In the intricate landscape of Mergers and Acquisitions (M&A), negotiating the price of the target company is paramount. The value of the target company can undergo significant shifts between the negotiation stage and the closing stage, making it crucial for all parties involved to seek pricing mechanisms that perfectly align with their interests. The M&A field is dominated by two primary pricing mechanisms: the Closing Accounts Mechanism and the Locked Box Mechanism.
Understanding these pricing mechanisms is essential for M&A practitioners and business professionals. In this article, we will explore these pricing mechanisms, shedding light on their core concepts and key considerations while also highlighting the advantages and drawbacks of each.
The Closing Accounts Mechanism
The closing accounts mechanism is a widely employed approach in M&A transactions, offering a flexible solution to address potential fluctuations in the target company's value between the negotiation and closing phases. It operates on the premise that the initial purchase price agreed upon during negotiations is provisional. Post-closing, both the buyer and the seller engage in a thorough examination of the target company's financial statements and accounts and any discrepancies or variations discovered during this review trigger adjustments to the purchase price.
Key features of the closing accounts mechanism include:
1. Adjustability
The purchase price is subject to change based on actual financial performance, ensuring a fair valuation for both parties.
2. Certainty
It provides a degree of certainty regarding the final purchase price, albeit after the transaction is completed.
3. Financial Transparency
The mechanism encourages financial transparency, as both parties have access to the target company's financial records, promoting trust and accountability.
The Locked Box Mechanism
In contrast, the locked box mechanism represents a different approach to pricing in M&A deals. Here, the purchase price is fixed at the outset of negotiations and is typically based on the target company's historical financial performance up to a specific date (usually the last available annual accounts or interim accounts of the target company), known as the “locked-box date.”
Key features of the locked box mechanism include:
1. Certainty
It offers price certainty from the beginning, reducing post-closing disputes over price adjustments.
2. Limited Adjustability
The purchase price remains fixed regardless of variations in the target company's performance post-lock box date. Any deterioration or improvement in financial performance becomes the buyer's responsibility or windfall.
3. Efficiency
The locked box mechanism is often seen as more efficient and less consuming from an administrative perspective than the closing accounts mechanism, making it less burdensome for the parties involved.
On account of the above, for any of the parties to arrive at the pricing stage a business valuation needs to be in order.
A business valuation seeks to estimate the enterprise value of the underlying entity, which is used as the starting point in determining the purchase price. The enterprise value represents value generated through future earnings working off a current asset base, or in other words, the value of currently invested assets plus the net present value of expected future investments. The distinction between enterprise and equity value is that the latter is the sum of claims of all the security-holders of a business (i.e. shareholders and debt-holders), whilst equity value is the residual value directly attributable to the shareholders after the respective net debt has been serviced.
The basis of a valuation is a fundamental assumption behind any valuation, as it underlies all assumptions that are made. Typically, general reference is made to “fair market value”, which is defined as the price that the entity might be reasonably expected to obtain, in a sale between a willing buyer and a willing seller, each of whom is deemed to be acting for self-interest and gain, and both of whom are equally informed about the entity and the market in which it operates. In the context of an M&A transaction, the hypothetical buyers are specifically identified, and therefore the valuation should require a detailed analysis of the respective synergies, motivations and context underlying the transaction. These considerations will ultimately have an impact on the enterprise value and the transaction price.
Generally, the income valuation approach is typically utilised in determining the enterprise value in the context of a transaction. Through this approach, the valuation is based on future earnings, cash flows and the expected return on investment. Synergies to the specific transaction can be taken into consideration, generally allowing the buyer to assess the incremental value available once the transaction is finalised, and a basis for leeway in negotiating prices going forward. The sustainability of the earnings utilised in the valuation will serve as a basis for any price adjustments during due diligence. The derived value through the income approach, can be benchmarked to publicly available data on peer group companies and/or similar transactions to better understand the reasonableness of the price discussed in the transaction.
Despite the similarities between price and value, in practice, price does not necessarily mean value. The price someone is prepared to pay reflects the value to the buyer, attitude towards risk, presence of other bidders to the transaction, and the cash flow needs of the vendor. All these factors will impact positively or negatively the business value derived through the referenced methodologies.
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