The purchase price and thus the purchase price clause of the sale and purchase agreement are the core elements – the centrepiece – of the entire transaction. Reaching an agreement on the purchase price and the adequate valuation model can often be challenging.
In the pre-COVID-19 sellers’ market, pricing models that have a fixed price determined that is payable on the closing date based on a historical economic transfer date (i.e. locked box) were popular and used more often than closing account mechanisms (which involve an adjustment post closing following determination of the purchase price by reference to a set of financial statements as at the closing date. The COVID-19 crisis will lead to a reversal in this trend. The market will become more diverse and flexible in terms of purchase price models. Closing accounts will prevail where an earn-out mechanism is not used. The reason for this is the existing uncertainty as to how to value a target asset in the current market and assess the achievability of its forecasts and projections, through the aforementioned purchase price models or components. To this extent, tough discussions are to be expected in 2020 as a result of the crisis when negotiating the definitions or determination of net financial debt and target or “normalised” working capital.
In addition to the classic concepts of locked box and closing accounts, we can expect an increasing number of variables to such purchase price models, in particular conditional purchase price components, according to which additional payments may become due at a later date (i.e. an earn-out) if certain conditions are satisfied or certain financial benchmarks are achieved. In practice and until now, parties have made use of an earn-out to build a bridge between the different purchase price expectations of the buyer and the seller. As a result of the COVID-19 crisis, it is likely that the need for such a bridge will become more prevalent and earn-outs will also serve as a way to balance the current overall economic risk between the seller and the buyer. Even after the crisis year 2020, such concepts may also work to redress the balance in the buyer’s favour (at least in part) in the event of (sustained) economic downturn or failure.
When it comes to the creation of earn-outs, a number of complex issues arise for which a solution acceptable to all parties must be found. This includes, for example, the selection of measurable and identifiable parameters for the earn-out as well as appropriate and practicable procedural rules and protections for the seller during the earn-out period. From a purely legal point of view, the focus will be on a clearly drafted mechanism, as earn-outs are often controversial due to their complexity.
The ability to finance transactions becoming more difficult will also have an impact on the purchase price and possibly the transaction structure. If the banks’ declining risk appetite materialises and financing via debt funds is not an alternative, vendor loans (also in the form of profit participation rights), retained minority shareholdings by the sellers or reinvestment of management sellers’ proceeds may be complementary structural alternatives. Above all, vendor loans are likely to be used more frequently to solve any such financing problems. The vendor loan is neither a purchase price component nor a special purchase price model, but rather a supplementary agreement to the purchase price mechanism which defers the need for available cash and which may be added to any purchase price model. The vendor loan may cover the total or – more often – a partial amount of the agreed purchase price.
In contrast to 2019, buyers are likely to be in a stronger position to enforce tougher purchase price and security protections. In addition to the classic escrow model (Escrow Account), in which part of the purchase price is paid into an Escrow Account and is used in particular to secure warranty and/or indemnity claims, there are also other mechanisms. MAC clauses, for example, provide for a contractual right of termination on the part of the buyer in the event of a significant change in the economic assumptions underlying the purchase agreement, or are designed as a pure closing condition. The changes may relate to the target company itself (a “business MAC”) or to the market environment (a “market MAC”). Typical parameters of a business MAC would be the deterioration of certain key figures of the company (e.g. turnover, EBITDA or EBIT) or the occurrence of insolvency or over-indebtedness of the target company. In contrast, market MACs are intended to cover macro-economic events and are therefore based on objective indexes, such as the DAX or another suitable stock exchange index.
Buyers will also insist on a more comprehensive due diligence, tighter covenants, more comprehensive warranties and far-reaching indemnities – and are more likely to win the argument for such provisions to be included than they would have in 2019.
W&I insurance is another option for the parties’ protection, and will likely be in (even) greater demand. At the same time, however, insurers are expecting a sharp rise in the number of claims due to the crisis, which in turn will lead to higher premiums in the medium term and stricter requirements for buyer due diligence.