Drafting Purchase Price Adjustment Clauses in M&A

Alexander W. Nürk Drafting Purchase Price Adjustment Clauses in M&A Guarantees, retrospective and future oriented Purchase Price Adjustment Tools Diplomica Verlag

Alexander W. Nürk Drafting Purchase Price Adjustment Clauses in M&A Guarantees, retrospective and future oriented Purchase Price Adjustment Tools ISBN: 978-3-8366-2011-6 Herstellung: Diplomica Verlag GmbH, Hamburg, 2009 Dieses Werk ist urheberrechtlich geschützt. Die dadurch begründeten Rechte, insbesondere die der Übersetzung, des Nachdrucks, des Vortrags, der Entnahme von Abbildungen und Tabellen, der Funksendung, der Mikroverfilmung oder der Vervielfältigung auf anderen Wegen und der Speicherung in Datenverarbeitungsanlagen, bleiben, auch bei nur auszugsweiser Verwertung, vorbehalten. Eine Vervielfältigung dieses Werkes oder von Teilen dieses Werkes ist auch im Einzelfall nur in den Grenzen der gesetzlichen Bestimmungen des Urheberrechtsgesetzes der Bundesrepublik Deutschland in der jeweils geltenden Fassung zulässig. Sie ist grundsätzlich vergütungspflichtig. Zuwiderhandlungen unterliegen den Strafbestimmungen des Urheberrechtes. Die Wiedergabe von Gebrauchsnamen, Handelsnamen, Warenbezeichnungen usw. in diesem Werk berechtigt auch ohne besondere Kennzeichnung nicht zu der Annahme, dass solche Namen im Sinne der Warenzeichen- und Markenschutz-Gesetzgebung als frei zu betrachten wären und daher von jedermann benutzt werden dürften. Die Informationen in diesem Werk wurden mit Sorgfalt erarbeitet. Dennoch können Fehler nicht vollständig ausgeschlossen werden und der Verlag, die Autoren oder Übersetzer übernehmen keine juristische Verantwortung oder irgendeine Haftung für evtl. verbliebene fehlerhafte Angaben und deren Folgen. Diplomica Verlag GmbH http://www.diplomica-verlag.de, Hamburg 2009

Dedicated to my Mother 25 th May, 2008

A TABLE OF CONTENT B C D TABLE OF FIGURES... IV LIST OF TABLES... V LIST OF ABBREVIATIONS... VI 1 INTRODUCTION...1 2 BASICS OF MERGERS & ACQUISITIONS...3 2.1 DEFINITIONS...4 2.2 ASSET DEAL SHARE DEAL...6 2.3 M&A MOTIVES...7 2.4 M&A PHASES...8 3 PURCHASE PRICE ASSESSMENT: METHODS FOR VALUATION OF A COMPANY.11 3.1 SINGLE VALUATION PROCEDURES...12 3.1.1 Net Asset Value on the Basis of Reproduction Values...12 3.1.2 Net Asset Value on the Basis of Liquidation Values...14 3.2 TOTAL VALUATION PROCEDURES...16 3.2.1 Capitalisation of Earnings Method...17 3.2.2 Discounted Cash flow Method...20 3.2.2.1 Weighted Average Cost of Capital Approach...23 3.2.2.2 Adjusted Present Value Approach...25 3.2.2.3 Equity Approach...26 4 GUARANTEES...28 4.1 FORMS OF GUARANTEES...29 4.1.1 Guarantee of Financial Statements...29 4.1.2 Equity Guarantee...30 4.1.3 Working Capital Guarantee...31 4.1.4 Other Guarantees...33 4.2 GUARANTEES ACCORDING TO GERMAN LAW...34 4.2.1 Dependent Guarantee...34 4.2.2 Independent Guarantee...35 4.3 CONSEQUENCES IN BREACH OF GUARANTEE...37 I

5 PURCHASE PRICE ADJUSTMENT TOOLS...40 5.1 RETROSPECTIVE PURCHASE PRICE ADJUSTMENTS: POST CLOSING ADJUSTMENTS...43 5.1.1 Cash free/debt free Clauses...44 5.1.2 Fixing of Metrics...46 5.1.3 Generally Accepted Accounting Principles...49 5.1.4 Potential for Manipulation...52 5.1.5 Purchase Price Calculation...58 5.2 FUTURE ORIENTED PURCHASE PRICE ADJUSTMENTS...59 5.2.1 Earn out Clauses...60 5.2.1.1 Fixing of Metrics...65 5.2.1.2 Drafting Considerations...67 5.2.1.3 Accounting Issues and Manipulations...69 5.2.1.4 Structure and Calculation of Earn outs...72 5.2.1.4.1 The Fixed Standard...74 5.2.1.4.2 The Variable Standard...74 5.2.1.4.3 The Accumulative Standard...75 5.2.1.4.4 Example of Calculating the Standards...75 5.2.1.5 Safeguards of Earn out Amounts...80 5.2.1.6 Advantages and Disadvantages for Buyer...82 5.2.1.6.1 Advantages for Buyer...82 5.2.1.6.2 Disadvantages for Buyer...83 5.2.1.7 Advantages and Disadvantages for Seller...84 5.2.1.7.1 Advantages for Seller...84 5.2.1.7.2 Disadvantages for Seller...85 5.2.2 Option Clauses...86 5.2.2.1 Option Clause Approaches...86 5.2.2.2 Content of an Option Clause...89 5.2.2.3 Advantages and Disadvantages of Option Clauses...91 6 DISPUTE RESOLUTION...93 II

7 COORDINATION OF CONTRACTUAL CLAUSES...97 7.1 CONTRADICTORY CLAUSES...97 7.2 EXAMPLE: OSI SYSTEMS, INC. V. INSTRUMENTARIUM CORPORATION...102 8 CONCLUSION...105 E APPENDIX: STATUTORY PROVISIONS...108 F BIBLIOGRAPHY...125 III

B TABLE OF FIGURES Figure 1: Elements of an M&A Process... 10 Figure 2: Company Valuation Methods... 11 Figure 3: Capitalisation of Earnings Method (Entity Approach)... 19 Figure 4: Capitalisation of Earnings Method (Equity Approach)... 20 Figure 5: WACC Approach... 24 Figure 6: APV Approach... 26 Figure 7: Equity Approach... 27 Figure 8: Call Option for Buyer... 88 Figure 9: Put Option for Seller... 88 Figure 10: Put Option for Buyer... 89 IV

C LIST OF TABLES Table 1: Combinations of Pricing... 63 Table 2: Profits generated in the years 2008 2011... 76 Table 3: Relevant Pre year Results of the Profit provided as Calculation Base... 77 Table 4: Calculation of Earn out on the Basis of different Standards... 77 Table 5: Fixed Standard Net Present Value Calculation of Situation I and III... 78 Table 6: Accumulated Standard Net Present Value Calculation of Situation I and III... 79 Table 7: Comparison of Net Present Values by using different Percentage Rates for Accumulated Standards to Fixed Standard... 80 V

D LIST OF ABBREVIATIONS AAA AktG APV BGB BGH CAPM CISG DCF DIS EBI EBIT EBITA EBITDA EGBGB FAA FIFO GAAP GmbHG HGB IAS IPO IFRS LIFO M&A MAI MBI MBO MAC American Arbitration Association German Companies Act (Aktiengesetz) Adjusted Present Value German Civil Code (Bürgerliches Gesetzbuch) German Federal Court of Justice (Bundesgerichtshof) Capital Asset Pricing Model United Nation Convention on Contracts for the International Sale of Goods Discounted Cash Flow Deutsche Institution für Schiedsgerichtsbarkeit Earnings Before Interests Earnings Before Interest and Tax Earnings Before Interest, Tax and Amortisation Earnings Before Interest, Tax, Depreciation and Amortisation Introductory Act to the German Civil Code (Einführungsgesetz zum Bürgerlichen Gesetzbuche) U.S. Federal Arbitration Act First In, First Out Generally Accepted Accounting Principles Limited Liability Company Act (Gesetz betreffend die Gesellschaften mit beschränkter Haftung) German Commercial Code (Handelsgesetzbuch) International Accounting Standard Initial Public Offering International Financial Reporting Standards Last In, First Out Merger and Acquisition M&A International Management Buy In Management Buy Out Material Adverse Change VI

MAE LCIA SIAC U.S. US GAAP WACC ZIP ZPO Material Adverse Effect London Court of International Arbitration Singapore International Arbitration Centre United States of America Accepted Accounting Principles of the United States of America Weighted Average Cost of Capital Zeitschrift für Wirtschaftsrecht German Code of Civil Procedure (Zivilprozessordnung) VII

1 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 slowdown in the second half. However, M&A transactions with a transaction volume of approximately $ 4.830 billion took place worldwide in 2007. 1 The forecasts for 2008 expect a recession of the transaction volume of up to 25 % of the previous year. 2 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) 3 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. 4 Various companies have also taken advantage of the weak U.S. Dollar exchange rate and plan M&A deals overseas. 5 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. 6 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 1 Cp. Kunisch S. M&A Markt 2007 in Deutschland Zwei unterschiedliche Jahreshälften M&A Review, 2/2008, 57. 2 Cp. Handelsblatt Erstes Quartal schockt Investmentbanken 23.03.2008, 24; Handelsblatt M&A Markt kühlt sich ab 21.11.2007, 25. 3 M&A International Inc. is the largest international organisation of independent M&A consulting firms for mid market M&A s. See M&A International Inc. (MAI) at <http://www.mergers.net/index.php>, last accessed 14.04.2008. 4 Cp. Landgraf R. Fusionsgeschäft verlagert sich Handelsblatt, 03.12.2007, 37 5 Deutsche Bank expects in the current year eight big M&A deals in the United States of America with a volume of at least $ 10 billion. Cp. Eberle M., Landgraf R. Günstige Gelegenheit Handelsblatt, 05.03.2008, 2. 6 Cp. Adel R. The Purchase Price Adjustment Process Protections and Pitfalls Orange County Business Journal, Jul 31 Aug 6, 2006, B 42. 1

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 7 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 book addresses lawyers and everybody who is in the position of drafting M&A contracts. Since M&A contracts include various clauses, this book covers only purchase price adjustment tools. It provides 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 book 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 valuationprocedures. Main attention is focused on discounted cash flow methods, since they are the ones that are mainly used, especially in international transactions. 7 To simplify writing, the male formulation is used to describe a person in this book, although there is a female counterpart for each. No sexist innuendo is intended. 2

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 depending 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 book; 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 book 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 common foreseeable problems. Chapter 6 provides a brief introduction to issues which can arise relating to dispute resolution, which are common avenues in international M&A transactions as arbitration does not necessary always follows the same international rules. Other clauses in an M&A contract also have influence, mainly indirectly, on the purchase price, so 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 book 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 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. 3

2 BASICS OF MERGERS & ACQUISITIONS This chapter intends to give the reader a brief introduction into the basics of Mergers and Acquisitions (M&A). Fundamental terms used in M&A transactions, its motives and objectives and how the whole transaction process is designed will be explained. 2.1 Definitions M&A is a widely used term which cannot be expressed in a standardized definition. Various definitions have been formed. Simply said, M&A describes various kinds of transactions for companies, where whole entities or parts of it are the object of purchase. 8 While some authors use the terms merger and acquisition as synonyms, 9 they are separated by others who ascribe different significances. 10 According to the latter, both mergers and acquisitions represent forms of company amalgamations, where at least one party of the M&A process loses its economic independence. In an acquisition, where the whole entity is acquired and integrated into the acquirer s corporate group, the acquired company s loses its economic independence and its legal entity. If only parts of the entity are acquired, the acquired company keeps its legal entity while the economic independence is restricted or abandoned. 11 A merger, when compared to an acquisition, is the closest form of company amalgamation. In this case, two companies come together to form a new company. Both companies give up their economic independence and legal entity and create a new economic and legal entity. 12 Although, there are various approaches of M&A definitions, there are some key common characteristics. Almost all definitions refer to the transaction process as 8 Cp. Various definitions of M&A in Wirtz B. Mergers & Acquisitions Management Strategie und Organisation von Unternehmenszusammenschlüssen, (Gabler Verlag, Wiesbaden, 2003), 11. 9 Cp. Napier, N.K., Simmons, G., Stratton, K. Communications during a merger: The experience of two banks, HRP, Vol 12, No. 2, 1989, 105; Ansoff H.I., Weston F.E. Merger objectives and organisation structure, Quarterly Review of Economics and Business, Vol. 2, No. 3, 1962, 56. 10 Cp. Achleitner A. K. Handbuch Investment Banking (3. Auflage, Gabler Verlag, Wiesbaden 2002); Wirtz, above No 8, 15. 11 Cp. Wirtz, above No 8, 15. 12 Cp. Wirtz, above No 8, 16; An example is the merger of Daimler Benz AG and Chrysler Corporation to the newly created DaimlerChrysler AG in 1998. 4

the central importance in M&A, in particular with regards to the transfer of ownership rights, and managerial and control authority. Purely from the term M&A, one may think that all the manifestations are covered. The fact is that not only company amalgamations but also various kinds of company co operations and other company activities are covered by this term. 13 These include: 14 Operative Co operations: The formation of trade associations, consortia or interest groups to safeguard and pursue shared objectives. Joint Ventures: Two or more companies joint together and form a not necessarily equally co owned new company. 15 Strategic Alliances: This is similar to joint ventures, where two or more companies agree to co operate strategically. The difference is normally no equity is involved and no separate entity is formed. 16 Management Buy Outs (MBO) or Buy Ins (MBI): In an MBO, the current management of the company is buying the whole entity or parts of it. In an MBI, managers from outside the company buy the whole entity or parts of it to form the new management. Initial Public Offerings (IPO): IPO represents the initial sale of a company s shares to the public. Going Private: This is the opposite of IPO. A company s shares are no longer offered to public (also called delisting). Spin off: This is the separation of a division from an entity that now forms a separate entity on its own. The list is not exhaustive. The term M&A also covers service activities from investment banks and/or other counsels and is not only limited to the perspectives of buyers and sellers. Considering this wide range of activities which are subsumed under M&A, it is understandable that a uniform definition is difficult. 13 Cp. Picot G. Handbuch Mergers & Acquisitions Planung, Durchführung, Integration, (3. Auflage, Schäffer Pöschel Verlag, Stuttgart 2005), 20. Other authors do not share the view that company co operations are included under the term M&A, but rather an alternative to M&A. Cp. Ernst D., Häcker J. Applied International Corporate Finance, (Vahlen Verlag, München 2007), 6. 14 Cp. Picot, above No 13, 20. 15 Cp. Carter S. CIM Coursebook International Marketing Strategy, (Butterworth Heinemann, Oxford 2002), 93; Joint Ventures with local companies are an interesting option for companies to enter a foreign market when the foreign government (like China, India or South Korea) restricts foreign ownership. 16 Cp. Carter, above No 15, 93. 5