There are several pricing mechanisms which can be applied when purchasing or disposing of the shares of a company or a business (Target). In this article, we discuss some of the common pricing mechanisms and key considerations for buy-side and sell-side transactions.

Locked Box

The purchase price in a locked box mechanism is based on financial information derived from the financial statements or management accounts at a point in time. These sources of information, along with other financial information such as forecasts, are used to calculate both enterprise value and equity value. The date of the financial information constitutes the agreed date of the “locked box” (Locked Box Date), which is usually the end of a most recent financial year. Financial statements would typically be audited, thus giving credence and credibility to the information. The purchase price will be agreed and fixed when the parties sign the transaction agreement (Signature Date), and will reference a locked box balance sheet at the Locked Box Date.

From the Locked Box Date (or even Signature Date), the seller or Target is prohibited from making certain payments which will extract value from the Target. Such prohibited payments may include dividends, management fees, and non-operational payments known as “leakage”, while payments in the ordinary course of business will be permissible and are regarded as “permitted leakage”. In spite of payment only being made by the buyer at a later date, risk and benefit in relation to the Target passes to the buyer on the Locked Box Date.

The purchase price is often payable on the closing date, when ownership of the Target transfers from the seller to the buyer in terms of the transaction agreement (Completion Date). As the purchase price is fixed as at the Locked Box Date, the period between then and the Completion Date may be an extended period of time (Locked Box Period). Therefore, where profits increase in the Target during the Locked Box Period, such profits will be locked in the “locked box” and lost by the seller. The converse also holds true, making it even more important that a robust valuation is conducted for both parties to assess, in their view, the value of the Target.

Although not common, the sell-side may negotiate value accrual based on (i) additional cash flow generated by the Target and/or (ii) interest on the purchase price during the Locked Box Period. The buyer may protect itself by crafting walk-away rights in the transaction agreement, such as the occurrence of a material adverse change in the Target.

Completion / Closing Accounts

When utilising the completion accounts as a pricing mechanism, the seller will prepare a preliminary closing balance sheet to indicate pertinent balances, such as net debt and working capital, et cetera, before the Signature Date. The estimated purchase price will be paid in full or partially on the Closing Date and on the Completion Date, and risk and ownership in relation to the Target will pass at this point or when the balance is paid in full, depending on the provisions of the transaction agreement.

The transaction agreement will detail a timeline within which the estimated purchase price will be finalised, based on final completion accounts to be provided by the seller to the buyer post the Completion Date. The buyer is provided an opportunity to accept or dispute such final completion accounts. Taking account of the pertinent balance sheet items, any difference between the estimated purchase price and the final purchase price is either paid by the buyer or reimbursed by the seller to adjust the purchase price.

Unlike with the locked box mechanism, the equity value is not fixed. It is finalised post the Completion Date, to adjust the purchase price based on the completion accounts.

Earnout

An earnout, as a pricing mechanism, allows the seller of the Target to receive additional compensation if the business of the Target meets specified financial metrics during a defined period. This is known as the “earnout period”, which is usually between one to three years. These financial targets are typically based on metrics such as earnings before interest, taxes, depreciation, and amortisation (EBITDA) or net profits (Financial Targets). The transaction agreement will define the metrics for calculating the earnout, with the final determination of whether the financial metrics are achieved being based on the results reflected in the Target’s annual financial statements.

The earnout mechanism eliminates uncertainty for the buyer as they only pay a portion of the purchase price upfront, with the balance based on future financial performance of the Target, usually at the end of each financial year during the earnout period. This holds the seller accountable for financial forecasts that it may have provided to the buyer which were used in determining the valuation and purchase price. The earnouts are usually paid in cash, but shares are not uncommon. Unlike a locked box mechanism (subject to negotiating value accrual), the seller benefits from future growth during the earnout period, depending on how the earnout is structured.

The method for calculating Financial Targets must be specified clearly in the transaction agreement to prevent disputes, as earnouts often lead to post-closing disputes that can escalate to litigation or arbitration, similar to the completion accounts mechanism.

The earnout calculation, period, and the management team post-acquisition must be carefully negotiated and detailed in the transaction agreement, as these factors will contribute to the Target’s ability to meet its Financial Targets. The transaction agreement should also cater for any potential anomalies, accounting complexities and recognition criteria (if applicable), ensuring that all parties are aligned as to how the Financial Targets will be measured.

Concluding which mechanism is appropriate for a particular transaction requires consideration of the business / industry of the Target, complexity, timing and cost, amongst other factors. The locked box may be preferred for transaction simplicity in respect of time and cost, whereas completion accounts and earnouts as mechanisms may be preferred because the purchase price paid aligns with the actual company / business value based on adjustments after the Completion Date.

Transaction advisors can assist parties to navigate each of the mechanisms and decide which one is appropriate for a specific party, and the Target being acquired or disposed of in a transaction.

Thandiwe Nhlapho and James Moody are Corporate Financiers | PSG Capital

This article first appeared in DealMakers, SA’s quarterly M&A publication.

DealMakers is SA’s M&A publication.
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