The Sale and Purchase Agreement is a contract for the purchase and sale of shares or quotas in a specific target company, designed based on the Common Law framework (the "SPA"). In the Italian legal system, the SPA is classified as a sales contract, as it meets the legislative definition of a contract whereby ‘the ownership of something or another right is transferred in exchange for a price’ (Article 1470 of the Italian Civil Code).
Therefore, it is essential, during the drafting of the SPA, to regulate the negotiation of the price, which is the exclusive result of negotiations between the parties. The parties may include particularly sophisticated price determination mechanisms. Price determination clauses can be grouped into two main categories: clauses that provide for a post-closing price adjustment mechanism and so-called "locked box" clauses, which do not require such adjustment.
The locked box mechanism is a pricing structure commonly utilized to establish the purchase price of a company based on its financial status at a specific date, referred to as the "locked box date". This approach entails transferring both the risks and rewards of the business to the purchaser from this designated date. The parties involved agree upon a fixed purchase price for the company, which remains unchanged despite any subsequent alterations in its financial performance or condition post the locked box date. Typically, the seller bears the risk of ensuring that the company's financial state matches the representations made in the financial statements at the locked box date. This risk is often addressed through warranties, indemnities, or other contractual mechanisms.
The locked box mechanism offers several advantages. Firstly, it ensures that the purchase price is established at the signing stage, providing both parties with price certainty. This eliminates the need for extensive negotiations regarding the closing balance sheet, which typically consumes considerable time and resources. Moreover, since there is no requirement for preparing a closing balance sheet, potential disputes and associated costs are avoided, allowing management to concentrate on the target business.
The completion accounts mechanism constitutes a pivotal stage within the SPA, particularly in connection with the post-closing price adjustment mechanism. This mechanism is instrumental in determining the final price of a company or asset following the closure of the deal. It is particularly suitable when there is significant potential for fluctuations in the company's financial performance and the purchaser doesn't want to take risks before the deal is done, or the seller thinks the company will be worth more in the future. But if it takes a long time between setting the price and finalizing the deal, using this mechanism could heighten the risks because the company's value might change.
Even though the buyer takes risks before the deal is done, if the seller still controls the company, they might end up not getting its full value. There are ways to reduce the risks for both sides, such as penalties or strong promises, yet their inclusion often engenders complex negotiation processes, thereby diminishing the relative simplicity benefit of the mechanism.
In some cases, such as in carve-out transactions (when part of a company is being sold off), it might be better to use a different way to decide the price. When a company is split from its parent company and sold, it can be hard to figure out the company’s financials because it is not fully independent yet. If the company being sold has valuable things that don't show up on its financial records, such as intellectual property or a strong customer base, it is better to use a different way alongside or instead of the completion accounts mechanism.
Once the economic risk shifts to the purchaser upon the locked box date, their primary concern revolves around safeguarding against potential devaluation of the target due to either leakage or inadequate management. Leakage means the seller takes value out of what's being sold between the locked box date and completion, typically through cash flows or other value transfers such as dividends, management fees, or non-commercial intragroup payments. Contractually securing assurances from the seller to prevent any unauthorized leakage, except for specifically agreed types or amounts (referred to as permitted leakage), is customary. In case of leakage, the purchase price is usually adjusted, either during the closing if the leakage is known, or subsequently if determined post-closing.
To prevent leakage and value loss because of inadequate management, the purchaser may incorporate certain provisions within the SPA to uphold the target's value, such as:
Restrictions on the seller: by implementing a comprehensive set of covenants [1], the purchaser can impose limitations and obligations on how the seller manages the target entity from the locked box date until completion. These restrictions aim to prevent actions by the seller that could significantly diminish the target's value, thus ensuring that the locked box price precisely mirrors the target's value upon completion. Examples of such restrictions may include prohibiting the execution or termination of significant contracts, mandating the purchaser’s approval for dividend distributions, and confining the target's activities to routine business operations.
Accurately recording leakage: permitted leakage denotes the sum of money or assets that the purchaser is allowed to withdraw from the target entity following the locked box date but before completion. Common examples of permitted leakages include regular dividends (which can serve as an alternative to price adjustments) and routine intragroup transactions for goods and services. The purchaser should meticulously define both leakage and permitted leakage terms, ensuring clarity and precision, while simultaneously safeguarding the target entity's value post the locked box date. Moreover, it is crucial to accurately delineate the seller and any potentially associated parties within the locked box provisions to prevent value being extracted in favour of a person not captured under the leakage provisions.
Warranties and indemnities: the SPA should incorporate warranties from the seller, affirming the absence of leakage from the target entity between the locked box date and the SPA's signature date, along with the right to claim any leaked amount. Complemented by covenants preventing leakage, except for specifically defined permitted leakage, until completion, this arrangement protects the purchaser throughout the risk period [2]. The locked box mechanism offers benefits that render it advantageous in scenarios where the company's financial performance is anticipated to remain relatively steady in the short term, the seller seeks a swift or uncomplicated exit, and for transactions of lesser complexity. However, in cases where the company's financial performance is expected to be more unpredictable, or when both parties wish to consider the company's future performance in determining the purchase price, an alternative mechanism is often more suitable. Consequently, careful consideration of transaction characteristics and parties' preferences is paramount when selecting the pricing mechanism for the SPA. If the decision favors the use of a locked box mechanism, purchasers should include the aforementioned concepts in the SPA to ensure adequate protection against leakage.
In conclusion, while the locked box mechanism within the SPA offers advantages such as price certainty and efficiency in negotiations, its suitability depends on the specific context of the transaction. This mechanism is beneficial when anticipating stable short-term financial performance and seeking a swift exit. However, in scenarios where financial performance is expected to be more volatile or when considering future performance in price determination, alternative mechanisms may be more appropriate. The inclusion of provisions to mitigate risks, such as leakage prevention strategies and warranties, is crucial for safeguarding the interests of both parties.
[1] Although the purchaser should ensure that the covenants are rigorous enough to protect against leakage and value loss, the covenants should be carefully drafted to permit the typical operation of the target. If drafted too stringently, the target may struggle to retain value in the period from the locked box date to completion.
[2] Alongside regular warranties, a purchaser might also pursue broader warranties covering the time between the locked box date and completion. These could involve stipulations regarding necessary working capital levels,
supplier payments, net asset levels, consistency in debt collection, or other concerns typically addressed through completion accounts, like inventory valuation or bad debt considerations.
Yet, sellers might push back against providing these warranties since they can undermine the fixed price nature of a locked box deal. Consequently, it might be harder for a buyer to obtain this level of protection in a competitive or time-sensitive transaction.
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