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Coronavirus - Bridging the gap on purchase price - Germany

  • Germany
  • Corporate

31-03-2020

What sellers and buyers can do to agree on a purchase price

Due to the economic turmoil that has been caused due to Covid-19 Sellers and Buyers are trying to find common grounds for the valuation of target companies ("Target"). Many Sellers are still unwilling to move-off their high valuations, inter alia with the argument that the economic effects of Covid-19 will be short term. On the other side Buyers would naturally be more sceptical and argue that the mid to long-term effects are absolutely unpredictable at this stage.

Buyers will be tempted to use each and every (even minor) due diligence finding to argue for a significant reduction on the purchase price and they will also be tempted to introduce Material Adverse Change/Effect Clauses (MAC/MAE-Clauses) into the purchase agreements, which will give them a withdrawal right, should the economic situation of the company or the entire economy materially change between signing and closing. MAC/MAE-Clauses only apply for the time period until closing of the transaction and are therefore not forward looking and a Seller would usually not be willing to accept any unpredictable forward looking statement. So, the parties will need to find other ways how to bridge the gap between the perceptions of the Sellers and the Buyers.

1. Earn-out

The most obvious instrument for the parties would be to agree on an Earn-out. Earn-outs are often used when the Sellers and Buyers disagree about the expected development and future performance of the Target. A typical Earn-out takes place over a 3 to 5-years period after closing of the transaction and the relevant variable has traditionally been the EBIT or EBITDA, whereby during the last 2 years the turnover was the most relevant variable. The Earn-out component of the purchase price can range up to 50 percent of the purchase price; whereby in the last years Ear-outs in Germany ranged between 10 and 20 percent of the purchase price.

The terms and conditions of an Earn-out will need to drafted carefully. A Seller would typically be afraid that a Buyer would, following closing undertake measures that would significantly negatively impact the results of the Target (e.g. push down the acquisition costs (legal fees, but also borrowings for the purchase price) and would therefore try to prohibit all such measures until the end of the Earn-out period. On the other hand, a Buyer would like to immediately start integrating the Target into its group and thereby lift synergies and also restructure the Target, if necessary. Despite all difficulties with Earn-out Clauses, they are a good instrument for the Seller to participate in any economic profits of the Target and for to Buyer to protect himself against a down-turn.

2. Staggered Sale

If the parties do not want to go for an Earn-out or cannot agree on its terms, it could be an idea, that the Buyer only acquires a portion of the Target shares, with the option to acquire additional shares in the future, based on a pre-defined calculation method (e.g. EBITDA-multiple based on the EBITDA results in 1 or 2 years after closing). Such option could be construed as a mere call option for the benefit of the Buyer, or a mutual Call and Put option.

Although the Buyer may need to acquire the first portion of the shares in the Target for a price that he believes to be too high, he could acquire additional portions for a lower price and thereby at least partly mitigate the valuation risk. Should the economic impact on the Target be limited (as a Seller would normally argue), the Seller would get the price he was looking for and the Buyer also does not loose, as he gets a solid company. Should be economic impact be more significant, the overall price paid by him would be lower.

3. Stock-for-Stock Transaction; Phantom Stocks

3.1. Stock-for-Stock Transaction

In order to have the Seller indirectly participate in the future development of the Target (either downwards or upwards) the parties can consider a stock-for-stock transaction; i.e. the Seller receives a portion of the purchase price in stocks of the Buyer company (typically not the entire purchase price). Also, a stock-for-stock transaction does not impact the cash position of the Buyer, so there is no need to go back to the market to raise more capital or to ask for a larger, credit facility. The latter could be of importance, if banks should start lending less or to much more restrictive conditions as they used to before the Covid-19 pandemic.

Should the contemplated transaction between the Seller and the Buyer be a larger transaction, the down-side could be that as a consequence of the stock-for-stock transaction the Seller would receive a significant stake in the Buyer and would therefore request certain shareholder rights.

3.2. Phantom Stocks

As Germany does not have a stock listing culture like for example in the USA and most companies are organised in the form of a German limited liability company (GmbH), an alternative to a stock-for-stock-transaction could be that a portion of the purchase price is converted into phantom stocks in the Target or the Buyer.

Phantom stocks are typically used in the venture capital industry to have employees benefit in the development of the Target. The value of the phantom stocks will increase as the value of the Target / Buyer increases, and decrease if the value of the Target / Buyer decreases, but without the recipient actually receiving any stock.

Also typically, phantom stocks do not give the Seller the same rights as he would have, should become a direct shareholder like under the stock-for-stock transaction.

4. Seller's Note

Especially in private equity transactions, portions of the purchase price are being converted into a vendor loan (Seller's Note). Such Seller's Notes can be interest bearing or not. If they bear interest, the interest typically depends on the creditworthiness of the Target. Before 2007, Sellers were often allowed to sell the Seller's Notes on the capital markets (typically in in larger transactions).

Depending on the development and performance of the Target, the Seller's Note would become payable or not. In a worst case, should the Target not perform as anticipated, the Seller would lose his entire payment claim after a certain period. From a Buyer's perspective, it should be ensured that the full or partial loss of Seller's payment claim under the Seller's Note does not qualify as a waiver, but as a reduction of the purchase price; otherwise a waiver would trigger taxable income on the side of the Buyer.

5. Summary

In order to bridge the gap between the purchase price expectations of a Seller and the uncertainties of a Buyer on the future development and performance of the Target as a consequence of Covid-19 and its economic impacts on a Target and/or the economy as a whole, the Sellers and Buyers could use:

  • Earn-outs,
  • Staggered sales,
  • Stock-for-stock transactions,
  • Phantom stocks,
  • Seller's notes, or
  • a combination of the above.