in the interim period – this can reduce the value of the target at completion. If any ‘leakage’ does occur the seller will be required to pay compensation to the buyer. In the period between the locked box date and completion, the seller will be restricted as to how it can run and operate the business.
Which mechanism is adopted will be driven by various factors, including the relative bargaining strength of the parties. As a (very general) rule of thumb, buyers tend to prefer completion accounts and sellers prefer a locked box.
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