Closing Period and Share Sale in Mergers and Acquisitions
As a result of the financial examination of the target company, usually before the negotiations begin and sometimes during the negotiations, a financial picture emerges before the share sale agreement is signed. But as both contract negotiation and closing take time, financial data keep changing during this process, because the business entity is a living organism and cannot be expected to engage in any commercial activity during this long period of time; on the contrary, they are asked to continue their activities as they are. It is often inevitable that the financial change occurring in this interim period will have an impact on the selling price.
So as to settle the acquisition price payable (equity value) for a target business in an M&A transaction, two primary pricing mechanisms have evolved and are now the widely accepted norms: “closing accounts” and “locked box” mechanisms.
The effective date is defined as the date on which the economic interest is transferred from the seller of a corporate to the vendor of a company to the customer, the signing date is the date on which the SPA is signed by the two parties. The major difference between the closing accounts and the locked box mechanism is the timing on which the economic interest within the target company is transferred from the vendor to the customer.
In a transaction during which closing accounts are used, the economic interest is transferred only on the closing date, i.e., the date on which the actual change of control (CoC) takes place, whereas under a locked box mechanism the economic interest is transferred to the customer even before the signing date, named as the “locked box date”.
The closing accounts method takes under consideration the results on the ultimate price of changes in working capital and within the financial position of the target company generally, debt and cash levels between the date of the financial review and the closing date. Accordingly, the parties agree on the financial data of the target company on the closing day and compare the financial picture resulting from the previous date's financial review with the financial picture of the closing day, and anticipate balancing the difference. E.g; The working capital, the quantity of debt of the target company to financial institutions or suppliers are effective during this context, and based on their increase or decrease, one among the parties may demand an amount of payment from the other.
In the second method, the locked box structure, the parties take the financial picture of the target company at the financial review stage, before the negotiations are over, and agree that there’ll be no "leaks" until the closing day. Leakage refers to expenses that don’t seem to be allowed under the contract and unexpected payments from the target company. E.g; payment or a benefit by the target company to the seller or its affiliates is usually described as a "leakage".
The Traditional Price Adjustment Mechanism: Closing Accounts
In the case of a SPA with a closing accounts mechanism, the SPA will provide a provisional price, based either on the accounts at some date before closing or on some projections of the target’s accounts at closing. Such provisional price is then adjusted on the idea of the Net Financial Position (NFP) at closing. The SPA usually will include an obligation to manage the corporate “consistently with past practice” so as to avoid that the vendor, within the period between signing and closing, intentionally “inflates” the cash position of the target company. Additionally, providing that NFP is also stricken by changes in working capital (payables and receivables, fluctuations of inventory, etc) intentionally made to vary the Equity Value, the SPA may provide for a mechanism for the adjustment of the working capital at closing as compared to working capital supported which the provisional purchase price is calculated (accounts at a date prior to closing or projection of accounts at closing) at the time of the signature of the SPA isn’t known.
Alternatively, the SPA may provide that the precise calculation of the acquisition price at closing is created after closing. This suggests that the customer will pay the enterprise value at closing and this will be adjusted following the preparation and agreement of the closing accounts. During this scenario, the SPA will usually provide the rules for the preparation of the accounts, so as to safeguard the interest of both the buyer and the seller.
The New Alternative: The Locked Box Structure
Under a locked box structure, the value is calculated based on accounts of the target prepared before the signing of the SPA. Therefore, at signing, the parties will already be aware of the amounts of cash, debt, and working capital and there’ll be no price adjustment after the closing, except those claims agreed between the parties and listed within the SPA. At closing, the buyer assumes the danger of paying more than the actual Equity Value of the target at closing; conversely, the vendor assumes the danger of selling at a price that’s less than the actual Equity Value at closing (because cash increased between accounts at signing and closing).
Unlike the closing accounts mechanism, a locked box SPA provides for a fixed price which might be adjusted only within the case the seller allows certain values to leak out of the target between the completion of transaction and locked box date. This essentially implies that the buyer: (i) must price the target business supported on a recent (but not updated) set of accounts prepared by the seller; (ii) will haven’t any ability to regulate the equity price after closing; and (iii) will have only remedies associated with leakage and other contractual protections (such as representation and warranties or, just in case the parties agree so, a material adverse effect provision). Additionally, the buyer may require that the vendor guarantees that NFP at closing be not higher than a certain amount, and seek for indemnification if NFP seems to be higher.
Attn. Ferhan Yıldızlı
Selenay KÖSE, Legal Trainee