Sale and Purchase Agreements

Transcription

1 Sale and Purchase Agreements Avoiding the Pitfalls Thomas Gruhn Frankfurt, 11 May 2011

2 Agenda Commercial purpose of a Sale & Purchase Agreement Purchase price structures Determining the purchase price Completion accounts Locked box mechanisms Warranties and indemnities Earn-outs Q&A 2

3 Commercial purpose of the SPA 3

4 Commercial Purpose of the SPA Main purpose of an SPA is to help to ensure that the Purchaser gets what he/she thinks he/she is paying for. So: SPA must set out clearly what the Purchaser thinks is being acquired including the purchase consideration and If the Target is not as the Purchaser envisaged, the process must enable the Purchaser to either: avoid being committed to the deal in the first place back out of the deal or to get some money back 4

5 Six key contractual tools (1/2) Contractual tools in the SPA for the Purchaser to: Avoid commitment to the deal Avoid commitment Conditions precedent to the deal Back out of the deal Get Vendor out of undertakings the deal Get some money back Warranties? Indemnities Get some money back Price adjustment mechanisms Retentions 5

6 Six key contractual tools (2/2) Price adjustment mechanisms: Clauses which set out how the price will be adjusted based on a comparison of the actual performance/net assets of the business against a pre-set target. Include a description of how the actual performance will be measured. Examples of price adjustment mechanisms are: Completion Accounts mechanism Earn-outs and (arguably) Indemnities Retentions: Make them sue you for the money, not vice versa 6

7 Key issues to consider What is being acquired - Shares or assets? Valuation methodology Valuation model normally based on the Purchaser s view of what business is worth under their ownership May be a function of: Future earnings (new products, synergy benefits) Future cash flows (capex, rationalisation costs) Break up values (cash from partial disposal) Purchase price mechanism Fine tuning the price (Completion Accounts) Fixed Price (Locked Box) 7

8 Purchase Price Structures 8

9 Common purchase price structures Cash free/debt free/normal working capital Net assets (e.g. banks) 9

10 Principles of the Cash & Debt-free/normal working capital pricing structure (1/3) The share purchase price (equity value) has to be in line with the value of the operating business (enterprise value) and net financial debt The buyer, economically, must be able to redeem all financial debt at closing DCF method (e.g. WACC) DEV method Multiples valuation Enterprise value/base price (value of operating business) Net financial debt (= financial debt cash) = Share purchase price (equity value) 10

11 Principles of the Cash & Debt-free/normal working capital pricing structure (2/3) Key Principles Focus on cash Sometimes mis- understood Economically, buyer has included in the enterprise value Fixed assets Normal level of working capital Value issues Fixed asset disposals Brakes on capex, maintenance, r&d etc. Cash maximisation exercises 11

12 Principles of the Cash & Debt-free/normal working capital pricing structure (3/3) m m Enterprise value X plus for for Cash X less for for Debt (X) plus for Actual Working Capital X less Normal Working Capital (X) X [less Budgeted Capex minus Actual Capex X] Price payable for equity Xm 12

13 Net Debt More Obvious Finance leases Cash at bank Bank loans and overdrafts Hire Purchase Petty cash Customer deposits Intercompany loans Pension deficits Unpaid corporation tax Product warranties Deferred income Break costs Unpaid legal claims Trapped cash Accrued interest Deferred consideration Less Obvious Tax losses/ assets Environmental liabilities Penalty charges on existing debt Unspent capex Out of the money derivatives Unpaid one-off bonuses JV/associate funding obligations Dilapidation provisions Factoring of trade debtors Change of lease treatment under different GAAP s 13

14 Normal level of working capital Buyer wants to have a target as high as possible (more positive, less negative) Seller wants to have a target as low as possible pay for change not absolute amounts Seasonality Growth Forex Wide versus narrow definition e.g. exceptional liabilities 14

15 Determining the purchase price 15

16 Completion Accounts 16

17 Completion Accounts Timeline Exchange Initial Bid Final Offer (i.e. SPA Completion signed) Agreement of Completion Accounts Completion Accounts Agree headline price Initial Consideration (based on estimates) Final Consideration (based on Completion Accounts) 17

18 Completion Accounts mechanism Price adjustment based on comparison of Actual balances at or near Completion with preset target Target may be a predetermined number or be derived by using a formula set out in the SPA Balances at Completion are determined by drawing up Completion Accounts according to bases set out in the SPA Adjustment is usually on a 1 for 1 basis May be one way or two way adjustment 18

19 Purpose of Completion Accounts mechanism Purchaser Price will have been based on business as warranted Completion Accounts mechanism ensures that Vendor hands over expected level of net assets and does not siphon off value before Completion Vendor Ensures that Purchaser does not get additional value for nothing 19

20 Possible bases of preparation of Completion Accounts Possible accounting policies that could be applied: in accordance with GAAP, (or applicable accounting standards, or IFRS), [so as to give a true and fair view] AND/OR consistent with past principles, policies, practices, procedures, princesses, preparation AND/OR in accordance with specific accounting rules set out in the SPA 20

21 Accounting policies hierarchy to prevent disputes But what is the difference between the two formulations? The Completion Statement shall be prepared in accordance with the following: a) the specific policies set out in Schedule X b) to the extent not covered by (a), the accounting policies, principles, practices, evaluation rules and procedures, methods and bases adopted by the Company in the preparation of the [Accounts] and c) to the extent not covered by (a) and (b), [GAAP] in force at the Accounts Date OR a) the specific policies set out in Schedule X b) to the extent not covered by (a), [GAAP] in force at the Accounts Date, on a basis consistent with those adopted by the Company in the preparation of the Accounts 21

22 The main causes of Completion Accounts disputes Failing to include all three bases of preparation Failing to set a clear order of precedence between the bases Getting the order of precedence wrong - should start with the most precise measure (Specific Policies), and end with GAAP [consistently applied??] Not specifying GAAP at a particular date Not specifying policies/values for material judgemental items (e.g. value of WIP) Specifying policies that are too vague/imprecise Hindsight period to be applied in drawing up accounts unclear 22

23 Locked Box Mechanisms 23

24 Completion Accounts vs Locked Box mechanisms Cash free debt free mechanism Enterprise value (EV) plus for for Cash less for for Debt plus for Actual Working Capital less Normal Working Capital X (X) m X X (X) X Completion Accounts Determine EV pre-signing SPA describes how to determine price payable for the equity post-signing (i.e. definitions, accounting policies) Locked Box Determine price payable for the equity pre-signing (fixed price) Price payable for equity Xm 24

25 Locked Box Timeline Exchange Initial Bid Final Offer (i.e. SPA Completion signed) Agreement of Completion Accounts Completion Accounts Agree headline price Initial Consideration (based on estimates) Final Consideration (based on Completion Accounts) Locked Box Agree equity price Final Consideration (specified in SPA) 25

26 Locked Box Mechanism: key principles FIXED PRICE Effective Date = pricing balance sheet date LEAKAGE Completion Date INTEREST RUN 26

27 Locked Box Mechanism: Fixed Price Debt, cash and working capital all calculated off the same pricing balance sheet (usually historical) No completion accounts so price adjusting items must be priced in up front Fixed Price Price determined based on information available prior to signing Price based on the Effective Date balance sheet. Purchaser bears economics risks/rewards from Effective Date 27

28 Locked Box Mechanism: Leakage Leakage usually defined as any payments/transfers of value (or asset stripping ) from the Target Group to the Seller s Group Purchaser will expect protection over the leakage of value from the Target in the period from the pricing balance sheet date to Closing Leakage Seller affirms no leakage after the pricing balance sheet, except permitted leakage Permitted leakage is agreed between the parties, is set out in the SPA and will need to be factored into the price 28

29 Locked Box Mechanism: Permitted Leakage Permitted Leakage is to cover transactions between the Seller s group and target business Exemption for e.g.: Specified level of dividends Management charges Bonuses up to capped amount Payments to Seller s Group e.g. because Seller is settling amounts on behalf of Target Transactions in the ordinary course (under specified agreeements - e.g. supply agreements) Amounts accrued in the Pricing Balance Sheet Date Management needs to consider Permitted Leakage carefully 29

30 Locked Box Mechanism: Interest run Equity Price is calculated as at the Effective Date Cash is paid to the Seller at Completion Effective Date = pricing balance sheet date Interest run from Effective Date to Completion (usually set at a rate that roughly equates to retained profits) Cash, debt and working capital balances will fluctuate up to Completion but in aggregate the three balances should change by retained profit only (after adjusting for depreciation and capex) Completion Date Forecast net debt needed for funding purposes only (not pricing) 30

31 Locked Box: Due Diligence considerations Definition of cash, debt and target working capital (although not visible in the SPA) Appropriate pricing balance sheet Selection of balance sheet date Available in time/sufficiently detailed Included in the VDD (if undertaken)/warranty Audited balance sheet Leakage protection ( for indemnity)/permitted leakage items Performance of the business in the gap period 31

32 Warranties and Indemnities 32

33 Warranties commercial principles Main value of warranties to Purchaser is to flush out information as part of overall due diligence process but warranties are not an adequate substitute for due diligence Enforcement is difficult, and result of litigation may be unfair/uncommercial. Litigation is rarely a good investment 33

34 Warranting statutory accounts Difficult for vendor to argue against giving such a warranty, since it echoes the audit opinion Vendors must beware of warranties regarding individual items in accounts - audit materiality covers accounts as a whole 34

35 Uses of indemnities Definition: Promises by Vendor to make good a loss, liability or deficiency in assets if certain specified circumstances arise Uses: To assign risk regarding material uncertainties between the parties. In particular, can protect the Purchaser against potential Black Holes, e.g.: Tax Environmental liabilities Litigation Government action 35

36 Indemnities advantages and disadvantages Much easier to prove liability than with warranties Not affected by parties knowledge and disclosure at time of contract BUT Limited to situations where there are quantifiable liabilities or losses Recovery may not reflect loss in value to the Purchaser 36

37 Earn-outs 37

38 What is an Earn-out? An arrangement whereby part of the consideration is calculated by reference to the post-completion results, (usually as a multiple of profits) In a way it is an extended completion accounts mechanism, which extends further into the future, and where the amounts at stake are usually greater Most useful in a people/knowledge business Can bridge an expectation gap on value But earn-outs also can cause big problems. 38

39 Earn-out Overview Objectives Which growth path does the target company follow? Incentives Objective 1 Readjustment of the purchase price Insecurity and different expectations with respect to: The business environment: e.g. general economic growth, economic situation of the industry sector, technological development, etc. Target: e.g. success with product launch/market entry Objective 2 Acquisition financing Payment of purchase price in multiple tranches Objective 3 Integration and transfer of the full earnings potential People driven entities, e.g. Technical know-how Customer relations Keep management/founders on board 39

40 Earn-out Overview Decisive factors Valuation difference: split fix/ variable purchase price Basis: Realistic assessment of opportunities and risks Importance of the management factor 40

41 Earn-out Overview Decisive factors Assessment base: Earn-out Formula Task: Preservation of aligned interests ( Pull into the same direction ) Planning/adjustment/ adaptation processes Definitions/ specific accounting rules 41

42 Commercial difficulties with Earn-outs Need to keep target business separate - may prevent synergies which underly acquisition rationale (during the earn-out term) Management (Vendors) will be concerned only with short term profitability Potential for management deadlock or lack of responsiveness Difficult to remove management and/or to plan succession 42

43 Drafting difficulties with Earn-outs Just like completion accounts clauses - difficulties of specifying in advance the basis of preparation of the Earn-out Accounts - but worse, because GAAP likely to change in next few years PLUS All the problems associated with forecasting - change of control and inherent uncertainty about the future AND The impact of any dispute may be magnified because the amount in dispute may be a multiple of profits - also because of any resulting business disruption 43

44 Common issues in drafting Earn-outs Moving revenue/costs between accounting periods. Moving revenue/costs into/out of Target, e.g.: management charges related party transactions (incl. rent) management remuneration Who bears costs of investment to develop the business? Need to allow for succession - interplay with restrictive covenants etc. Interplay with warranty limitation periods 44

45 Earn-outs a few suggestions In a volatile market environment, buyers and their respective banks want to rule out as much as possible overpayments related to misjudgements of the future development of a company. Problematic Rash agreement of an earn-out Earn-out with ulterior motives continuation of purchase price negotiations with other means Over-engineering Highly restricted level of action for management Low transparency Aggressive monitoring of the earn-out parameters/covenants Disparities in determining the quantitative thresholds and the earn-out calculation ( Apples and Oranges ) Negotiations over fixed price to be followed though Detailed negotiations on earn-out ( Temporary marriage ) Willingness of the Recommended Buyer to pay the full purchase price (including earn-out) Seller to waive the earn-out payment as long as objectively justified Upper ceiling for the earn-out payment Assessment bases: focussing yields advantages Earn-out formula as simple as possible 45

46 Q&A 46

47 SPA Contact Thomas Gruhn Director Deloitte & Touche GmbH Transaction Advisory Services Telefon: +49 (0) Mobil: +49 (0) Thomas Gruhn is a Director in the Frankfurt office of Deloitte with more than 18 years work experience. He specialises in advising on mergers & acquisitions transactions, in Germany and cross border, focusing on Sale & Purchase Agreement financial and accounting advice, negotiation support and post-m&a litigation support. In 1990, Thomas started his professional career in Private Equity at Deutsche Beteiligungs AG. His tasks comprised identifying investment opportunities, performing financial due diligence reviews and valuations as well as the administration of an investment portfolio. In 1993 he joined Pricewaterhouse-Coopers where he focused on enterprise valuations and financial due diligence reviews. In 2001, he joined Clifford Chance where he specialised in structuring Sale & Purchase Agreements and advising on M&A disputes. In 2007, Thomas joined Deloitte, where he heads Deloitte s German Sale & Purchase Agreement Advisory Practice. Thomas has qualified as a German Public Auditor and as a Tax Adviser. 47

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