Whilst activity in the mergers and acquisitions market continues to pick up, buyers are still keen to ensure that they can be certain of what they acquire by incorporating some method of testing the target’s value in the acquisition agreement. Two popular methods of doing this are by using completion accounts or by using the locked box method.
Using this method, the buyer will usually pay an amount for the shares in the target company at the time when the deal completes, based on an estimate of the value of the net assets and/or the net profits at the completion date.
The share sale agreement will contain provisions setting out the accounting policies to be used by the seller and the buyer and their advisers in preparing the completion accounts and will include a process for settling any dispute between them (see details of a recent case which considered these provisions below).
The agreement will also include provisions that provide for the price to be adjusted once the completion accounts reflecting the true value of the net assets/profits as at the completion date have been agreed. The adjustment provisions may provide for downward only adjustments (clearly in favour of the buyer), upward only adjustments (in favour of the seller) or a combination of the two for a more balanced position.
When this method is used, the share price is calculated by reference to a set of accounts prepared at some point prior to the sale completing (known as the Locked box accounts). The agreement will require the seller to confirm that there has been no reduction in the value of the assets since the date of the locked box accounts, known as ‘leakages’. The buyer and the seller will agree certain permitted leakages which can come out of the target’s locked box prior to completion, such as salaries, agreed dividends, etc. but the seller will be required to indemnify the buyer for any other non-permitted leakages.
In a recent case, the Court of Appeal considered a provision in a share purchase agreement governing the accounting policies to be applied when drawing up completion accounts. Typically, buyers prefer completion accounts to be prepared in accordance with all applicable accounting standards. However, sellers will often want the historic policies used in the preparation of the target’s previous accounts to take priority in order to ensure there is consistency with how the target is valued.
In this case, the agreement required the completion accounts to be prepared using the same procedures and accounting policies that the target company had used in the preparation of its last annual accounts. Whilst the accounts were being prepared, the parties disagreed on the use of an accounting policy and under the terms of the agreement an expert was engaged to settle the matter. The expert found that the target’s previous accounting practice was incorrect and did not comply with the requirements of the applicable accounting standards. However, because the share purchase agreement required the completion accounts to be prepared in the same manner as the last full accounts, the expert said he was unable to apply the correct policy in the completion accounts.
The court held that the expert was wrong. The court interpreted the relevant provision in the share purchase agreement as requiring the completion accounts to be prepared applying the correct accounting policy, supplemented if required by reference to practices adopted by the company. The provisions in the share purchase agreement did not mean the accounts should be drawn up on the basis of policies in fact adopted by the target company, even if their treatment of liabilities was right or wrong.
Following this case, it seems that very clear wording will now be needed for sellers to ensure that the target’s historic accounting policies take priority, particularly where those historic policies are inconsistent with the applicable accounting standards governing the relevant accounts.
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