Capturing value through sales purchase agreements and pricing mechanics

SPA process

During the wider SPA negotiation process, tax often becomes a focus both in relation to the pricing of the deal and also in relation to any contractual protections offered by the seller.

The determination of what is reflected in the pricing of a transaction or what contractual protection is given is a process of negotiation, and there is no ‘correct’ answer to the question - ‘should items be priced or not?’

In a competitive process, the SPA negotiations will often start from an “auction draft” where Sellers put forward a proposal for how the deal is priced and which (if any) protections will be available in the SPA contract. The SPA process is then likely to include a number of iterations of the document as the due diligence and wider commercial negotiation progresses, until the parties reach an agreement on whether / how to address any relevant tax assets or exposures.

Pricing mechanisms and tax

When it comes to negotiating value for tax items during a transaction, it is important to consider the two most common mechanisms for pricing a deal: locked box and completion accounts. 

In terms of tax, both parties (buyer and seller) need to consider which liabilities and/or assets are appropriate to include in pricing, a fact which usually hinges upon whether they are considered real value drivers. Is the tax contingency identified in due-diligence genuinely expected to result in a cash outflow? If so - when? Will the tax losses generate an actual cash tax saving? If so - over what time period?

We often see deferred tax (e.g. brought forward losses and capital allowances) and current tax assets/liabilities (e.g. research & development credits) being negotiated, as well as uncertain tax positions uncovered during due-diligence. A further point worth considering is whether the transaction itself can lead to the crystallisation of tax assets, such as with deductions for share-based payments, or those arising from the refinancing of existing debt. There may also be one-off deal related items such as transaction costs or deal bonuses which should be considered.

In order to secure a value adjustment (whether positive or negative) these balances would need to be treated as follows, depending on the pricing mechanism used in the transaction:

• Included in the locked box balance sheet or the Enterprise value(EV)-equity bridge
• Drafted into the SPA as a completion accounts policy
• Factored into the pricing model

Completion accounts

Completion accounts are prepared after the transaction completes, and cover the period to the completion date. At the time of closing the final price is not fixed, so it has to be estimated before being ‘trued-up’ once the accounts are prepared. 

As with locked box accounts, it is important to remember that completion accounts are usually drawn-up for the purposes of pricing the transaction, and are not usually audited statutory accounts. As such, while often using statutory accounts as a reference, they do not necessarily have to follow them, and can reflect specific accounting policies negotiated and agreed between buyer and seller. 

Both buyer and seller need to consider whether the agreed accounting policies are drafted in such a way that the completion accounts capture the assets and liabilities appropriately at the point of completion, as this will ultimately determine the price of the transaction. The process of assessing which items are reflected, and how these are reflected, is based on diligence findings and negotiation.

Other protections available to a buyer

When considering tax assets and liabilities identified as part of due-diligence, an alternative to pricing those directly in the consideration may be to use one of the mechanisms detailed below. Ultimately, the route taken will depend on the quantum, likelihood of any risk and bargaining power of each party in the process.

Deferred consideration

Should an asset be contingent on certain conditions, or only materialise after some time after the transaction, a deferred consideration mechanism could be included in the SPA contract, meaning a portion of the proceeds could be withheld by the buyer and passed through to the seller once the relevant criteria are met. This can be a reasonable outcome where there is material uncertainty on whether assets may be realised, and the timing thereof. Although it is worth noting that this does require revisiting the position post completion, which may not suit all parties, and usually requires detailed drafting on how items are calculated for the purposes of future deferred consideration payments. It should also be noted that deferred consideration payments require detailed review from a stamp duty / transfer tax and capital gains perspective.

Indemnities

Depending on the commercial negotiation, a general tax covenant / indemnity may be included as part of the SPA contract, to protect a buyer against historical tax liabilities which have not been provided for in the accounts or otherwise priced into the deal. Specific indemnities can also be agreed to provide coverage on any discrete tax risks uncovered during due-diligence. Monetary and time limits, as well as other exclusions, are usually included to limit the Seller’s liability. A recent trend in the market is for buyers to take out warranties & indemnities insurance policies on acquisitions, which may pass on certain liabilities to the underwriters and therefore reduce the liability for the Sellers.

Warranties

Finally, the SPA will usually include a list of tax warranties, which are statements made by the Sellers and / or management confirming the historical tax governance and compliance position of the business, amongst other areas, for the purposes of giving comfort to the Buyer that any known risks or exposures have been disclosed. We note the legal protection offered by warranties may not be as robust as that of an indemnity, however these can still be useful to elicit information from the sellers and/or management as part of the disclosure process.

Important notice

It is important to remember that every deal and transaction is unique, with its own inherent issues and risks. This article provides a high-level overview of this topic, and is not intended to be applied to specific deals or transactions. To discuss a specific deal or transaction, please get in contact with us.