Consideration Flashcards
1
Q
When is consideration paid?
A
- The full purchase price will often be paid at completion, but sometimes payment of an element of it is delayed until a date after completion (“deferred consideration”). In either case, the parties need to decide what method will be used to agree the purchase price and, once it is agreed, what form the consideration will take.
2
Q
- Debt free/cash free
A
- One method for agreeing the price to be paid for the target is on a “debt free/cash free” basis.
- This means that the value of the target is set on the assumption that there is no debt or surplus cash in the target company at completion, which allows the buyer to concentrate solely on the value of the underlying business itself.
- However, in order to move from this valuation to a final consideration to be paid, the parties will need to know how much cash and debt is actually in the target at the date of completion, in order to factor this into the price.
- This is likely to require completion accounts to be drawn up after completion and an adjustment to be made to the price, either up or down, depending on whether the target turns out to have had net cash or net debt at completion.
- There is no universal standard definition of “debt free/cash free”, therefore, if the parties agree that this method is to be used, it is important to check that they both have a mutual understanding of what this means in the context of their deal - for example, the buyer may claim that certain cash held by an overseas subsidiary of the target cannot be distributed to the target without incurring tax or other costs and so a discount should be made for any such “trapped cash”. A debt free/cash free valuation seeks to determine the value of the target’s business ignoring how it is funded: this is sometimes also referred to as the “enterprise value”.
3
Q
- A debt free/cash free valuation is one of the most common forms of valuation and is often used by convention. In particular:
A
· In auction sales it provides a common basis for comparing indicative bids; and
· It takes the purchaser’s perspective by showing precisely how much money it will need to raise in order to fund the purchase (the funds payable to the seller and any bank lending required to service any net debt (i.e. debt minus surplus cash) of the target).
4
Q
- Net asset value (‘NAV’)
A
- The buyer may also use the NAV of the target company, taken from the last set of audited accounts, as a basis for its calculation of the purchase price.
- This would generally be used where the target company has significant property or other tangible assets and is commonly found in certain sectors, such as financial services businesses.
- On a NAV offer, the buyer will want confirmation that this NAV has not changed since the last accounts were drawn up. However, the NAV will inevitably have changed since the date of the last set of audited accounts and the parties may therefore agree that the purchase price will, after completion, be adjusted up or down, as applicable, in order to reflect any material change, as shown by a set of completion accounts.
5
Q
- Earnings basis
A
- Where a target company’s value is not accurately reflected in the value of its net assets, valuation is more likely to be made on an earnings basis. This is a common basis for valuation across many sectors, including, for example, research and development companies or companies that have yet to turn a profit.
- This is determined by taking the future maintainable earnings of the target multiplied by an appropriate multiplier (usually related to comparable quoted companies).
- Although the valuation is based on future earnings, an analysis of past earnings will usually be relevant as a guide to future prospects (where appropriate). The agreed multiple will usually be applied to earnings before interest and tax (‘EBIT’) or earnings before interest, tax, depreciation and amortisation (‘EBITDA’).
6
Q
- Price adjustment: completion accounts
A
- In both the debt free/cash free scenario and where the NAV of the target company is used as a basis for the calculation of the purchase price, the parties may agree to prepare accounts which show the actual financial position of the target as at the date of completion (“completion accounts”).
- Such accounts can only be prepared after completion and the parties will agree a date after completion by which they must be prepared.
- After the completion accounts have been agreed, the purchase price will be adjusted, if necessary, to take into account:
· (where the purchase price is based on a debt free/cash free scenario) any net cash or debt which the completion accounts show was left in the target company at the completion date and which was not already provided for and, often, any deviation in the amount of working capital or capex in the target from an agreed baseline level; or
· any difference between the NAV in the completion accounts and the original NAV figure (in the last audited accounts) that the purchase price was based on (where the purchase price is based on the NAV of the target company). - If the purchase price is to be adjusted, the parties may agree a cap on the amount of consideration that the buyer may have to pay in the event of an increase (or the seller may have to refund in the event of a decrease).
- The acquisition agreement should specify the applicable procedure for preparing and agreeing the completion accounts (including a hierarchy or “waterfall” of accounting policies to be applied). Typically, this involves a first draft of the accounts being drawn up by one party, following which they are sent to the other party for review. The reviewing party is usually given a specified period of time in which to complete their review and either agree the draft accounts, or raise any objections concerning the basis of preparation, or any of the figures included in the draft accounts. If an objection is lodged, there is a prescribed resolution period where the parties will attempt to resolve the matters in dispute by negotiation. If the parties fail to reach agreement within the allotted resolution period, the completion accounts provision commonly provides for the outstanding issues to be referred to an independent expert, typically an accountant, for determination.
- The buyer and the seller will also sometimes agree for funds to be deposited into an escrow account with a third party bank. The funds in this account are then released to either the seller and/or the buyer (as appropriate) after the completion accounts and therefore the final price is agreed. As you learnt earlier in this knowledge stream, escrow accounts are sometimes used for other purposes such as ensuring funds are available to meet warranty or indemnity claims and in that case the funds can be locked up for the duration of the warranty period.
7
Q
- Locked box mechanism
A
- An alternative to using completion accounts to adjust the purchase price is a mechanism called a “locked box”.
- Instead of setting the purchase price by reference to completion accounts (which, as noted above, are drawn up after completion and could potentially be the subject of dispute), the parties may agree to use accounts that are drawn up prior to completion. These are referred to as the “locked box” accounts.
- An advantage of using locked box accounts is that the price can be finalised before signing, and this provides certainty to both parties (for this reason, locked box mechanisms are generally favoured by private equity sellers as it enables them to more quickly transfer the proceeds of the sale up to their investors).
- A disadvantage can be that the parties will incur the expense of having the locked box accounts drawn up and agreed (although the parties could use existing accounts (or even management accounts) for this purpose if they are recent). There will, however, be no post-completion delay where a locked box mechanism is used
- Locked box structures are more difficult on carve-out transactions where there is not a clear and identifiable target group prior to signing in relation to which locked box accounts can be drawn up.
- In a locked box transaction initial due diligence is more important as the final price is fixed earlier in the sale process.
8
Q
- Locked box mechanism: Leakage
A
- A buyer agreeing to a locked box mechanism is at a further disadvantage where monies (or assets) have been taken out of the target outside of the ordinary course of business, after the accounts which are used to value the target have been finalised (known as ‘locked box accounts’. This is known as leakage or unauthorised leakage. Buyers will seek to minimise their risks with respect to the acquisition in several ways:
- Undertaking careful due diligence of the target, especially financial due diligence.
- Negotiating the inclusion of comprehensive warranties relating to the conduct of the target pre-completion. For example, since the buyer is expected to rely on a set of historic accounts and because the buyer will not usually have the same visibility in the preparation of the locked box accounts as they would have with completion accounts, when a locked box mechanism is used it is common for a buyer to ask for a warranty that the locked box accounts have been prepared with reasonable care and on a basis consistent with the annual accounts.
- Including indemnities from the seller for any unauthorised leakage from the target company.
- Unauthorised leakage is to be contrasted with any payments that the buyer and seller have agreed can be taken out of the target before completion (generally, ordinary course, arm’s length payments – often up to an agreed cap). Such expenditure is generally known as “permitted” or “authorised” leakage. The seller will not have to indemnify the buyer for any permitted leakage.
- Since the indemnity for unauthorised leakage will usually cover only specific deliberate acts of the seller, the risk of a general downturn in trading after the finalisation of the locked box accounts falls on the buyer. It is for this reason that locked box accounts are more likely to be used where the seller is in a strong bargaining position and where the buyer has had the opportunity to carry out full financial due diligence on the target company.
- It is also worth noting that the buyer will reap the benefits of any upturn in trading in the period from the locked box accounts to the date of completion.
9
Q
- Locked box mechanism - interest
A
- There is also often an interest mechanism applied to the price, or a daily profit amount agreed, from the date of the agreed locked box accounts to the date that the proceeds are paid to the seller in order to reflect the delay in the seller receiving the proceeds. The amount of interest or daily profit amount is more likely to be a matter for debate where there is a gap between signing and completion. There is no set “market rate” for these payments as each situation is different.
- Seller’s perspective: the seller may view the payment as compensation for its loss of increase in the value of the business, in which case it should mirror the expected profitability of the target.
- Buyer’s perspective: the buyer, on the other hand, may argue that the seller benefits from certainty of price and any payment should be solely interest reflecting the fact that the seller has to wait for the money.
- Interest rates may be used as a penalty for delays in completion and as a means of encouraging the parties to complete quickly.
10
Q
- Earn-outs
A
- An earn-out is where only part of the consideration is paid on the date of completion, with the rest being paid at a particular time or times in the future dependent on whether agreed milestones have been achieved. A common example is whether a certain level of profits have been achieved. The amount to be paid later is the deferred consideration and, where profits are the agreed milestone, will generally depend on the level of profits of the target company in the relevant period after completion.
- Earn-outs are bespoke and are tailored to the business and/or transaction.
- Earn-outs have potential benefits for both the buyer and the seller(s).
· The buyer benefits from the delay in having to pay the consideration, and indeed will only have to pay the further consideration if the target achieves certain targets (such as a certain level of profitability) during the period after it has changed hands.
· If all goes well and the target achieves the relevant milestone after completion the seller may end up receiving more consideration in total than it would have done had it insisted on receiving all the consideration up front, at completion. - Even though an earn-out may have potential benefits for both the buyer and the seller(s) and it may seem like a win/win situation, the drafting of the finer details of the earn-out provisions can become a source of conflict between the parties and is difficult to make work in practice.
11
Q
- Earn-outs – sectors
A
- Earn-outs are particularly appropriate in the sale of service companies that have been owned and managed by individual shareholders. This is because much of the value of the target is likely to be directly linked to the shareholders, who will have very considerable knowledge of the target’s business affairs and will have close relationships with its customers and suppliers.
- In such a situation a potential buyer of the target may well want to keep the seller/shareholders working for the target after the sale, at least during the initial handover period, in order to ensure a smooth handover and preserve relationships with customers and suppliers. An earn-out is a very good way of achieving this. The earn-out is likely to help to incentivise the seller/shareholders, as, if profitability is the agreed milestone for example, the greater the profits of the target post-completion, the greater the deferred consideration they will receive.
- Earn-outs are also often seen in scientific/biomedical companies where value is closely linked to matters such as product development, the launch of products or the obtaining of key licences or drug approvals. In these cases, these would be the milestones used to trigger payment of the deferred consideration.
- Earn-outs can also be used when the seller is a company and tend to be seen where the target is a younger business which does not yet have an established record of profitability and therefore its future value cannot be agreed by the buyer and seller.
12
Q
- Methods of payment are:
A
· Cash
· Paper
13
Q
- Methods of payment - paper
A
- When the buyer is a company, an alternative to cash is payment in paper, which means payment in the form of issuing shares or loan notes. However, it should be noted that this is rare and cash is, by far, the most common method of payment.
- If the buyer wishes to pay the consideration in shares, the buyer will issue shares in itself to the seller in exchange for the transfer of the shares in the target which are owned by the seller. This is known as a share for share exchange.
- Practical point: As a general rule, a seller will only be prepared to accept consideration in the form of shares in the buyer if the buyer is a listed company since then its shares will be freely marketable.
- Alternatively, the buyer may issue loan notes to the seller. A loan note in its simplest form is a document that contains the terms of the buyer’s debt to the seller. If loan notes are to be issued, the terms of the loan notes will have to be negotiated (for example, when the loan notes will be repaid and how much interest is payable).
- Practical point: If a seller accepts consideration in the form of loan notes it should require the loan notes to be supported by a guarantee from a bank (or a listed parent of the buyer) or by security over the buyer’s assets.
14
Q
- Set-off
A
- Wherever part of the consideration is to be deferred (for example, if the consideration includes loan notes or an earn-out) the buyer may ask for the documentation to include a set-off clause. Such a clause allows the buyer to deduct from any payment of deferred consideration, any sum which is due to the buyer at the time the payment of the deferred consideration falls due. For example, after completion but before the payment of deferred consideration, the buyer may discover that it has a claim against the seller under an indemnity included in the acquisition agreement (including, in the case of a share sale, the tax covenant), or that damages are payable to the buyer as a result of a breach of warranty. A set-off clause allows the buyer to withhold the sum due when it pays the deferred consideration, and so pay a reduced amount to the seller.
- This effectively reverses the usual burden of proof for warranty and indemnity claims, forcing the seller to prove that the buyer’s warranty or indemnity claim is erroneous if the seller wishes to receive the full amount of the deferred consideration. Therefore, a seller may resist inclusion of a set-off clause, or at least try to limit severely the circumstances in which sums may be set off, for example to sums which a court has ordered to be paid, or which have been agreed in writing by both parties.
15
Q
- It is important to note that if the conditions for the Substantial Shareholding Exemption are satisfied then, even if the consideration is in paper form, no chargeable gain will have arisen on the sale of shares for the seller. If the conditions for SSE are satisfied the seller will have the benefit of SSE whether the consideration is paid in cash, shares or loan notes.
A
· Sale by a corporate seller
· Tax deferral on share-for-paper exchange
