The choice of the purchase price mechanism should not affect the content of the due diligence review of the target company, nor should it, in principle, affect the key focus areas of the review. However, there are some impacts, primarily related to the process flow and timelines, but not limited to them. In practice, the time periods and cut-off points subject to review differ slightly.
Generally speaking, when conducting due diligence work, the numbers that exist at that moment are examined. This means that, in terms of historical figures, the financial performance and position are reviewed up to the last available closed month in the accounting records. The key difference from a due diligence perspective lies in the analysis of historical figures. However, forward-looking analyses do not differ depending on the choice of the purchase price mechanism.
Closing Accounts
If the closing accounts mechanism is applied, the effective balance sheet date in relation to the signing date is in the future, meaning that historical data until completion balance sheet date is not available at the time of the due diligence review. The completion balance sheet date refers to the date on which the final purchase price is determined based on the balance sheet position and potentially relevant off-balance-sheet items at that time. Thus, historical analyses conducted during the due diligence phase alone are insufficient for constructing a sufficiently accurate understanding of the purchase price determination.
A sufficiently comprehensive analysis must therefore be conducted to assess what has occurred between the financial cut-off date of the due diligence analyses and the closing date. Typically, it is advisable to examine the development of the income statement and balance sheet in sufficient detail to determine whether any significant changes affecting the target company’s value have occurred. Additionally, it is crucial to be able to calculate the purchase price based on reliable information. Ideally, a sufficiently precise understanding of what should be included in net cash (or debt) and net working capital at the closing date has already been achieved during the due diligence phase. While the actual numbers are not yet available at that stage, the content should be well understood.
The advantage of the closing accounts method is the precise determination of the purchase price based on the balance sheet transferred at the time of transaction completion. The downside is the time required to confirm the final purchase price, as in practice, it can only be calculated a few months after the transaction has been completed.
Locked Box
If the locked box mechanism is applied, the effective balance sheet date is in the past. Consequently, in principle (and in most cases in practice), all necessary information is already available when conducting due diligence. One of the advantages of the locked box method is that the final purchase price is known at the time of signing the transaction. No separate calculation is needed to determine the final purchase price based on a future balance sheet date (at closing date).
However, things are not always that simple. The locked box mechanism inherently involves agreements on permitted and non-permitted value leakages (permitted leakage, non-permitted leakage) between the locked box date and the completion of the transaction. Before signing, it is important to ensure that no non-permitted leakages have occurred; if they have, they must be quantified and deducted from the purchase price before payment.
Locked box mechanisms typically include a so-called locked box interest element, which aims to compensate for value creation or the cost of capital between the locked box date and the actual transaction completion. More details on locked box interest can be found in a previous blog post:
Hybrid Mechanism
If a combination of the above two methods is applied i.e., a so-called hybrid mechanism—what needs to be considered in due diligence is entirely case-specific. At best, no additional work is required, but at worst, everything applicable to both main mechanisms must be conducted, along with additional steps.
A typical hybrid mechanism involves selecting a locked box date that is in the future relative to the financial data reviewed during due diligence but before the actual transaction completion. For example, if the financial data reviewed in due diligence extends until the end of October, but a locked box date of December is selected with a transaction completion date at the end of January, a key process efficiency advantage of the locked box mechanism is lost. This is because a “trading update” or “closing accounts review” must be performed, which is typically also required under the closing accounts method.
Conclusion
The choice of the purchase price mechanism has practical implications for the organization of due diligence work and the required workload.
Particularly when the purchase price mechanism and timelines are changed during the process, additional work is often required across different due diligence workstreams. It is important to recognize that analyses cannot simply be updated by inputting new figures; the content of the figures must also be examined to avoid misinterpretations. Additionally, it is common for figures to be provided in different formats, further increasing the workload. While such practical challenges can be mitigated through good communication, the more analyses that need to be reinitiated, the more practical challenges arise.
apton Partners’ experienced team is at your service to assist with purchase price mechanisms as part of the due diligence process.