The challenge of drafting purchase price adjustment clauses in merger & acquisition contracts

Magisterarbeit von Alexander W. Nürk

Introduction:

The topic of Mergers and Acquisitions (M&A) is currently on everyone’s lips. No day passes by without reading about a planned or realised M&A transaction in the newspapers. The last few years have been record years for the M&A business. The year 2007 could in fact top the record year of 2006. Although, the first half of 2007 was remarkably successful, the subprime crisis of the credit markets led to a slow-down in the second half. However, M&A transactions with a transaction volume of approximately $ 4.830 billion took place worldwide in 2007. The forecasts for 2008 expect a recession of the transaction volume of up to 25 % of the previous year. Mega-deals will not make the headlines as often as in 2007, because banks became more careful in granting credits for such deals due to the subprime crisis. However, M&A International INC. (MAI) expects that the subprime crises will have only little impact on small and medium-sized M&A transactions and 2008 will still be a good year for the M&A business.Various companies have also taken advantage of the weak U.S. Dollar exchange rate and plan M&A deals overseas. Since the wind has not yet been taken out of the M&A businesses sails, the challenge of performing a successful M&A transaction remains.

Like any other businesses, M&A transactions are a dynamic process which has to be accounted for. When a buyer purchases a company (target), the assets of the company cannot be held in stasis until the transaction is settled. The company is in a constant flow and its value changes constantly. This makes it hard to determine a precise purchase price that remains valid from the beginning until the end of the transaction process. Since the value of the company changes through this process, the purchase price has to be adjusted. Therefore, purchase price adjustment tools have to be part of the M&A contract to ensure so. Generally, legal counsels are assigned to draft M&A contracts for the parties. Although, an M&A team should consists not only of lawyers, but also of accountants, tax consultants and others, where every member is specialised in a certain field, the legal counsel should have a general overview, since he is the one drafting the contract. The quality of his drafting becomes apparent when disputes arise. Most lawyers have no clue about company valuation methods or the principles of orderly accounting. However, these two applications are essential when it comes to drafting purchase price adjustment clauses.

This paper addresses lawyers and everybody who is in the position of drafting M&A contracts. Since M&A contracts include various clauses, this paper covers only purchase price adjustment tools. It gives a general overview of purchase price adjustment tools, manipulation issues, purchase price calculation standards and the coordination of the clauses among each other. Various possible problems which should be factored into the drafting process will be mentioned. It is impossible to predict every potential issue that is relevant for purchase price adjustment, because every transaction is different. Therefore, this paper is rather a guideline which supports the drafter of a purchase price adjustment clause to think about the main issues that can occur and to inspire further thoughts.

In chapter 2, the basics of M&A are discussed, such as the scope of definition for M&A, and motives and phases in the M&A process. Chapter 3 provides a brief introduction into company valuation methods. This is a very important chapter for the following purchase price adjustment tools. Someone who drafts purchase price adjustment clauses has to know how the company was valued, since different valuation techniques can lead to different results, and hence to different purchase prices. The various valuation approaches can be applied to purchase price adjustment issues. Therefore, it is essential to know their components to obviate manipulation potentials. Three company valuation methods are discussed: the net asset value method, representing single-valuation-procedures, capitalised earnings value method and discounted cash-flow method, representing total-valuation-procedures. Main attention is focused on discounted cash-flow methods, since they are the ones that are mainly used, especially in international transactions.

In chapter 4, various guarantees will be highlighted where breaches can also result in purchase price adjustment. Discussion focuses especially on the guarantees under German law, which have different impacts on the magnitude. An ambiguously formulated clause can have the surprising opposite effect than desired by the parties. This leads to one of the central themes that can be found throughout the paper; unambiguous precise formulation of clauses is the basis for a successful contract drafting, resulting in a reduction of potential future disputes.

The main chapter of this paper is chapter 5 where the two tools which directly influence the purchase price will be discussed: retrospective purchase price adjustments (post-closing adjustments) and future-oriented purchase price adjustments. While post-closing adjustments only apply to the period between signing and closing date, future-oriented purchase price adjustments come into effect after the closing date. The differences, advantages and disadvantages for both parties, the appropriate metric, manipulation issues and the calculation of the purchase price adjustment will be topics covered to provide support to the drafter of relevant clauses of most problems which can occur subsequently.

Chapter 6 provides a brief introduction to dispute resolution problems, which are particularly relevant in international M&A transactions, since arbitration does not follow the same rules internationally. As other clauses in an M&A contract also have influence, mainly indirectly, on the purchase price, chapter 7 covers the matter of coordination of purchase price influencing clauses. This chapter concludes with a case, decided from an U.S. Court, where contradictory clauses in an M&A contract cost the buyer millions of U.S. Dollars of purchase price adjustment. This example shows the importance of clear formulation of the clauses so that it leaves no room for interpretation.

The paper does not deal with tax issues that affect purchase price adjustment procedures. It further does not address Generally Accepted Accounting Principles (GAAP) in detail, but rather shows some differences and issues that might occur. It is also impossible to mention every possibility for manipulation that the parties might thinks of, since every transaction is different and each industry and business branch has its own peculiarities. Overall, this paper is meant to be a guideline and does not provide an ultimate solution for purchase price adjustment.

Table of Contents:

Text Sample:

Chapter 4., Guarantees:

This section of the paper discusses guarantees, the first tools which can directly influence the purchase price of an M&A transaction. Generally, guarantees have the purpose of minimising the risk to the buyer for a specific period of time. In the case of a very quick and hence imprecise performed due diligence, the buyer cannot get as much information about the target as desired. It is common to limit the time for performance of due diligence and when the transaction is a large-cap, there are lots of data to go through. Due to the limited time, not all information can be gathered; getting a general overview of the target as opposed to a resourced consuming detailed information. Under these circumstances, the buyer acquires the target without having all the information he prefers to have. He bears the risk that something unforeseen and unexpected will occur after the deal is made. To limit this risk, the seller issues guarantees at the expense of a higher purchase price. If the due diligence period is short, the buyer is well advised to ask for guarantees and therefore pays a higher purchase price. If the due diligence period is extended, the buyer does not need a plenitude of guarantees, because he can gather all the information he needs to reduce his risk and hence pays a lower purchase price. Therefore, the rule is, the more comprehensive and precise the due diligence of the target is performed by the buyer and the more transparent it is documented, the less guarantees will be issued by the seller.

A guarantee usually ensures the quality or characteristics of the object of purchase and is limited to a certain period of time. Generally, until closing, since the buyer has no control or influence over the target until this date, or for a certain period after the closing date (post-closing guarantees). The buyer can ask for various kinds of guarantees and the seller can issue the same.

Forms of Guarantees:

According to the general principle of freedom of contract, the parties are independent to choose the form, quantity and the scope of guarantees. It is up to the parties in deciding how detailed the guarantee clauses ought to be. From a seller’s point of view, guarantees are a way to raise the purchase price at the expense of increased liability risk. If the seller feels confident that all the data provided to the buyer are correct, complete and not manipulated in anyway, he should be happy to issue guarantees. In cases where the parties have not agreed to all terms in the M&A contract or there is an argument about the purchase price, this move might persuade the buyer to agree and convince him that his concerns are limited by these guarantees. From the buyer’s point of view, guarantees are a helpful tool to overcome uncertainties which have occurred during due diligence or negotiations.

Guarantees that can influence the purchase price are not only issued for retrospective qualities or characteristics, but also for future ones. Typical forms of guarantees include: equity guarantee, working capital guarantee, asset guarantee, debt-free guarantee, guarantees concerning parts or the complete financial statements, and the non-realisation of certain risks in the future.Some of them will be discussed at the following in detail.

Guarantee of Financial Statements:

Probably one of the most important guarantees is the one about financial statements. Regardless of which method of purchase price adjustment is used, all of them depend on the numbers in the financial statements. Therefore, these statements must be reliable. A guarantee typically involves the preparation of the financial statements according to GAAP, in compliance to formal and material continuity of past prepared financial statements, and its completeness and correctness. From a buyer’s perspective, this type of guarantee should always be drafted in an M&A contract as it builds the foundation for post-closing adjustment and earn-out clauses. That also ensures the buyer about the numbers that build the basis for the company valuation. The guarantee of the financial statements goes hand-in-hand with other purchase price adjustment tools.

Equity Guarantee:

An offset of the guarantee of the financial statements is the equity guarantee. Both parties agree to an estimated balance of equity at a certain future point-in-time. The estimated balance of equity could, for example, be calculated by taking the book value of equity of the last balance sheet, increased by the planned profit. If the estimated balance of equity equals the actual balance of equity by that time, the purchase price falls due. If there are any variances in terms that the actual balance of equity is higher or lower as the estimated balance of equity, purchase price adjustments will take place. As a consequence, the purchase price which the buyer has to pay can increase or decrease. It is commonly accepted that a negative purchase price, which stands for an additional payment by the seller in case the actual balance of equity does not reach the estimated balance of equity at the point in time when the object of purchase is handed over, is contractually excluded.

This kind of guarantee does not only take solely the equity into account. It also considers other assets of the balance sheet. To name a few, the buyer can reduce the following risks: distribution of company profits by the seller after the signing date, withdraw of cash of the target by the seller after signing date, reduction of profit through exercising an option with regards to items included in the financial statement after the signing date (for example, alteration in accruals) or the reduction of revenue reserves.

An equity guarantee is a very attractive guarantee for a buyer, since it leads to an intense minimisation of his risk. It is not so attractive for the seller, because his ability to calculate future revenues is limited by the guarantee and he has partially to bear the risk of future business development. Therefore, this guarantee will lead to an increase in purchase price to equalise the seller’s risks.

A legal counsel drafting this kind of guarantee has to be aware of the conceptual scope of the term ‘equity’. Equity in terms of a legal, economic or commercial context can be distinguished and include different financial assets. The term must be precisely defined in order to prevent future misunderstanding.

Working Capital Guarantee:

The working capital guarantee when compared to the equity guarantee is not as comprehensive and therefore easier to reach an agreement between the parties. It is also an offset of the guarantee of the financial statements. Working capital guarantees insure against fluctuations in the company’s operational current assets. It is preferred by companies that have comparatively high fluctuations in operational current assets, like the consumer goods industry. The objective of a working capital guarantee is that the seller assures a certain amount of working capital at the closing date. This assures the buyer that there will be no outflow of liquidity until that date.

Similar to equity, working capital is ambiguous. It is not clearly defined what exactly can be subsumed under ‘working capital’. All definitions agree that ‘working capital’ represents the current assets financed by long-term debts, or in other words, the difference of current assets and current liabilities. Various definitions take diverse balance sheet items into account. Here are some definitions of working capital:

‘Operating working capital comprises of operating cash, accounts receivable, stocks (inventories), and other current assets (such as prepaid expenses) less accounts payable and other current liabilities (such as tax payable)’.

Working capital is cash, marketable securities, accounts receivable and inventory, less accounts payable, accrued liabilities and short debt.

Working capital is the sum of stocks, operating liquid assets, accounts receivable and other current assets, less trade accounts payable, other accounts payable and deposits received.

‘(Working Capital) refers to current assets less current liabilities. Current assets include cash, marketable securities, debtors and stock. Current liabilities are obligations that are expected to be repaid within the year’.

‘Short-term or current assets and liabilities are collectively known as working capital.’ Current assets include but are not limited to cash, marketable securities, accounts receivable and inventories. Current liabilities include but are not limited short-term loans, accounts payable, accrued income taxes and current payments due on long-term debt.

It is essential for the drafter of this clause to define precisely which items are included in ‘working capital’ and which are not. That is the only way to avoid any ambiguity after the closing about the calculation of the purchase price. A detailed scheme should be enclosed as an annex of the contract, stating the relevant items of the balance sheet which identify working capital.

Comparable to an equity guarantee, the working capital guarantee has a purchase price adjusting effect if the guaranteed working capital is not given at the closing date. Depending on the fluctuations, the purchase price can be higher or lower. The drafting counsel must be aware of the fact that the working capital guarantee alone cannot prevent manipulations. On the basis that working capital is only a result of a mathematical mixture of current assets and current liabilities, it is easy to manipulate the amount of it. For example, long-term assets and long-term debts are not part of the various working capital definitions. An accounting exchange on the asset side can take place, where long-term assets, like machines, can be sold. The liquidity increases and hence the working capital increases as well. At the closing date, the working capital would be higher than the guaranteed one and the purchase price would be increased. The consequence is that the buyer pays a higher purchase price for the company that is of a lower value, since assets are sold.Another possibility is to create bank debts, which are usually not covered under the working capital definitions, that increases the liquidity and ultimately the working capital. Through these manipulation possibilities, the seller can influence a higher purchase price. Therefore, legal counsels should use a combination of guarantees that collude to prevent manipulations.