Purchase price adjustments are an important topic in a business acquisition. When acquiring a business, you want clarity on this so you know where you stand. The total purchase price in an acquisition usually differs from the amount a seller receives on transfer date.
Therefore, it is essential to be aware of the different possibilities how a purchase price can be built up. But what should you pay attention to?
Equity transactions vs. assets/liabilities
When considering the purchase or sale of a business, business owners face important choices regarding transaction structure. Two common options are an equity transaction and an asset/liability transaction. Understanding the difference between the two is critical to achieving desired outcomes and managing risk.
In an asset/liability transaction, the buyer acquires specific assets and liabilities of the business. In this, the buyer does not take over the entire business, but only balance sheet items such as inventory, equipment, intellectual property, current contracts, and associated debts and liabilities.
Unlike an asset/liability transaction, in an equity transaction the buyer acquires the shares of the selling company, including all the assets, liabilities and risks involved. This choice also involves a piece of risk management: the buyer assumes all of the company's historical and future liabilities. When negotiating an equity transaction, it is common to include warranties and indemnities to protect the buyer against hidden defects or future liabilities of the business dating back to the past.
Locked-box vs. closing accounts
When determining the transaction structure, entrepreneurs must also decide between a locked-box and closing accounts mechanism. These mechanisms govern how the final purchase price is determined and when the transfer of beneficial ownership occurs.
With a locked-box approach, the purchase price is set based on a financial date that always goes back in time, called the economic transfer date. From this date, the seller transfers the risk and responsibility for the business to the buyer, incidentally at a time when the seller still bears full responsibility for the course of business. Any changes in the value of the business after this date accrue to the buyer.
In contrast, in closing accounts, the economic transfer takes place in the future. Even from this economic transfer date, the seller transfers risk and responsibility to the buyer, but that is when the buyer assumes actual responsibility. By estimating future balance sheet items and results before the transfer date, the provisional purchase price is determined and the final purchase price is calculated on actual figures of balance sheet and results and offset against the previously determined purchase price.
Purchase price adjustments
Purchase price adjustments can be made based on several factors, such as the reduction on the purchase price due to the buyer invoking warranties or indemnities. Another element is a vendor loan, where the seller of the business makes a loan to the buyer to finance the transaction.
Furthermore, an earn-out arrangement can also be a reason for a purchase price adjustment, where part of the purchase price depends on the future performance of the business after the acquisition. These adjustments are designed to allocate risk fairly between buyer and seller and make the transaction go smoothly.
Conclusion
In short, in a business acquisition, understanding purchase price adjustments is essential. While the total purchase price may differ from the amount received by the seller on the transfer date, these adjustments do provide much-needed clarity and certainty.
Therefore, it is important to be aware of how the purchase price is structured and what to look for during the process of negotiation and transfer.
