Earn-Out, fixed price, cash free, debt free

Possibilities of purchase price clauses in the acquisition of a company in Germany

One of the most important areas of regulation in the acquisition of a company in Germany is the purchase price regulations. This is an extremely complex issue in which various aspects have to be considered. In addition, the opposing perspectives of buyer and seller have to be reconciled. In this respect, various basic models and approaches have become established in german M&A practice. These vary in complexity, so that correspondingly complex procedures should only be used for larger transactions in Germany, while others are more suitable for medium-sized company sales. A distinction must be made between regulations that govern the determination of the purchase price and those that define the payment modalities.

In the following, we provide an overview of the most important purchase price clauses and purchase price adjustments in german company acquisitions:

• Fixed price
• Cash free, Debt free
• Earn Out

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Legal services for german company purchase agreements

Our certified specialists for german corporate law and tax law advise and represent clients at our offices in Hamburg, Berlin, Munich, Frankfurt and Cologne in all areas of M&A transactions, in particular:

1. Preparing the purchase of a company, at the seller's end conducting an examination of the legal and tax structure in order to exclude factors reducing the purchase price or triggering liability, if possible, before the actual sales process (vendor due diligence)
2. Legal organization of auction-based sales procedures in which several prospective buyers are approached simultaneously
3. Structuring and design of the transaction, e.g. advising on accompanying transformation measures and whether an asset deal (sale of assets) or a share deal (sale of shares) is preferable
4. Drafting, reviewing and negotiating the transaction documentation, in particular the company purchase agreement, especially the purchase price provisions
5. Legal and tax due diligence (Legal and Tax DD)
6. Tax optimization of company acquisitions or sales
7. Representation in conflicts following corporate transactions
8. Legal and tax advice and structuring of subsequent integration processes regarding the purchased company (Post Merger Integration - PMI)

Fixed purchase price in german practice

The fixed purchase price is very simple, at least in the first step. In this respect, an economic reference date in the past is defined and the seller and buyer agree on a certain company value at this point in time. In german practice, a fixed purchase price for the company is then determined on the basis of this company value. In determining the enterprise value, the parties are generally guided by the last available annual financial statements.

The costs of preparing interim financial statements are often not economical in smaller transactions and should therefore be avoided in Germany. It is clear that this approach, while simple, has certain limitations and risks under german law. The economic closing date should not be too far in advance of the actual transfer of the business to the buyer. Otherwise, the value at the time of the handover may already have moved far away from the value determined at the economic cut-off date. Therefore, if the annual financial statements are to be used as a basis, as is usually the case in german practice, the transaction must not be too far removed in time from the preparation of the same.

If a fixed price is used in Germany, the purchaser must also prevent any outflows to the purchaser between the economic reference date and the transfer of the company which would reduce the value of the company. In this respect, the buyer is contractually bound by strict behavioral requirements for the period between the economic closing date and the transfer of the business. These are the so-called "representations" relating to the past and the so-called "covenants" relating to the future. These covenants, which relate to the future, create a legal framework within which the seller may operate until the economic closing date and which is intended to prevent manipulation to the detriment of the buyer until he can control the company himself. In US transaction practice, the term "locked box" has become established for this.

Purchase Price Adjustment Clauses in german practice

The background to purchase price adjustment clauses in Germany is the fact that the contracting parties do not have the data necessary for a concrete calculation at the time of negotiation of the purchase price. These often only result from a balance sheet that has yet to be drawn up. In german transaction practice, the annual financial statements are preferably used for this purpose in order to avoid the costs of preparing interim financial statements.

The parties then negotiate an abstract purchase price formula and a provisional purchase price, which is then calculated or adjusted on the basis of the balance sheet values contained in the relevant balance sheet. Which purchase price formula is to be used as a basis is a matter of negotiation and in this respect there is no generally applicable procedure in german law, but rather various methods which are presented below.

In german practice, an agreement on the purchase price mechanism should be reached as early as possible, i.e. already in the preparatory documentation of the basic economic agreement in the letter of intent (LoI) or term sheet. Otherwise, there is a risk that the company acquisition will fail at this fundamental point, after considerable time and costs have already been invested in the sales process.

Equity guarantee in Germany

A method that dominated in Germany, at least in the past, is the purchase price adjustment based on equity. In this process, a fixed purchase price is initially determined on the basis of already available balance sheets. This is then adjusted at a later date by the amount by which the equity capital determined in the final decisive balance sheet is higher or lower. The seller therefore issues an "equity guarantee" on the fixed purchase price. This is rarely found today, especially in transactions involving private equity investors.

Cash free - Debt free under german law

A purchase price adjustment under the keyword "Cash free - Debt free" is generally only useful in larger corporate transactions, as it is regularly costly and complex. The german company is treated as if it had neither cash ("cash free") nor debt ("debt free"). The value of the company is then regularly determined on the basis of a so-called "discounted cash flow" or "DCF" method or on the basis of an income capitalization approach recognized by the IDW S1 standard of the Institute of German Certified Public Accountants.

The "cash free - debt free" assumptions are intended to help neutralize the influence of the liquidity and financing situation, which vary from company to company in Germany. Any manipulation by the seller to the detriment of the buyer is then regularly prevented by a contractually stipulated adjustment of the purchase price in relation to the change in net working capital (so-called "working capital adjustments"). In this way, the seller should not be able to "artificially" increase cash with effect on the purchase price, for example through delayed payments from suppliers or the sale of customer receivables by way of factoring. In this respect, a large number of circumstances have to be taken into account during the purchase agreement negotiations and their treatment has to be specified contractually in german practice. The resulting complexity is regularly not justifiable for smaller medium-sized company sales in Germany, so that a purchase price adjustment on this basis is ruled out.

Final purchase price in german practice

As soon as the relevant closing date balance sheet is available, the variables specified in the agreed purchase price formula are applied, resulting in the actual purchase price. In german practice, this price is not fixed either at the time of signing or at the time of closing. Only afterwards a refund of a part of the purchase price or an additional payment by the buyer takes place, depending on the adjustment necessary on the basis of the purchase price determination.

Earn-out - the variable purchase price under german law

A variable purchase price adjustment by means of "earn-out" clauses can help to reconcile different price expectations of the seller and the buyer in a german company acquisition. The purchase price is then made up of a fixed and a variable part. However, the variable part must first be earned. Otherwise, it is cancelled without replacement. This applies in particular to situations in which the selling entrepreneur remains associated with the company, for example as a managing director or consultant.

Example: The selling shareholder-managing director is to remain in the german company after the transfer of the shares and continue to steer its fortunes. He will only receive part of the purchase price if he achieves the defined economic objectives.

The reference framework for these economic targets can be, for example, sales, gross profit, EBIT, EBITDA or net income, but also the number of newly acquired customers or production quantities. In german practice, EBITDA is widely used. In any case, the mechanism should be well thought out and regulated in as much detail as possible in order to avoid disputes. If disagreements do arise, an auditor is usually called in as an arbitrator.

Earn-out - good for the buyer in Germany...

In german practice, earn-out clauses primarily serve the buyer because

1. He shifts part of his economic risk as the new owner of the company to the seller,
2. Earn-out clauses give the buyer the option of deferring the purchase price because at least part of the purchase price does not have to be paid until a later date.
3. Earn-out clauses have a positive effect on the financing of the buyer (financing through current profits)

Earn-out clauses are particularly recommendable from the buyer's point of view when acquiring german companies whose future performance is difficult to assess. This applies above all to start-ups, but also to companies whose success is heavily dependent on individual persons in Germany.

... not so good for the seller in Germany

One man's joy is another man's sorrow. For the seller in Germany, an earn-out entails numerous risks that are hardly or not controllable. The seller bears economic risk even though he is no longer a shareholder or only a minority shareholder. In addition, he is at the mercy of structural changes (e.g. merger with another, loss-making company) without protection. When negotiating the purchase price, the seller must therefore take particular care to ensure, for example, that he is granted far-reaching information rights with which he can counter manipulation in the event of an emergency.

However, residual risks for the seller cannot be completely ruled out even if detailed clauses are agreed. A german seller should therefore always approach an earn-out clause with skepticism. Here, it is worth negotiating with particular persistence.

On the other hand, it should also be noted that the seller can leverage additional purchase price potential vis-à-vis a skeptical buyer through an earn-out arrangement, especially if he can continue to exert significant influence on the achievement of the targets as managing director.