Purchase price adjustment in a company acquisition: net debt, working capital and the bridge to equity value

In the market a company is usually valued via its enterprise value. This value describes the operating business independent of its financing. What is paid, however, is the value of the equity, the equity value. The transition from one to the other is called the bridge, and it is the core of every purchase price determination.

The bridge follows a simple principle: from the enterprise value the net financial debt is deducted and the working capital is offset against an agreed target value. The underlying assumption is cash-free and debt-free. The seller thus hands over the company without surplus cash and without financial debt, both of which are settled in the price.

Net debt comprises the interest-bearing liabilities less the freely available cash. Working capital is the current assets tied up in ongoing operations, simplified the receivables and inventories less the short-term liabilities. How to secure these figures in the contract is shown in our post on the warranty catalogue in the purchase contract.

With the completion accounts method the purchase price is first paid on the basis of estimated figures and then settled precisely after completion. For this one side, usually the buyer, draws up a set of accounts as at the completion date. From these accounts result the actual figures for net debt and working capital, which are then offset against the estimate and the target value.

The other side reviews the accounts presented and can raise objections within a deadline. If differences remain open, an independent expert determiner decides, as a rule an audit firm. This procedure should be governed precisely in the contract: deadlines, the form of objections, the choice of the expert and the bearing of the expert costs.

The advantage lies in accuracy. The buyer pays the price that corresponds to the actual state at completion. The disadvantage is the later certainty over the final amount and the effort of the accounts procedure. How completion itself runs is covered in the post on the conditions to completion.

The locked box reverses the logic. The purchase price is determined definitively on the basis of an audited balance sheet at a date in the past, the so-called locked-box date. From this date the economic performance of the company is deemed to be for the account of the buyer, even though completion takes place only later.

Because the price is already fixed, no accounts at completion are needed. Instead a leakage clause protects the buyer against value flowing improperly to the seller after the date, for example through dividends, advisory fees or intra-group payments. Permitted outflows, the permitted leakage, are expressly named.

For the time between the date and completion, interest is often agreed, the so-called equity ticker. It compensates for the fact that the seller already runs the company for the account of the buyer but has not yet received the money. The advantage of the locked box is early price certainty and lower effort, the disadvantage lies in the reliance on the balance sheet at the date.

Whether a particular item counts as net debt or working capital or as an ordinary operating position decides directly on the amount of the purchase price. This is exactly where the greatest risk lies. Is a short-term liability part of working capital or financial debt? Do provisions, deferred taxes or open lease liabilities count towards net debt? After completion such questions can only be litigated.

Prevention is possible through a precise definition. The contract should list conclusively which items belong to net debt, define working capital clearly and set a target value against which the offset is made. A worked example on the basis of the latest available figures shows both sides how the formula is meant and later serves as an aid to interpretation.

The accounting principles also need to be governed. Are the accounts drawn up by the same methods as in the past, or do special valuation rules apply? An initial assessment of the risks of your transaction is provided by our M&A transaction risk profile.