Recessionary impacts on completion mechanisms
Recessionary impacts on completion mechanisms
Author: Michael Smith and Nick Andrews
This article explains the completion accounts process and explores potential pitfalls and how to avoid them. However, as the economic outlook for the UK economy appears relatively volatile and pessimistic, we have begun by considering how a recession could affect the choice of completion mechanism.
What could be the impact of a recession on the choice of completion mechanism?
In a recession, deal activity is usually reduced. However, the deals that do proceed tend to be scrutinised more heavily and are more likely to use completion accounts and an earn-out mechanism rather than a locked box mechanism.Why Earn-outs and Completion accounts are popular in a recession
Earn-outs can be a useful way of bringing the parties together if there are divergent views between the parties regarding valuation and future earning capability of the target. Differing opinions on valuation are more common during times of economic uncertainty when estimating future earnings based on historical performance becomes an increasing challenge, and predicting the length of a recession and whether it will have a temporary or permanent impact on the business can be complicated.Coming to a consensus view on how a recession will impact the target company long term can be difficult, and an earn-out is a way to bridge the gap between the parties’ expectations.
Earn-outs also have the added incentive for the buyer that they effectively allow part of the purchase price to be paid from the future profits of the business if the agreed criteria are met, thereby reducing the upfront cash
outflow requirements at completion.
In contrast to a locked box mechanism, completion accounts give the parties more time to scrutinise the deal and make adjustments to the purchase price as appropriate post completion. The increased flexibility of completion accounts is beneficial in times of economic uncertainty, especially for cautious buyers seeking added protection.
The completion accounts mechanism means the purchase price is calculated precisely as at the completion date based on the target’s actual balance sheet. In this way, the affects of any adverse events impacting the company in the period up to completion are reduced compared to the locked box mechanism where price is based on the historical locked box accounts which pre-date completion.
Given the potential increased prevalence of the use of completion accounts in times of economic uncertainty, the rest of this article examines the optimal process for completion accounts, first explaining the different completion mechanisms and how completion accounts work, and highlights some of the issues that can make the process longer and more difficult.
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Common completion mechanisms
When you are buying or selling a business, the two most common mechanisms for settling on the final price to pay are completion accounts and locked box. These are regularly used in conjunction with earn-outs. The process for establishing the price for the business can be complex and significantly affect the final outcome.This article examines the different mechanisms available and also goes into more detail on the optimal process for completion accounts where that process has been selected, and highlights some of the issues that can make the process longer and more difficult.
- What are completion accounts?
- What is the locked box mechanism?
- What are earn-outs?
- How do completion accounts work?
- What is the typical basis for preparation of completion accounts?
- What is the SPA hierarchy?
- The three most common pitfalls of completion accounts
- Conclusion
What are completion accounts?
When using a completion accounts mechanism, the parties agree a base amount payable by the buyer to the seller at completion, known as the ‘headline offer price’ and which represents the ‘enterprise value’. This can also be thought of as the initial unadjusted purchase consideration. The buyer typically calculates the headline offer price assuming that the target will be cash and debt free and have a normal level of working capital.
Post completion, a purchase price adjustment is then made to take account of the actual cash, debt and working capital of the business as at the completion date, to arrive at the final purchase price (known as the ‘equity value’). This is achieved through the creation of bespoke “completion accounts”. You will find an illustrative example of this below.
|
Enterprise Value |
A |
|
£400 million |
|
Plus: Cash |
B |
£10 million |
|
|
Less: Debt |
C |
£30 million |
|
|
Net debt adjustment |
D = B - C |
|
(£20 million) |
|
E |
£50 million |
|
|
|
Less: normal working capital |
F |
£65 million |
|
|
Working capital adjustment |
G = E - F |
|
(£15 million) |
|
Equity Value |
H = A + D + G |
|
£365 million |
What is the locked box mechanism?
In a locked box mechanism, the purchase price is agreed based on a balance sheet dated prior to completion, known as the ‘locked box balance sheet’ or the ‘locked box accounts’.At this date pre completion (called the ‘locked box date’), the levels of cash, debt and working capital are fixed (or ‘locked’), and the risks and rewards of ownership effectively transfer to the buyer at the locked box date.
Completion can be some weeks or months after the locked box date, and because of this the locked box price is adjusted to take account of: a) ‘leakage’; and b) ‘value accrual’.
In the period between the locked box date and completion, the buyer needs assurance that the seller will not transfer value from the target company to itself (which would reduce the value of the business which the buyer has paid for). Such value transfers are known as ‘leakage’. Typical examples of leakage are payments of dividends or management bonuses.
To this end, the Sale and Purchase Agreement (SPA) will define ‘permitted leakage’ of assets which are allowed between the locked box date and completion. The SPA will also contain warranties by the seller to the buyer that there will be no other payments or leakage which do not form part of the defined permitted leakage. To the extent any such leakage does then occur, the buyer can make a claim against the seller.
Whilst the economic risks and rewards transfer to the buyer at the locked box date, the seller will still be running the business until the completion date when the consideration is actually paid. To the extent the target company has been profitable during this period, the seller is usually then compensated for any value or cash that has built up by way of either a ‘value accrual’ or cash accrual adjustment to the purchase price.
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What are earn-outs?
With an earn-out mechanism, part of the purchase consideration is deferred and is dependent upon the results achieved by the target company post completion.Typically, an earn-out mechanism will work alongside a completion accounts or locked box mechanism, whereby the seller receives an agreed fixed amount at completion (which will usually be calculated based on a completion accounts or locked box mechanism), but then the parties agree certain metrics which if achieved post completion by the acquired company result in further payments being made to the seller.
A number of different metrics can be used for earn-outs, and these can be either financial (such as profits or revenues) and/or non-financial (such as customer satisfaction ratings or number of customer accounts or subscribers in some service sector entities).
The metrics and method for calculating the earn-out will be agreed between the parties and set out in the SPA.
Earn-outs can be used to help bridge the gap between what the buyer and seller consider the business is worth.
For example, where the seller thinks the business is worth £10m but the buyer is only prepared to pay £7.5m, the seller might be prepared to accept an up-front payment of £7.5m at completion and a further deferred consideration of up to £2.5m post completion dependent upon the business achieving certain growth targets, which if achieved the buyer is prepared to pay.
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How do completion accounts work?
The purchase price adjustment is based on the assets and liabilities actually acquired upon completion and relative to pre-completion assessments or estimates in the case of working capital. Additionally, where the offer references an assumed level of net debt, an adjustment to the Equity Value is made where the actual net debt differs. The purchase price adjustment can be significant and result in monies becoming due to either the buyer or the seller, i.e. it can result in the initial unadjusted purchase consideration being either increased or decreased.To determine the required purchase price adjustment, and thus ultimately the final purchase price, a bespoke set of “completion accounts” are drawn up post completion, which show the net assets of the company acquired as at the date of completion. Completion accounts can be prepared by either the buyer or the seller, and are then reviewed by the other party. Completion accounts include a balance sheet and often contain separate statements for net debt, working capital and non-current net assets.
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What is the typical basis for preparation of completion accounts?
Given the importance of completion accounts it is critical that both the seller and buyer agree how the completion accounts should be prepared and that this is clearly set out within the SPA.It is not enough to agree that the completion accounts will be prepared under Generally Accepted Accounting Principles (GAAP), such as International Financial Reporting Standards (IFRS), UK GAAP or US GAAP. This is because a degree of discretion often exists under GAAP which means a range of accounting treatments can all be deemed appropriate and in-line with GAAP. The result of this is that two accountants, even when presented with the same facts, could come to two quite different views on the same issue. One view may be more cautious / prudent, and one may be less so, but both views could still be in compliance with GAAP.
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What is the SPA hierarchy?
The most common approach for the basis of preparing completion accounts is a hierarchy with three limbs as follows:
- First limb: specific accounting policies set out within the SPA
- Second limb: consistency with past practice, i.e. the policies, procedures, practices, principles, treatments, methodologies and/or categorisations applied in preparing the last set of audited accounts of the target company (often referred to as consistency with past practice to the referenced accounts)
- Third limb: GAAP (e.g. IFRS, UK GAAP, etc.)
The second most common approach is:
- First, specific accounting policies set out within the SPA
- Second, consistency with past practice, to the extent past practice is in compliance with the accounting treatment under a specified GAAP
- Third, GAAP
As one goes down the hierarchy, there is more potential for the preparer to apply judgement in determining how an item is treated and so more potential for disputes between the parties.
Specific accounting policies for completion accounts
Specific policies can be agreed between the two parties and can range from stating a rule for a category of items (for example, specifying that the value of all inventory which is over one year old as at completion is written down to zero in the completion accounts) to stating a figure to be adopted for a specific item as at completion (for example, the value of a particular specific provision).
These specific policies aim to give a high degree of certainty to both parties regarding the figures to be recorded in the completion accounts.
It is not practical to have specific policies covering all items within the completion accounts. However, specific policies are often included where the item relates to a subjective accounting estimate or the item did not exist in the previous accounts, particularly where these items form a significant part of the target’s business.
The specific policies do not have to follow GAAP or the past practice applied in the last set of accounts for the target company, although they may do. This is part of the overall negotiation of the purchase price between the parties.
Consistency with past practice
Where there is a set of audited financial statements for the target company prior to completion, the policies, procedures and practices applied in preparing those accounts are often referenced as the consistent basis for preparing the completion accounts. The SPA may also specify that past practice is to include consistent application of management judgement.
By applying the same practice as used in the past, it protects the buyer or the seller from the completion accounts being prepared based on a different level of prudence than used historically (i.e. either more or less conservative) so as to affect the purchase price adjustment in favour of the preparer.
GAAP
For those items which are not covered by the first or second limbs of the hierarchy, the parties need to agree which relevant GAAP should then be applied. This is normally the GAAP that was applied in preparing the last set of audited accounts of the target, but it can differ. If this is the case, both parties should consider any impact on balances purely due to changing GAAP.
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The three most common pitfalls of completion accounts
There are three common issues that can result in disagreement when it comes to preparing completion accounts.Unclear and ambiguous wording
Wording which is unclear and ambiguous can lead to issues and disputes between the parties. You should ensure that language is as clear and definitive as possible, avoiding wording which is convoluted or lacks specificity.
It is crucial that the SPA has clear and unambiguous wording in defining specific policies or rules and to which items they apply. For example, stating that the pensions figure is “To be calculated based on the methodology agreed between the Parties, plus taking into account the risks on pensions as mentioned in the Vendor Due Diligence Report” is vague and open to interpretation, and can lead to disagreements between the parties.
The SPA should also clearly set out which accounts and for which entity in which year form the basis for “consistency with past practice”. Merely stating there should be “consistency with past practice” is not sufficient, as whose past practice and when?
When specifying which GAAP to apply, it is also necessary to state the effective date of that GAAP as accounting standards are often amended and occasionally replaced entirely, sometimes with quite significant impacts to the accounting treatment.
If the hierarchy wording in the SPA is ambiguous and results in differing views regarding the correct order of priority, this can lead to lengthy and costly disputes between the parties.
Depending on which limb of the hierarchy is applied, the treatment of an item can be very different. For instance, a specific policy relating to trade debtors (monies due from customers) could be that all trade debtors are written down to zero 12 months after an invoice has been issued to a customer. In contrast, the practice applied in preparing the last set of accounts could have been to write down all trade debtors by 50% after 12 months and then 100% after 18 months. IFRS is broader and instead states that an entity must assess at the end of each reporting period whether there is any objective evidence that a trade debtor is impaired, and the extent if so. The potential for disputes is clear.
It should be clearly understandable from the SPA in exactly which order the hierarchy is to be applied, and which limb takes precedence where there is any conflict between the limbs.
Errors in previous accounts
Although the usual order of priority is that consistency with past practice takes precedence over GAAP, one exception to this is where there are errors in the historical accounts. Errors in the historical accounts can lead to large and unexpected adjustments, either in favour of the seller or the buyer depending on the nature of the error.
In the expert determination case of Shafi vs. Rutherford, the SPA contained the usual three limb hierarchy, and for the purposes of the second limb (consistency with past practice), defined the target’s last accounts as being prepared in accordance with GAAP.
However, an error in the historical accounts was identified, post completion, whereby the accounting treatment of certain equipment leases in the reference accounts was incorrect under GAAP.
In the case of historical errors, courts are likely to order that the previous incorrect past practice, that also contravened the stated accounting policy and applicable GAAP in the reference accounts, should not be perpetuated and that the completion accounts should be prepared based on the correct accounting treatment per GAAP and the stated accounting policy.
Post balance sheet events
A potential area of dispute arises where the SPA is silent regarding the cut-off date for the admissibility of information that can be considered when preparing the completion accounts.
We have seen a range of cut-off dates used in practice, including:
- the completion date of the deal
- the date on which the preparer of the draft completion accounts submits them to the other party
- the date of the objection notice from the recipient of the draft completion accounts
- the date of agreeing the completion accounts or the determination of the completion accounts
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Conclusion
In a recession, where there is significant economic uncertainty, there can be a shift towards increased use of completion accounts and earn-outs rather than a locked box mechanism. These methods offer increased flexibility in terms of the final purchase price paid which can be helpful to getting a deal done between parties in times of uncertainty.The application of a completion accounts mechanism can lead to a significant post-completion price adjustment. This means all the parties must understand and agree the basis for the preparation of the completion accounts and set this out unambiguously in the SPA.
Getting it wrong can lead to a significant loss of value, not only due to an adverse purchase price adjustment, but also through management time spent resolving complex and lengthy disputes between the parties. A seemingly good deal can easily become a prolonged headache.
Even with the best of intentions and despite following advice, an M&A transaction can result in a dispute post-Completion. Each transaction is unique and any issues which arise on a particular transaction will need to be considered in the context of that specific case. Our Forensic M&A Services team has a wealth of experience and offers a range of specialist services both to reduce risk exposure pre-deal and to assist with any issues that arise post-deal.
Do you need advice on a completion accounts process or support resolving a dispute? Please get in touch to discuss how we can help.