Advanced Financial Issues in Acquisition Agreements

Part One

Structuring the Purchase price– overview of different approaches

• Enterprise vs Equity Value

• Completion Accounts

• Locked Box Approach

• Earn-outs

Main components in the Equity Bridge

• Reconciling Enterprise to Equity Value

• Key differences between the main items in M&A and traditional Valuations

• Main adjustments in the Equity Bridge in M&A Debt

• Cash

• The Working Capital Delta

• Other adjustments & how to negotiate them Non-controlling (Minority) Interests – where and why they matter

• Preference shares: Convertible, Redeemable, other

• Non-operating assets (valuation?)

What does “Debt” include?

• Why M&A debt definitions are broader than traditional accounting

• Impact on valuation and deal structure

• Common areas of dispute in debt classification

• The main categories of Debt in M&A Traditional debt-like items (e.g. bank debt)

• Deal-related items

• Contentious “debt” items Pensions (unfunded)

• Deferred Capex

• Deferred/reduced rent

• Stretched creditors

• Operating leases

• Environment liabilities

Supply chain finance

• Contingent debt-like items; potential approaches

• Litigation

• Deferred Tax

• Warranty claims (for products)

‘Sweeper’ clauses in the SPA

Off-balance sheet items

Director’s Loan Accounts (s455) [UK only]

Treatment of Leases

• Operating vs finance leases

• IFRS 16 vs FRS 102

• Practical issues and impact on valuation

What does “Cash” include?

• How and why treatment of cash differs in M&A vs traditional valuations

• Which cash figure matters – Bank vs Ledger

• The three main types of cash in M&A Surplus Cash - retained by seller or paid for separately by buyer

• Trapped Cash - negotiation points and treatment options Regulatory cash

• Withholding taxes

Operating Cash: how to determine operating cash

• Review historical patterns

• Map operating cash cycle

• Establishing the ‘buffer’

Review of selected items

• Rent deposits

Case study: Calculating the Equity Bridge by reviewing key aspects of “Debt”, “Cash” and “surplus assets”. Discussion on how to treat deferred revenues

Completion Accounts

• First-principles – the 6 key issues

• Composition of the Completion Accounts The three bases of preparation of the Completion Accounts

• Establishing the hierarchy & why it matters Buyer’s perspective

• Seller’s perspective

• GAAP/ IFRS override – good or bad?

The main areas of dispute (& how to resolve them)

• Setting IFRS date

• Directors’ judgement – WIP

• Ambiguous accounting policies

• Bad debts – what is an adequate provision

• Obsolete vs damaged inventory

Four main categories in the Accounts requiring clarification

Case study: Reviewing the Accounting principles and the “hierarchy of accounts” – which approach is best? Does the abolition of Operating Leases actually impact the Accounts?

Net Working Capital-delta

• Overview: the Working Capital Delta in M&A   Why working capital adjustments exist in M&A but not in traditional valuations

• Working capital as a value protection mechanism

• The interaction between net debt categories and working capital definitions

No “Standard” Accounting definition of working capital

Additional challenges in defining working capital in M&A (typical exclusions)

• Cash

• Other debt-like items excluded

• Impact of Seasonality/ cyclicality

• Positive vs Negative

• Erratic profiles & how to manage them

• Broad vs narrow definition of working capital

• “Judgement” areas

• Intra-monthly movements

• Dealing with zero balances

Setting the Working Capital PEG/Target: pros and cons of various approaches

• Average

• ‘Normalised’

• ‘Run-rate’

• Choosing the reference period for determining the PEG

• Historic TTM

• Challenges when valuation based on prospective multiples

Dealing with differing working capital profiles

• Seasonal /cyclical

• Growth

• Positive vs Negative

• Erratic profiles & how to manage them

• Review specific issues that affect Net working capital adjustment across various Sectors

Case study: Determining the working capital ‘target/peg’

Part Two

Locked box Mechanism

• Four key areas of risk for Buyers

• Leakage vs Permitted Leakage; three categories Permitted leakage (no adjustment to equity)

• Permitted leakage (reduces to equity)

• Leakage that is not permitted or agreed

The Value Accrual: three approaches

• The traditional approach (interest) - what is the typical market rate?

• Using a "ticker"

• Using actual profits/cash

Types of tickers

• Cash profits

• EBITDA based variants

• Revenue based

• Multi-stage tickers

• Tickers for loss-making targets - potential solutions

Problems with actual profit value accruals

Which 'Accounts' should be used for deriving the Locked Box

Choosing the Reference Date Balance Sheet (RDBS) for the Locked Box

• Annual audited accounts

• Interim audited accounts

• Management accounts

• Carve-out accounts (for divisions/units within larger groups)

• Vendor Due Diligence (VDD) reports

• Pros and cons of each

How reliable is the Locked Box

• Issues for buyers

• Issues for sellers

• Potential solutions for both parties

• What are the critical areas of focus

Case study on Leakage

Case study on the value accrual for a loss-making firm

Revenue Recognition in M&A: Contract Liabilities and Contract Assets (IFRS 15)

• The three timing gaps that create value leakage Revenue recognised before invoice: contract asset / unbilled WIP -- inflates EBITDA

• Cash received before revenue recognised: deferred revenue -- inflates EBITDA

• Revenue recognised before substance: asset, liability or excluded -- inflates EBITDA inappropriately

Deferred revenue: debt or working capital?

• Buyer's preference: debt (reduces price); seller's preference: working capital (replenishes at completion)

• Key cases for each treatment

The double-count trap: worked example

• Three scenarios: WC only; debt but not excluded from WC; debt and excluded from WC

• SPA drafting to avoid the trap

Accelerated deferred revenue recognition: hidden value leakage

• Five pre-completion acceleration methods

• Direct effects: EBITDA inflation and Year 1 shortfall

• SPA and due diligence responses

Unbilled WIP: When Revenue Runs Ahead of Invoicing

• When and why unbilled WIP arises; sectors affected

• The buyer's core question: is the WIP real, billable and collectible?

• SPA protection: converting WIP risk to a cash collection test

• Bundled arrangements: where WIP meets deferred revenue Common pattern: upfront payment plus ongoing delivery obligation

• SPA mitigations

EBITDA Adjustments

• Where and why does EBITDA matter

• How to derive EBITDA; the main adjustments Net interest

• Depreciation & Amortisation

• Exceptional items

• Synergies

• Business optimisation initiatives

EBITDA ‘adjustments’ by ownership structure (what to look for)

How Pro forma EBITDA matters in M&A

• Typical adjustments for PE-owned firms

• Typical adjustments for Owner-managed firms

• Typical adjustments in corporate entities

• Sector-specific adjustments

• Checklist of EBITDA manipulations (with real-life examples)

EBITDA manipulation (impact & examples)

• How accounting policies can affect EBITDA

• Impact of areas affected by ‘Management’ discretion (WIP, real estate valuation)

Revenue recognition issues

Expense classification

Asset valuation impacts

Working capital manipulation

Provisions and reserves

Earn-outs

• Anatomy of an Earn-out The two key aspects - duration & key performance met

• Other important issues Dispute resolution

• Payment structure/intervals

• Acceleration clauses (early termination)

• Tax considerations

• Caps and floors

Buyer’s perspective: key issues

Seller’s perspective: key issues

Selecting the appropriate benchmark

• Financial benchmarks

• Other benchmarks (Life sciences, Renewables, Retail, Services)

Earn-out Duration – key factors to consider

• Industry norms & business cycle

• Business profile/revenue streams

• Integration / Transition period

• Milestones & objectives

• Other considerations

• Review of examples from various sectors

• Frequency of payouts: annual, quarterly, other?

Manipulation of financial benchmarks: considerations for buyers

• Dealing with synergies

Key risks for the Buyer

• Who determines how the consideration is satisfied

• Tactics for keeping the vendor interested

• The premature departure of the vendor(s)

• Issues for Listed buyers

Key risks for the Seller

• Disputes RE the benchmark

• Buyer is acquired

• Security for any deferred consideration (Buyer is insolvent)

Case study: Earnouts – identifying key risk areas and how to mitigate them. Dealing with consideration loan notes and shares (what are the pitfalls)

Please be advised that there is some content overlap between this course & our 'Advanced Negotiation Issues in M&A' & 'Sale & Purchase Agreements' courses.  If you are considering enrolling in one or more of these courses, we recommend reviewing the course outlines and videos carefully to determine the most suitable combination for your needs.

Training Objectives

Our course focuses on the following key areas of advanced financial issues in acquisition agreements:

• The Equity Bridge -  Understand the essential components of the Equity Bridge in M&A transactions, including debt, cash, working capital adjustments, and minority interests. Learn how these components bridge Enterprise Value to Equity Value and significantly impact final purchase price

• Cash in M&A - Recognise how cash is categorised differently in M&A versus traditional valuations, with focus on the three critical classifications: surplus cash (retained by seller), trapped cash (requires negotiation), and operating cash (assumed by buyer but excluded from working capital). Understand the inherent tension between these classifications and their impact on deal negotiations

• Debt in M&A - Appreciate why debt definitions in M&A extend far beyond traditional accounting principles to include "debt-like" items such as unfunded pensions, environmental liabilities, and deferred income. Learn to identify hidden debt-like items that can materially affect purchase price

• Working Capital - Understand why working capital adjustments exist in M&A but not in traditional valuations, serving as a key value protection mechanism. Master the challenges in defining ‘normalised’ working capital and setting the appropriate PEG/target, with awareness of sector-specific considerations

• Completion Accounts - Identify the critical challenges in selecting which accounts to use for completion accounts, establishing the appropriate accounting hierarchy, and resolving disputes that arise from different accounting approaches

• Locked Box Mechanism - Recognise the main risks in locked box transactions including leakage, reliability of the reference accounts, and value accrual. Understand the different approaches to value accrual through various ticker metrics (EBITDA-based, revenue-based, seasonal, and even negative tickers for loss-making businesses)

• EBITDA - Appreciate why EBITDA is crucial in M&A, affecting valuation multiples, working capital adjustments, and earn-outs. Distinguish between legitimate EBITDA adjustments and manipulative practices, with the ability to identify common manipulation techniques using real-world examples

• Earn-outs - Master the structure and mechanics of earn-outs, including benchmark selection, duration, and protection mechanisms. Understand the key risk areas for both buyers and sellers and develop strategies to mitigate these risks in acquisition agreements

Training Course Summary

This course is tailored for experienced M&A professionals seeking practical, advanced insights into the financial mechanics underpinning acquisition agreements. Unlike conventional valuation courses, this programme delves deeply into the nuanced financial instruments and negotiation dynamics that critically influence deal outcomes.

The course begins by dissecting the Equity Bridge , explaining how Enterprise Value translates into Equity Value through adjustments for debt, cash, working capital, and other value-related items. Participants will explore practical negotiation points, supported by case studies and real-world examples.

An intensive examination of Cash in M&A reveals how subtle distinctions between surplus, trapped, and operating cash can substantially influence transaction terms. Participants will understand strategies for handling each cash category effectively in negotiations.

The section on Debt in M&A expands traditional definitions to include crucial debt-like obligations that materially impact valuations. Participants will learn to uncover hidden liabilities, critically assess their valuation implications, and negotiate robust financial protections.

The course also thoroughly addresses Working Capital Adjustments , highlighting their importance in protecting value. Participants will explore the complexities in defining working capital across various industries and learn proven methodologies for setting robust working capital targets.

Practical, hands-on case studies provide participants with real-world experience in evaluating the strategic merits of Completion Accounts versus Locked Box mechanisms , navigating common pitfalls and disputes, and effectively addressing risks related to leakage and value accrual.

Participants will also gain essential insights into EBITDA adjustments , distinguishing legitimate adjustments from manipulative practices. Detailed examples will equip attendees with the skills to spot potential valuation distortions and negotiate effectively around these adjustments.

Finally, the intricacies of structuring effective Earn-outs are covered comprehensively, including benchmark selection, mitigating risks, and handling disputes effectively. Participants will leave equipped with sophisticated strategies to enhance transactional outcomes.

By completing this course, attendees will possess advanced skills essential for maximising value, managing risks, and conducting successful negotiations in complex M&A transactions.