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Purchase Price Adjustment in an Acquisition

Locked box, closing accounts, net debt, working capital and typical points of dispute after completion.

| Reading time 9 min. | Author: Johannes Egelhof LL.M.

In brief

The purchase price adjustment in an acquisition translates the economically negotiated enterprise value into the amount that the buyer pays for the shares. The parties frequently first agree on a debt-free and cash-free enterprise value. Net financial liabilities are deducted from it, available cash is added and deviations of the working capital from an agreed normal level are taken into account. The result is the equity value.

The calculation seems simple, but is in practice one of the most frequent sources of dispute after closing. The definitions decide the outcome. Whether a shareholder loan counts as debt, which provisions are to be included or whether overdue receivables belong to normal working capital can change the purchase price considerably.

  • The purchase price adjustment translates the enterprise value into the equity value. Net financial debt is deducted, available cash added and working-capital deviations from an agreed normal level taken into account.
  • The definitions matter more than the formula. Whether shareholder loans, leases or provisions count as debt can change the purchase price considerably.
  • With a locked box, the price is fixed at signing on the basis of a historical reference date. Leakage is prohibited, and permissible payments are expressly designated as permitted leakage.
  • With closing accounts, the provisionally paid price is adjusted after completion on the basis of the actual net-debt and working-capital figures. The final amount is known only weeks or months later.
  • Where objections remain in dispute, an expert arbitrator decides. The determination binds the parties and, applying Section 319(1) BGB, ceases to bind only where the result is manifestly incorrect.

Why is the purchase price adjusted?

Companies are usually valued on the basis of their sustainable earning power. An EBITDA multiple leads first to the enterprise value, that is, the value of the operating business independently of how it is financed. In a share deal, however, the buyer also takes over the specific balance sheet of the target company. Where the company has high financial debt, it must bear this economically. Where it has surplus liquidity, this in principle increases the value of the shares.

The working capital required for operations also influences the value. A company needs receivables, inventories and other current assets to operate its business, but finances part of these through trade payables and other short-term obligations. Where the company is handed over with unusually low working capital, the buyer must inject additional liquidity immediately after closing. The mechanism is therefore intended to ensure a handover at a normalised level.

The purchase agreement must capture the same economic items only once. A liability may not be both deducted as debt and, via working capital, take effect on the price a second time. This dividing line is the core of the definitions.

What is the difference between enterprise value and equity value?

The enterprise value describes the value of the operating business before regard to its specific financing structure. The equity value is the value to which the shareholders are entitled after application of the agreed bridge. In a simplified logic, net debt is deducted from the enterprise value and a deviation of the actual net working capital from the target value is added or deducted.

In practice, the bridge contains further items. These may include shareholder loans, factoring, lease liabilities, transaction costs, outstanding bonuses, pension obligations or non-operating assets. Whether they are treated as debt, a debt-like item, cash or a separate purchase-price adjustment must be determined in the agreement.

The parties should not rely solely on terms from a financial due diligence. The report describes and analyses items. Only the purchase agreement turns them into a binding purchase-price rule.

How does a locked box work?

In the case of a locked box, the purchase price is fixed on the basis of a historical balance-sheet date, frequently the last audited annual financial statements or specially prepared interim accounts. Net debt and working capital are determined as at this locked-box date. The equity value derived from them is in principle already fixed at signing and is not adjusted after closing by new completion accounts.

Economically, the buyer bears the development of the company from the locked-box date, even though it obtains legal control only at closing. So that the seller does not extract value in the intervening period, the agreement prohibits so-called leakage. This includes in particular distributions, repayments to shareholders, non-arm's-length remuneration or other transfers of value to the seller and related persons. Permissible payments are expressly designated as permitted leakage.

The seller frequently receives, for the period between the reference date and closing, interest or a daily purchase-price uplift. This so-called ticker is intended to reflect the economic success that is already attributed to the buyer. It does not replace an examination of whether the underlying locked-box figures are reliable and free of unusual effects.

When is a locked box suitable?

The locked box creates price certainty and a lean completion. It is particularly suitable where current, robust financial figures are available and the business remains stable between the reference date and closing. In auction processes it facilitates the comparison of offers, because the bidders can state a fixed equity value.

From the buyer's perspective, the risk increases where the reference accounts are old, the company is subject to strong fluctuations or the time to closing becomes long. The buyer then bears economic changes without yet controlling the company. A strict ordinary-course obligation, an effective leakage regime and current monthly reports become all the more important.

The locked box does not eliminate every purchase-price dispute. Disputes frequently shift to the question of whether a payment constitutes leakage, whether it was permitted as permitted leakage or whether the reference accounts correctly reflect the agreed basis.

How do closing accounts work?

In the case of closing accounts, the purchase price is initially calculated on a provisional basis. After completion, one party, frequently the buyer, prepares accounts or a purchase-price calculation as at the closing date. On the basis of the actual net-debt and working-capital figures, the provisionally paid purchase price is adjusted upwards or downwards.

The mechanism in principle attributes the economic development up to closing to the seller. It may be sensible where the business is volatile, a carve-out is completed, material financings are repaid only at closing or balance-sheet items may change considerably by then.

The final figure is fixed only weeks or months after closing. The seller then no longer has access to the ongoing accounting, while the buyer controls the company and prepares the settlement. The agreement therefore needs detailed rights of preparation, information and objection as well as clear dispute resolution.

What belongs to net debt?

Net debt regularly begins with interest-bearing financial liabilities and is reduced by agreed cash. This typically includes bank loans, current-account credit and accrued interest. The actual negotiations concern the borderline cases.

Lease liabilities may, depending on the valuation model and accounting standard, count as debt or already be reflected in the underlying EBITDA. Shareholder loans are frequently deducted in full or repaid before closing. Factoring may create genuine liquidity or may represent only hidden financing and the advance collection of future cash flows. Outstanding transaction bonuses, advisory costs or taxes on the transaction are frequently treated as debt-like items where they economically stem from the seller's period.

Cash must also be defined. Not every account credit is freely available. Pledged balances, customer monies, minimum liquidity, foreign funds subject to transfer restrictions or cash on hand may fall to be excluded. The definition should therefore not refer in blanket terms to the balance-sheet item "cash".

How is the working capital determined?

Net working capital comprises the short-term operating assets less the short-term operating liabilities. Typical are trade receivables, inventories and certain prepaid expenses on the one hand, and trade payables and operating provisions on the other. Cash, financial debt and other items already captured in net debt in principle remain outside.

What is decisive is the target value, the so-called peg or target working capital. It is intended to reflect the normal level of the company. A simple average of the last twelve months can be misleading in seasonal businesses. Growth, price increases, extraordinary projects, supply-chain disruptions and changes in payment terms must be taken into account.

The mechanism should also capture the quality of the items. Overdue or irrecoverable receivables increase the working capital in accounting terms but do not provide the buyer with a full-value source of liquidity. Obsolete inventories can have the same effect. Value adjustments, cut-off rules and ageing structures therefore belong in the principles of calculation.

What accounting rules apply to closing accounts?

The purchase agreement should establish a hierarchy of accounting principles. First come the specific definitions and rules of the purchase agreement. Expressly agreed sample calculations and the accounting and valuation methods consistently applied to date may then follow. Only subordinately do general accounting standards such as the HGB or IFRS apply.

This hierarchy is important because a company may apply several legally defensible accounting methods. The purchase price adjustment should, however, not be changed by the buyer using different options or estimates for the first time after closing. On the other hand, the continuity of past methods must not lead to obvious errors or practices in breach of the agreement being perpetuated.

Cut-off, provisions, value adjustments, foreign currencies, intercompany items and events after the closing date should be expressly regulated. The more concretely the agreement addresses the known areas of dispute, the less the purchase-price calculation depends on general accounting interpretation.

How does the purchase-price settlement proceed after closing?

The agreement determines who prepares the closing accounts and the purchase-price calculation derived from them, and within what period. The other party is granted a period for examination. It receives access to the underlying books, working papers and the responsible staff or advisers. Objections must usually be individually identified and quantified.

Items not objected to become final. The parties first negotiate the remaining points within a short period. Where no agreement is reached, an independent expert arbitrator, frequently an audit firm, decides. Its task should be limited to the specific open questions of calculation and accounting. The expert arbitrator's determination in principle binds the parties. In the case of an expert determination in the narrower sense, this binding effect ceases, in the corresponding application of Section 319(1) BGB, only where the result is manifestly incorrect. A merely defensibly different accounting question or an ordinary error is not sufficient for this. The agreement should also regulate what applies where the appointed expert cannot decide, does not wish to decide or delays its mandate.

The undisputed adjustment amount should already be paid without awaiting the end of the entire procedure. For the remaining payment, interest, set-off and the payment route are to be regulated. In this respect, contractual interest should be clearly separated from statutory default interest. The parties may agree that the finally determined adjustment amount already bears interest from closing or from an economic reference date, irrespective of when it is quantified and becomes due. Statutory default interest under Sections 286, 288 BGB, by contrast, in principle presupposes maturity and default. The clause should therefore expressly determine the interest rate, the commencement of interest, maturity after final determination and the treatment of undisputed partial amounts. In the case of larger possible adjustments, an escrow or purchase-price retention can secure completion.

Which points of dispute arise particularly frequently after closing?

There is frequently a dispute as to whether an item is net debt or working capital. This classification decides the category and may, through the working-capital peg, have different economic consequences. Further conflicts concern the availability of cash, the treatment of leasing, factoring, tax items and transaction costs not yet settled.

For working capital, receivable value adjustments, inventory write-downs, period allocation and unusual payments shortly before closing are at the centre. The seller may be tempted to collect receivables aggressively and defer payments to suppliers. After closing, the buyer may value more cautiously or form additional provisions. Ordinary-course rules and clear accounting principles are intended to limit both effects.

The competence of the expert arbitrator is also prone to dispute. May it decide only between the parties' positions or develop its own calculation? May it interpret legal contractual questions? Who bears its costs? These points should not be clarified only in the expert-arbitrator agreement.

Locked box or closing accounts: which mechanism is suitable?

The locked box suits stable companies with robust reference figures and a desire for price certainty. Closing accounts suit better where the balance sheet and financing may change materially by closing or the transaction involves a complex carve-out. Neither method is generally buyer- or seller-friendly. What is decisive are data quality, bargaining power and the allocation of risk in the specific case.

Hybrid forms are possible but should not be made unnecessarily complicated. Individual items may be adjusted separately in a locked box or treated as fixed values in closing accounts. Every exception, however, increases the risk of double counting and contradictory rules.

The decision should be taken early, ideally already in the letter of intent. Where enterprise value, the cash-and-debt-free assumption and the working-capital mechanics are clarified only at the end of the contract negotiation, the parties may be negotiating over different purchase prices even though they name the same enterprise value.

About the author

Johannes Egelhof
Johannes Egelhof LL.M.
Partner · M&A & Corporate
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Johannes Egelhof LL.M. advises buyers and sellers on national and international M&A transactions. He designs purchase-price mechanisms and aligns legal definitions with financial due diligence, accounting and the closing process.

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Frequently asked questions about the purchase price adjustment

The enterprise value values the operating business independently of its financing. The equity value is the share purchase price after regard to net debt, cash, working capital and further agreed adjustment items.

In the case of a locked box, the purchase price is fixed on the basis of a historical set of reference accounts and in principle not adjusted after closing. Outflows of value to the seller between the reference date and closing are safeguarded by a leakage prohibition.

Closing accounts are a settlement as at the completion date. The initially provisional purchase price is adjusted after closing on the basis of the actual net-debt and working-capital figures.

Regularly, bank liabilities and other financial debt less agreed cash belong to it. Leasing, factoring, shareholder loans, bonuses, taxes and transaction costs must be expressly classified in the agreement.

Target working capital is the agreed normal level of the operating current assets less operating short-term liabilities. A deviation as at the closing date increases or reduces the purchase price.

They are frequently prepared by the buyer after closing, because it then controls the accounting. The seller therefore needs contractual rights of examination, information and objection. Preparation by the seller or an independent third party is also possible.

The usual approach is first a negotiation phase and then a decision by an independent expert arbitrator for the open questions of calculation and accounting. Fundamental legal questions should be kept separate from this.

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