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Insight

Purchase price adjustment in a corporate acquisition

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

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

The purchase price adjustment converts the negotiated enterprise value into the actual equity value paid. This is achieved by deducting net financial liabilities, adding cash and cash equivalents, and taking into account deviations in working capital from the agreed normal level. The definitions used here are crucial, as classifying shareholder loans, leases or provisions as debt can significantly alter the purchase price. Under the locked-box method, the price is fixed at the time of signing based on a historical cut-off date and any leakage is prohibited. In the case of closing accounts, the provisional purchase price is adjusted after completion based on the actual net debt and working capital figures. If any disputes remain, an arbitrator will decide. Their decision is binding on the parties unless it is manifestly incorrect under Section 319(1) of the German Civil Code (BGB).

Why is the purchase price adjusted?

Companies are usually valued on the basis of their sustainable profitability. An EBITDA multiple initially yields the enterprise value, i.e. the value of the operating business regardless of how it is financed. In a share deal, however, the buyer also takes on the target company’s specific balance sheet. If the company has high levels of financial debt, the buyer must bear the economic burden of this. If it has surplus liquidity, this generally increases the value of the shares.

Working capital required for operations also influences the value. A company needs trade receivables, inventories and other current assets to run its business, but finances part of this through trade payables and other current liabilities. If the company is transferred with unusually low working capital, the buyer must inject additional liquidity immediately after closing. The mechanism is therefore designed to ensure a transfer at a normalised level.

The purchase agreement must record the same economic items only once. A liability must not be deducted as debt and simultaneously affect the price a second time via working capital. This distinction lies at the heart of the definitions.

What is the difference between enterprise value and equity value?

Enterprise value describes the value of the operating company before taking its specific financing structure into account. Equity value is the value to which the shareholders are entitled after applying the agreed ‘equity bridge’. In simplified terms, net debt is deducted from the enterprise value, and any deviation of the actual net working capital from the target figure is either added or deducted.

In practice, this bridge includes further items. These may include shareholder loans, factoring, lease liabilities, transaction costs, outstanding bonuses, pension liabilities or non-operating assets. Whether these are treated as debt, debt-like items, cash or a separate purchase price adjustment must be specified in the contract.

The parties should not rely solely on terms used in a due diligence report. The report describes and analyses items; it is only the purchase agreement that turns these into a binding purchase price rule.

How does a locked box work?

With a locked box, the purchase price is determined on the basis of a historical balance sheet date, often the most recent audited annual accounts or a specially prepared interim set of accounts. Net debt and working capital are determined as at this locked-box reference date. The equity value derived from this is generally fixed at the time of signing and is not adjusted by new financial statement figures after closing.

Economically, the buyer bears the responsibility for the company’s performance from the locked-box reference date onwards, even though they do not obtain legal control until closing. To ensure that the seller does not extract any value in the meantime, the contract 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 parties. Permissible payments are expressly identified as ‘Permitted Leakage’.

The seller often receives interest or a daily purchase price premium for the period between the reference date and closing. This so-called ‘ticker’ is intended to reflect the economic success already attributed to the buyer. It does not replace an assessment of whether the underlying locked-box figures are reliable and free from extraordinary effects.

When is the locked box approach appropriate?

The locked box provides price certainty and a streamlined closing process. It is particularly suitable when up-to-date, reliable financial figures are available and the business remains stable between the reference date and closing. In bidding processes, it makes it easier to compare offers because bidders can quote a fixed equity value.

From the buyer’s perspective, the risk increases if the reference financial statements are out of date, the company is subject to significant fluctuations, or the period until closing is lengthy. In such cases, the buyer bears the risk of economic changes without yet having control of the company. A strict ordinary-course obligation, an effective leakage regime and up-to-date monthly reports become all the more important.

The locked box does not eliminate every purchase price dispute. Disputes often shift to the question of whether a payment constitutes leakage, whether it was permitted as ‘permitted leakage’, or whether the reference transactions accurately reflect the agreed basis.

How do closing accounts work?

In closing accounts, the purchase price is initially calculated on a provisional basis. Following completion, one party – often the buyer – prepares a final statement or purchase price calculation as at the closing date. The provisional purchase price is then adjusted upwards or downwards based on the actual net debt and working capital figures.

This mechanism generally attributes the company’s financial performance up to the closing date to the seller. It can be useful where the business is volatile, a carve-out is being carried out, significant financing is only being repaid at closing, or balance sheet items may change substantially by that point.

The final figure is not determined until weeks or months after closing. By that point, the seller no longer has access to the day-to-day accounts, whilst the buyer controls the company and prepares the settlement statement. The contract therefore requires detailed rights regarding the preparation of statements, the provision of information and the raising of objections, as well as a clear dispute resolution mechanism.

What is included in net debt?

Net debt is generally calculated by starting with interest-bearing financial liabilities and deducting agreed cash and cash equivalents. This typically includes bank loans, overdraft facilities and accrued interest. The actual negotiations centre on borderline cases.

Lease liabilities may be treated as debt, depending on the valuation model and accounting standard, or may already be factored into the underlying EBITDA. Shareholder loans are often deducted in full or repaid prior to closing. Factoring can generate genuine liquidity or merely represent hidden financing and the advance receipt of future cash flows. Outstanding transaction bonuses, consultancy fees or taxes on the transaction are often treated as debt-like items if, in economic terms, they originate from the seller’s period.

Cash must also be defined. Not every credit to an account is freely available. Pledged balances, client funds, minimum liquidity requirements, foreign funds subject to transfer restrictions or cash on hand may need to be excluded. The definition should therefore not refer indiscriminately to the balance sheet item ‘cash and cash equivalents’.

How is working capital calculated?

Net working capital comprises current operating assets less current operating liabilities. Typical examples include 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 included in net debt are generally excluded.

The key figure is the target value, known as the ‘peg’ or ‘target working capital’. This is intended to reflect the company’s normal level. A simple average of the last twelve months can be misleading for seasonal businesses. Growth, price increases, exceptional projects, supply chain disruptions and changes to payment terms must be taken into account.

The mechanism should also take account of the quality of the items. Overdue or uncollectible receivables increase working capital on the balance sheet but do not provide the buyer with a fully valuable source of liquidity. Obsolete stock can have the same effect. Value adjustments, cut-off rules and ageing structures must therefore be included in the calculation principles.

What accounting rules apply to closing accounts?

The purchase agreement should set out a hierarchy of accounting principles. The specific definitions and rules set out in the purchase agreement take precedence. These may be followed by expressly agreed illustrative calculations and the accounting and valuation methods that have been consistently applied to date. General accounting standards such as the German Commercial Code (HGB) or International Financial Reporting Standards (IFRS) apply only as a last resort.

This hierarchy is important because a company may apply several legally valid accounting methods. However, the purchase price adjustment should not be altered simply because the buyer exercises different options or makes different estimates for the first time after closing. On the other hand, the continuity of past methods must not lead to the perpetuation of obvious errors or practices that contravene the contract.

Cut-off dates, provisions, write-downs, foreign currencies, intercompany items and events occurring after the closing date should be expressly regulated. The more specifically the contract addresses known areas of dispute, the less the purchase price calculation depends on general interpretation of the financial statements.

How is the purchase price settled after closing?

The contract specifies who is responsible for preparing the closing accounts and the resulting purchase price calculation, and within what timeframe. The other party is granted a period in which to review these documents. They are granted access to the underlying books, working papers and the relevant staff or advisers. Objections must usually be specified individually and quantified.

Items not contested become final. The parties first negotiate the remaining points within a short timeframe. If no agreement is reached, an independent arbitrator – often an audit firm – will decide. Their role should be limited to the specific outstanding accounting and financial reporting issues. The arbitrator’s finding is, in principle, binding on the parties. In the case of an arbitrator’s opinion in the strict sense, this binding effect—in accordance with Section 319(1) of the German Civil Code (BGB)—only ceases to apply if the result is manifestly incorrect. A accounting issue that could simply be assessed differently in a reasonable manner, or a minor error, is not sufficient for this. The contract should also stipulate what applies if the appointed expert is unable to decide, refuses to decide or delays the completion of their mandate.

The undisputed adjustment amount should be paid immediately, without waiting for the entire proceedings to be concluded. Provisions should be made regarding interest, set-off and the method of payment for the remaining balance. In this context, contractual interest should be clearly distinguished from statutory default interest. The parties may agree that interest is to accrue on the finally determined adjustment amount from the closing date or from an economic reference date, regardless of when it is quantified and becomes due. Statutory default interest under Sections 286 and 288 of the German Civil Code (BGB), on the other hand, generally requires that the amount be due and that default has occurred. The clause should therefore expressly specify the interest rate, the date from which interest accrues, the due date following final determination, and the treatment of undisputed partial amounts. In the event of potentially significant adjustments, an escrow arrangement or a retention of the purchase price may be used to secure performance.

Which points of contention arise most frequently after closing?

There are often disputes over whether a particular item constitutes net debt or working capital. This classification determines the category and, due to the working capital peg, can have different financial implications. Further disputes relate to the availability of cash, the treatment of leases, factoring, tax positions and transaction costs that have not yet been settled.

In the case of working capital, the focus is on bad debt provisions, inventory write-downs, accruals and unusual payments made shortly before closing. The seller may be tempted to collect receivables aggressively and defer payments to suppliers. The buyer may adopt a more cautious valuation approach after closing or set aside additional provisions. ‘Ordinary course’ rules and clear accounting principles are intended to limit both effects.

The scope of the arbitrator’s authority is also a source of potential dispute. Are they permitted only to rule on the parties’ respective positions, or may they develop their own calculation? Are they permitted to interpret legal contractual issues? Who bears their costs? These points should not be left to be clarified only in the arbitration agreement.

Locked Box or Closing Accounts: which mechanism is right for you?

The locked box approach is suitable for stable companies with robust financial figures and a desire for price certainty. Closing accounts are a better fit if the balance sheet and financing are likely to change significantly by the closing date, or if the transaction involves a complex carve-out. Neither method is generally buyer- or seller-friendly. The decisive factors are data quality, bargaining power and risk allocation in each specific case.

Hybrid approaches are possible, but should not be made unnecessarily complicated. Individual items can be adjusted separately under a locked box arrangement or treated as fixed values under closing accounts. However, every exception increases the risk of double-counting and conflicting rules.

The decision should be made early on, ideally as early as the Letter of Intent. If the enterprise value, the cash-and-debt-free assumption and the working capital mechanism are only clarified at the end of the contract negotiations, the parties may find themselves negotiating different purchase prices, even though they are citing the same enterprise value.

About the author

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

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Frequently asked questions about purchase price adjustments

Enterprise value assesses the operating business independently of its financing structure. Equity value is the purchase price of the shares after taking into account net debt, cash, working capital and other agreed adjustments.

In a locked-box arrangement, the purchase price is determined on the basis of historical reference financial statements and, as a rule, is not adjusted after closing. Any outflows of value to the seller between the reference date and closing are safeguarded by a leakage prohibition.

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

Bank liabilities and other financial debts, less agreed cash and cash equivalents, are usually included. Leases, factoring, shareholder loans, bonuses, taxes and transaction costs must be explicitly specified in the contract.

Target working capital is the agreed normal level of current assets, less current operating liabilities. Any deviation from this figure on the closing date will increase or decrease the purchase price.

It is often drawn up by the buyer after the closing, as this is when they review the accounts. The seller therefore requires contractual rights to inspect the accounts, obtain information and raise objections. It is also possible for the seller or an independent third party to draw it up.

The usual procedure is to begin with a negotiation phase, followed by a decision by an independent arbitrator on any outstanding calculation and accounting issues. Fundamental legal issues should be dealt with separately.

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