The challenge of drafting purchase price adjustment clauses in merger & acquisition contracts

A TABLE OF CONTENT

B TABLE OF FIGURES

C LIST OF TABLES

D LIST OF ABBREVIATIONS

1 INTRODUCTION

2 BASICS OF MERGERS & ACQUISITIONS
2.1 Definitions
2.2 Asset Deal - Share Deal
2.3 M&A Motives
2.4 M&A Phases

3 PURCHASE PRICE ASSESSMENT: METHODS FOR VALUATION OF A COMPANY
3.1 Single-Valuation-Procedures
3.1.1 Net Asset Value on the Basis of Reproduction Values
3.1.2 Net Asset Value on the Basis of Liquidation Values
3.2 Total-Valuation-Procedures
3.2.1 Capitalisation of Earnings Method
3.2.2 Discounted Cash-flow Method
3.2.2.1 Weighted Average Cost of Capital Approach
3.2.2.2 Adjusted Present Value Approach
3.2.2.3 Equity Approach

4 GUARANTEES
4.1 Forms of Guarantees
4.1.1 Guarantee of Financial Statements
4.1.2 Equity Guarantee
4.1.3 Working Capital Guarantee
4.1.4 Other Guarantees
4.2 Guarantees according to German Law
4.2.1 Dependent Guarantee
4.2.2 Independent Guarantee
4.3 Consequences in Breach of Guarantee

5 PURCHASE PRICE ADJUSTMENT TOOLS
5.1 Retrospective Purchase Price Adjustments: Post-Closing Adjustments
5.1.1 Cash-free/Debt-free Clauses
5.1.2 Fixing of Metrics
5.1.3 Generally Accepted Accounting Principles
5.1.4 Potential for Manipulation
5.1.5 Purchase Price Calculation
5.2 Future-oriented Purchase Price Adjustments
5.2.1 Earn-out Clauses
5.2.1.1 Fixing of Metrics
5.2.1.2 Drafting Considerations
5.2.1.3 Accounting Issues and Manipulations
5.2.1.4 Structure and Calculation of Earn-outs
5.2.1.4.1 The Fixed Standard
5.2.1.4.2 The Variable Standard
5.2.1.4.3 The Accumulative Standard
5.2.1.4.4 Example of Calculating the Standards
5.2.1.5 Safeguards of Earn-out Amounts
5.2.1.6 Advantages and Disadvantages for Buyer
5.2.1.6.1 Advantages for Buyer
5.2.1.6.2 Disadvantages for Buyer
5.2.1.7 Advantages and Disadvantages for Seller
5.2.1.7.1 Advantages for Seller
5.2.1.7.2 Disadvantages for Seller
5.2.2 Option Clauses
5.2.2.1 Option Clause Approaches
5.2.2.2 Content of an Option Clause
5.2.2.3 Advantages and Disadvantages of Option Clauses

6 DISPUTE RESOLUTION

7 COORDINATION OF CONTRACTUAL CLAUSES
7.1 Contradictory Clauses
7.2 Example: OSI Systems, Inc. v. Instrumentarium Corporation

8 CONCLUSION

E APPENDIX: STATUTORY PROVISIONS

F BIBLIOGRAPHY

B TABLE OF FIGURES

Figure 1: Elements of an M&A Process

Figure 2: Company Valuation Methods

Figure 3: Capitalisation of Earnings Method (Entity Approach)

Figure 4: Capitalisation of Earnings Method (Equity Approach)

Figure 5: WACC-Approach

Figure 6: APV-Approach

Figure 7: Equity Approach

Figure 8: Call-Option for Buyer

Figure 9: Put-Option for Seller

Figure 10: Put-Option for Buyer

C List of Tables

Table 1: Combinations of Pricing

Table 2: Profits generated in the years 2008 – 2011

Table 3: Relevant Pre-year Results of the Profit provided as Calculation Base

Table 4: Calculation of Earn-out on the Basis of different Standards

Table 5: Fixed Standard - Net Present Value Calculation of Situation I and III

Table 6: Accumulated Standard - Net Present Value Calculation of Situation I and III

Table 7: Comparison of Net Present Values by using different Percentage Rates for Accumulated Standards to Fixed Standard

D List of abbreviations

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1 INTRODUCTION

The topic of Mergers and Acquisitions (M&A) is currently on everyone’s lips. No day passes by without reading about a planned or realised M&A transaction in the newspapers. The last few years have been record years for the M&A business. The year 2007 could in fact top the record year of 2006. Although, the first half of 2007 was remarkably successful, the subprime crisis of the credit markets led to a slow-down in the second half. However, M&A transactions with a transaction volume of approximately $ 4.830 billion took place worldwide in 2007.^[1] The forecasts for 2008 expect a recession of the transaction volume of up to 25 % of the previous year.^[2] Mega-deals will not make the headlines as often as in 2007, because banks became more careful in granting credits for such deals due to the subprime crisis. However, M&A International INC. (MAI)^[3] expects that the subprime crises will have only little impact on small and medium-sized M&A transactions and 2008 will still be a good year for the M&A business.^[4] Various companies have also taken advantage of the weak U.S. Dollar exchange rate and plan M&A deals overseas.^[5] Since the wind has not yet been taken out of the M&A businesses sails, the challenge of performing a successful M&A transaction remains.

Like any other businesses, M&A transactions are a dynamic process which has to be accounted for. When a buyer purchases a company (target), the assets of the company cannot be held in stasis until the transaction is settled.^[6] The company is in a constant flow and its value changes constantly. This makes it hard to determine a precise purchase price that remains valid from the beginning until the end of the transaction process. Since the value of the company changes through this process, the purchase price has to be adjusted. Therefore, purchase price adjustment tools have to be part of the M&A contract to ensure so. Generally, legal counsels are assigned to draft M&A contracts for the parties. Although, an M&A team should consists not only of lawyers, but also of accountants, tax consultants and others, where every member is specialised in a certain field, the legal counsel should have a general overview, since he^[7] is the one drafting the contract. The quality of his drafting becomes apparent when disputes arise. Most lawyers have no clue about company valuation methods or the principles of orderly accounting. However, these two applications are essential when it comes to drafting purchase price adjustment clauses.

This paper addresses lawyers and everybody who is in the position of drafting M&A contracts. Since M&A contracts include various clauses, this paper covers only purchase price adjustment tools. It gives a general overview of purchase price adjustment tools, manipulation issues, purchase price calculation standards and the coordination of the clauses among each other. Various possible problems which should be factored into the drafting process will be mentioned. It is impossible to predict every potential issue that is relevant for purchase price adjustment, because every transaction is different. Therefore, this paper is rather a guideline which supports the drafter of a purchase price adjustment clause to think about the main issues that can occur and to inspire further thoughts.

In chapter 2, the basics of M&A are discussed, such as the scope of definition for M&A, and motives and phases in the M&A process. Chapter 3 provides a brief introduction into company valuation methods. This is a very important chapter for the following purchase price adjustment tools. Someone who drafts purchase price adjustment clauses has to know how the company was valued, since different valuation techniques can lead to different results, and hence to different purchase prices. The various valuation approaches can be applied to purchase price adjustment issues. Therefore, it is essential to know their components to obviate manipulation potentials. Three company valuation methods are discussed: the net asset value method, representing single-valuation-procedures, capitalised earnings value method and discounted cash-flow method, representing total-valuation-procedures. Main attention is focused on discounted cash-flow methods, since they are the ones that are mainly used, especially in international transactions.

In chapter 4, various guarantees will be highlighted where breaches can also result in purchase price adjustment. Discussion focuses especially on the guarantees under German law, which have different impacts on the magnitude. An ambiguously formulated clause can have the surprising opposite effect than desired by the parties. This leads to one of the central themes that can be found throughout the paper; unambiguous precise formulation of clauses is the basis for a successful contract drafting, resulting in a reduction of potential future disputes.

The main chapter of this paper is chapter 5 where the two tools which directly influence the purchase price will be discussed: retrospective purchase price adjustments (post-closing adjustments) and future-oriented purchase price adjustments. While post-closing adjustments only apply to the period between signing and closing date, future-oriented purchase price adjustments come into effect after the closing date. The differences, advantages and disadvantages for both parties, the appropriate metric, manipulation issues and the calculation of the purchase price adjustment will be topics covered to provide support to the drafter of relevant clauses of most problems which can occur subsequently.

Chapter 6 provides a brief introduction to dispute resolution problems, which are particularly relevant in international M&A transactions, since arbitration does not follow the same rules internationally. As other clauses in an M&A contract also have influence, mainly indirectly, on the purchase price, chapter 7 covers the matter of coordination of purchase price influencing clauses. This chapter concludes with a case, decided from an U.S. Court, where contradictory clauses in an M&A contract cost the buyer millions of U.S. Dollars of purchase price adjustment. This example shows the importance of clear formulation of the clauses so that it leaves no room for interpretation.

The paper does not deal with tax issues that affect purchase price adjustment procedures. It further does not address Generally Accepted Accounting Principles (GAAP) in detail, but rather shows some differences and issues that might occur. It is also impossible to mention every possibility for manipulation that the parties might thinks of, since every transaction is different and each industry and business branch has its own peculiarities. Overall, this paper is meant to be a guideline and does not provide an ultimate solution for purchase price adjustment.

2 BASICS OF MERGERS & ACQUISITIONS

This chapter intends to give the reader a brief introduction into the basics of Mergers and Acquisitions (M&A). Fundamental terms used in M&A transactions, its motives and objectives and how the whole transaction process is designed will be explained.

2.1 Definitions

M&A is a widely used term which cannot be expressed in a standardized definition. Various definitions have been formed. Simply said, M&A describes various kinds of transactions for companies, where whole entities or parts of it are the object of purchase.^[8] While some authors use the terms ‘merger’ and ‘acquisition’ as synonyms,^[9] they are separated by others who ascribe different significances.^[10] According to the latter, both ‘mergers’ and ’acquisitions’ represent forms of company amalgamations, where at least one party of the M&A process loses its economic independence.

In an acquisition, where the whole entity is acquired and integrated into the acquirer’s corporate group, the acquired company’s loses its economic independence and its legal entity. If only parts of the entity are acquired, the acquired company keeps its legal entity while the economic independence is restricted or abandoned.^[11]

A merger, when compared to an acquisition, is the closest form of company amalgamation. In this case, two companies come together to form a new company. Both companies give up their economic independence and legal entity and create a new economic and legal entity.^[12]

Although, there are various approaches of M&A definitions, there are some key common characteristics. Almost all definitions refer to the transaction process as the central importance in M&A, in particular with regards to the transfer of ownership rights, and managerial and control authority.

Purely from the term M&A, one may think that all the manifestations are covered. The fact is that not only company amalgamations but also various kinds of company co-operations and other company activities are covered by this term.^[13] These include:^[14]

- Operative Co-operations: The formation of trade associations, consortia or interest groups to safeguard and pursue shared objectives.
- Joint Ventures: Two or more companies joint together and form a not necessarily equally co-owned new company.^[15]
- Strategic Alliances: This is similar to joint ventures, where two or more companies agree to co-operate strategically. The difference is normally no equity is involved and no separate entity is formed.^[16]
- Management Buy-Outs (MBO) or Buy-Ins (MBI): In an MBO, the current management of the company is buying the whole entity or parts of it. In an MBI, managers from outside the company buy the whole entity or parts of it to form the new management.
- Initial Public Offerings (IPO): IPO represents the initial sale of a company’s shares to the public.
- Going Private: This is the opposite of IPO. A company’s shares are no longer offered to public (also called delisting).
- Spin-off: This is the separation of a division from an entity that now forms a separate entity on its own.

The list is not exhaustive. The term M&A also covers service activities from investment banks and/or other counsels and is not only limited to the perspectives of buyers and sellers. Considering this wide range of activities which are subsumed under M&A, it is understandable that a uniform definition is difficult.

The object of transactions is always a ‘company’ or part of it. What exactly is covered by this term will not be discussed in this paper, because each country has different kinds of corporate forms that can be characterised as ‘company’.^[17] Therefore, the legal basis for defining a company differs from country to country and has to be looked up in each case separately. Basically negated is the application of the United Nation Convention on Contracts for the International Sale of Goods (CISG) (1980) for company acquisitions.^[18] Due to the fact that legal and economical differences in the relevant countries exist, a consistent examination is complex and would exceed the scope of this paper.

2.2 Asset Deal - Share Deal

From a legal perspective, a company is neither considered solely an object nor a right, which can be transferred like a good in the common sense of a purchase agreement. It is more of an embodiment of objects, rights, actual business relations, market shares, resources and employment contracts or the like.^[19] If a company is sold, all these aspects have to be covered in the acquisition. Asset deal and share deal represent the two basic types of company acquisitions.

Objects of purchase of an asset deal are the single assets of the company. The target’s legal entity endorses single assets to the buyer, but the legal entity itself stays with the target. The company is separated from its legal entity. The assets themselves are transferred according to the relevant valid legal principles.^[20] What is left of the target company is merely an ‘empty shell’.

In contrast to an asset deal, the object of purchase in a share deal is not the assets of the company but the legal entity itself. The shares of a company are transferred and with it all obligations and duties of the target.^[21]

An essential difference between asset and share deal is that in an asset deal, the single assets can be listed and valued according to market prices. The buyer is aware of what he buys. It is also an attractive way of purchasing a company, because the buyer does not have to take over the obligations and duties arising from various contracts that the target company has with employees, customers, suppliers and other groups. On the other hand, in a share deal, the legal entity with all obligations and duties, also the unknown, are taken over by the buyer. Therefore, a professional performance of due diligence and a particular attention in drafting guarantee and warranty clauses in the M&A contract are essential.^[22]

2.3 M&A Motives

Every M&A transaction affects both parties with chances and risks. Motives are tied to the chances of an M&A transaction, which both parties try to achieve with the transaction.^[23] A multitude of motives and objectives exist for both parties which prompt them to do M&A.

On the buyer’s side, growth, risk management, synergies or personal motives are some motives to be mentioned. Growth can be achieved horizontally or vertically; horizontally, through diversification (acquiring a company outside the industry) or integration (acquiring a company inside the buyer’s industry) and vertically, through backward integration (acquiring a supplier) or forward integration (acquiring a customer). By building up a portfolio of companies, the risk of failure is reduced. Even if one company is mis-managed, other companies in a portfolio can make up for the loss.

Strategic motivations of M&A tend to, in particular realise synergies.^[24] Quantitative synergies, like economies of scale and economies of scope, and qualitative synergies, like time or quality effects, can be distinguished.^[25] Synergies are achieved, if the co-operation of both companies is more efficient than both companies together working on their own (1 + 1 = 3). Personal motives, like more power and prestige of managers, as they control a bigger company after M&A, or to prevent a hostile takeover of the company an owner spent his life on building up, are also motives that play a role in M&A.

On the seller’s side, owner specific motives and company specific motives can be distinguished.^[26] Owner specific motives apply if, for example, there are no follow-up arrangements, where the old owner retires and no successor is found, the owner has a more lucrative investment possibility or a better job offer than keeping the business running. The lack of liquidity for investments, debt reduction, reduction of capital costs or the retirement of essential employees are a few reasons for selling the company under company specific motives.^[27]

Various more motives exist on both sides for running M&A transactions. Some of the most important ones are listed above to give the reader an idea of why M&A takes place.

2.4 M&A Phases

An M&A process consists of various phases which will be briefly discussed (see Figure 1). Firstly, there is the strategy phase. M&A should be tied to the strategy process of the company in either way, as the corporate strategy itself or as an outcome of the strategy process. Without strategy process, M&A is in most cases doomed to fail. Part of the strategy phase is the development of criteria for a search profile, before the actual search for a target begins.

The second phase is the selection and analysis phase. Having set up the criteria for the search profile during the first phase, the actual search for potential targets can start. Information of potential targets is collected from all sources available, such as publications, personal contacts and networks. The outcome of this search is the so-called ‘long list’ which includes around ten to fifteen potential targets. After a more detailed selection and analysis of these candidates, a ‘short list’ is created which represents the main three to five targets of interest. In a next step, the acquirer shows his interest by approaching the targets.

The negotiation phase is the third phase. After having asserted the willingness to negotiate, first pre-negotiations will take place to put up the rules for the information exchange, including the exchange of non-disclosure agreements and the review of information memorandums. The drafting of a letter of intent followed by due diligence are the final steps in this phase.

The contracting phase represents the fourth phase. As the name implies, the signing of the contract is the main element. After due diligence, the acquirer proposes a binding offer. Followed by detailed negotiations about the contracts, signing and closing conclude this phase. Signing and closing are two very important elements, especially in terms of purchase price adjustments, which will be seen later. Signing stands for the physical signing of the contract of the parties, while closing corresponds to the actual handing over of the object of purchase; the purchase price or stock split on the one hand and the company shares or assets on the other hand.^[28] At this date, the management, control and the entrepreneurial liability devolves to the buyer.^[29] In practise it is also the temporal reference point for various regulations, like the begin for statute of limitations of guarantees or the end of rescission options.^[30]

The sixth phase is a very important phase for a successful M&A transaction. The integration phase, meaning the integration of the target in the buyer’s organisation and corporate culture, is a phase where many mistakes occur. This stage will reveal if the planning and preparation of the M&A transactions was precise and is paying out. For example, if the buyer now finds out that the culture of the target is different to his corporate culture, it will be too late for any changes. The M&A transaction will most certainly fail, because of that little but important detail. Therefore it is important to also think about integration during the whole M&A process.

The last phase is the control phase. It is basically a target-performance comparison. Did the buyer reach the objectives set at the beginning of the M&A transaction? Or put otherwise, to what extent did the M&A process support the corporate objectives? If a target is acquired, for example, because of synergy objectives, then the answer to these questions will be one plus one equals three.

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Figure 1: Elements of an M&A Process

Source: Author

3 PURCHASE PRICE ASSESSMENT: METHODS FOR VALUATION OF A COMPANY

The lawyer drafting an M&A contract needs first to understand the applied valuation method for the targeted company, which parties will have to agree on for calculating the target's purchase price. This is an essential step before the lawyer starts thinking about the various tools he can use for adjusting the purchase price of the target. There are different kinds of valuation methods. Although, the lawyer does not have to carry out a company valuation himself, he should know the basic valuation methods and be familiar with the major differences among them, so that he can implement them as effectively as possible. Formulating purchase price adjustment clauses without any particular knowledge of valuation methods is difficult, if not impossible.

Valuation methods can be separated into two main procedures, single-valuation-procedures and total-valuation-procedures. This chapter will introduce the reader to the net asset value method as being part of single-valuation-procedures as well as the capitalisation of earnings method and the Discounted Cash-Flow (DCF) method as being part of total-valuation-procedures (see Figure 2).

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Figure 2: Company Valuation Methods

Source: Cp. Ernst D., Schneider S., Thielen B. “Unternehmensbewertungen erstellen und verstehen” (Franz Vahlen Verlag, München 2003), 2.

3.1 Single-Valuation-Procedures

The starting point of the single-valuation-procedures is the single assets of the target.^[31] Each single asset will be valued at a certain valuation date and these values then summed up. As a general rule, the company value is calculated by subtracting the company’s debts from the summed-up assets. Single-valuation-procedures relate to a certain date, are static in respect of the basis for evaluation and cannot make statements regarding future profits.

The net asset valuation method is the oldest method for valuating a company.^[32] Net asset values can be based on reproduction values or liquidation values. The key is the valuation of the single assets and debts.^[33] Which value has to be estimated for assets and debts? The replacement value, the liquidation value ^[34] , the redemption value or the nominal value, are examples of consideration.

3.1.1 Net Asset Value on the Basis of Reproduction Values

The basic idea of calculating the net asset value on the basis of reproduction values is rebuilding an identical company on the “green field”.^[35] Therefore, the reproduction value^[36], which is necessary for the reproduction of an identical company, has to be determined at a certain valuation date.^[37] The intention is the continuation of the business of the evaluated company (going concern principle), without considering future expected earnings.^[38]

The single relevant assets for the valuation are picked from the balance sheet as well as from the inventory. The reason for the latter is that the balance sheet does not always reflect the entire assets.^[39] Under German law, it is prohibited to activate non-purchased industrial property rights.^[40] For example, if a company purchases a patent, the patent can be activated in the balance sheet. However, if the company develops the patent on their own, activation is not possible. For some assets, accountants have the choice to activate these assets or not and other assets might not appear in the balance sheet as they have been entirely depreciated in terms of accounting values, despite still having a market value.^[41] For example, a machine which has been fully depreciated has a book value of zero or one currency units but might still have a market value of X currency units.

The net asset value on the basis of reproduction values accounts only for assets which can be evaluated solely. The assets are then grouped into operating assets (assets essential for the operation of the business) and non-operating assets (assets not essential for the operation of the business). The operating assets are calculated on the basis of their replacement values at the valuation date, assuming that the assets are second-hand.^[42] The non-operating assets are calculated on the basis of their liquidation value.^[43] When the potential buyer rebuilds an identical company on the “green field” he will not acquire assets which are non-operating. Therefore, these assets are calculated on the basis of the liquidation value, which can differ from the replacement value.

The company’s debts are also grouped into operating debts (debts essential for the operation of the business) and non-operating debts (debts not essential for the operation of the business).^[44] The former are calculated on the basis of nominal values and the latter are calculated on the basis of redemption values.^[45]

In summary, important for calculating the net asset value are solely the operating assets and operating debts. Only they are indispensable for the purpose of obtaining the company.^[46] Therefore, the calculation of the net asset value on the basis of reproduction values can be formulated as follows:^[47]

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The core concept of the net asset valuation is that a company must be worth at least the amount of money which a potential buyer saves on expenditures compared to a necessary reproduction.^[48] Or put in words, if it is cheaper to reproduce an identical company, the buyer should not think of acquiring the target. The problem is that this idea cannot be applied in practice. First of all, the buyer typically does not want to rebuild the entire company. Secondly, economies of scope are disregarded, and thirdly, advantages resulting from factors such as customer and supplier relationships, reputation, location, workforce motivation and know-how, cannot be reproduced easily.^[49]

The advantages of this method include the simple way of calculating the net asset value and forecasting issues can be avoided. However, the disadvantage is that the outcome can be misleading.^[50] For example, a company that holds valuable long-term assets, like buildings or real estates, has a high net asset value, although it has produced losses for years. Investing in this company would be not profitable, if an investor strives to continue the business. Therefore, the net asset value on the basis of reproduction values has no significance when it comes to the decision of selling or purchasing a company, but it can be used for the compensation of shareholders and in certain industries, like the power industry to calculate the current market value of electricity networks.^[51]

3.1.2 Net Asset Value on the Basis of Liquidation Values

In contrast to the idea of calculating the net asset value on the basis of reproduction values, which follows the going concern principle, there is the idea of calculating the net asset value on the basis of liquidation values for the liquidation of the entire business at a certain valuation date.^[52] This means asset stripping where all legal relationships concerning the company are liquidated and debts are paid back.^[53] The relevant assets are taken from the balance sheet and the inventory for the same reasons as in the net asset value method based on reproduction values above.

For the calculation of the net asset value on the basis of liquidation values all single assets, operating and non-operating assets, are valued at market prices.^[54] The debts of the company are evaluated at their nominal values.^[55] After the evaluation of the single assets and debts, the sum of debts is subtracted from the sum of the company’s assets. Further, the liquidation costs, like the costs to execute the social compensation plan, environmental clean-up costs, removal expenses, or additional tax charges, have to be subtracted from the company’s assets as well.^[56] Therefore, the calculation of the net asset value on the basis of liquidation values can be formulated as follows:^[57]

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The liquidation revenues have to be discounted, where the liquidation process lasts for a longer time than expected.^[58] Unlike the net asset value on the basis of reproduction value, the net asset value on the basis of the liquidation value is of significant importance for the decision of selling or buying a company. It represents the lower value limit for a company which is crucial to a rational decision maker to know.^[59] If the net asset value on the basis of liquidation value is larger than the net asset value on the basis of reproduction value, it is economically and financially wise to liquidate the company instead of maintaining it.^[60]

3.2 Total-Valuation-Procedures

Total-valuation-procedures have an approach which is different as single-valuation-procedures. In these procedures, the company is not evaluated by the sum of its individual assets but rather as an entity.^[61] Therefore, the company is considered as an evaluation entity, whose value is the total financial advantage from the use of all assets and debts.^[62]

The purchase of a company is considered as an investment (according to the theory of investments). The company value is the end result of the sum of discounted net-influx.^[63] Thus, the company value reflects the future earning capacity of the company.^[64] Total-valuation-procedures have a high significance among valuation methods because of the future-oriented approach.^[65]

There are various total-valuation-procedures like the capitalisation of earnings method, the Discounted Cash-Flow (DCF) method or other methods summarised under market approaches^[66]. However, only the first two shall be specifically discussed in this paper, since they are two of the most commonly used methods.^[67]

The capitalisation of earnings method, which was widely-used in Germany^[68], and the DCF method, which is the prevailing method in Anglo-American countries, are both based on similar methodical procedures.^[69] Both methods rely on future prospects, like earnings, costs, financing structure and market success, but differ in reference figures for capitalization, discounting factors and assumptions of the financial structure for the company.^[70]

3.2.1 Capitalisation of Earnings Method

The capitalisation of earnings method belongs to the flow-oriented valuation methods, which aligns with future earnings.^[71] The entity-approach and equity-approach can be distinguished. The capitalized earnings value represents the net present value of future earnings of a company, available to investors/shareholders.^[72] Therefore the earnings have to be forecasted, as well as future liquidation value of assets and discounting rates.^[73]

This capitalization of earnings method applies from the beginning of the perpetuity principle and calculates with constant eternal free cash-flows, which equates the Earnings Before Interests (EBI) using the entity approach.^[74] In the calculation of the EBI, the exact taxes have already been adjusted. Therefore, the Weighted Average Cost of Capital (WACC), the relevant discount factor, does not have to be tax adjusted anymore.

WACC is a mixed-interest rate of cost of equity and cost of debts.^[75] The cost of debt reflects the cost of debt rate, which is the interest rate of borrowings at current market rates multiplied with the debt portion of the value of the company (see Figure 3). Defining the cost of equity is comparatively more difficult than the cost of debt. It represents the interest rate which investors expect in return for their investment in the company. Naturally, investors want a higher interest rate for their carried-risk investment than what they would receive under a risk-free investment. The Capital Asset Pricing Model (CAPM) is applied to measure this risk premium.^[76] Therefore, the cost of equity reflects the risk free-rate, which the investors would get in a risk-free investment, plus the product of the beta factor, which is the systematic risk that all companies in the market face (market risk), and the risk premium, which reflects the usual market risk premium (see Figure 3).

Calculating the market value of equity for a company by using the entity approach, EBI has to be discounted by WACC and the market value of debts has to be subtracted from the result.^[77] EBI takes only operating assets into account. Therefore, the market value of non-operating assets has to be separately calculated and added to the discounted EBI before the market value of debts can be subtracted (see Figure 3).^[78]

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Figure 3: Capitalisation of Earnings Method (Entity Approach)

Source: Cp. Hölters W. “Handbuch des Unternehmens- und Beteiligungskaufs“ (6. Auflage, OVS Verlag, Köln 2005), 100; Volkart R. “Corporate Finance – Grundlagen von Finanzierung und Investition” (2. Auflage, Versus Verlag, Zürich 2006), 314.

Using the equity approach, the net profit, which is the flow to equity,^[79] has to be discounted by the cost of equity and the market value of non-operating assets has to be added to achieve the market value of equity (see Figure 4).^[80] This approach is comparable with the equity-approach of the DCF-method below.^[81]

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Figure 4: Capitalisation of Earnings Method (Equity Approach)

Source: Cp. Peemöller V. “Praxishandbuch der Unternehmensbewertung” (3. Auflage, Verlag Neue Wirtschafs-Briefe, Herne/Berlin 2005), 70 et seq.

3.2.2 Discounted Cash-flow Method

The DCF-method is a widespread and popular method in Anglo-American practice to evaluate the enterprise value. It is a common valuation method in major international company transactions.^[82] The DCF-method is based on the assumption that the operating free cash-flow, which represents the surplus cash-flow resulting from operating business, is at investor’s disposal.^[83] This amount could fully be distributed to investors if there were no company debts.^[84] Alternatively, it can also be regarded as the amount that is available to the company to cover the interest payments resulting from company’s debts.^[85] It is the right basis for measurement because it does not include finance related cash-flows like interests and dividends, and represents the cash-flow available to repay debts and investors.^[86]

The net present value of cash-flows (operative plus non-operative), which a company generates during its lifetime, at a certain valuation date, represents the total enterprise value.^[87] Significant for the valuation process is that only the cash-flow based on operating assets is capitalised under DCF.^[88] Non-operating cash-flows (for example rental income from non-operating assets or profits from sales of non-operating assets) are also capitalised but usually with a different discount factor.^[89] For this reason, the net present value of non-operating cash-flows are calculated separately and added to the net present value of the operating cash-flow to obtain the total enterprise value of a company.^[90] Therefore, market values of operating and non-operating assets have to be distinguished.^[91]

The advantage, compared to the capitalization of earnings method, is that the DCF-method is based on cash-flows and not on earnings. Earnings are to a certain extent determined by balance sheet ratios, as well as on the basis of profit and loss statements. Different accounting principles or standards such as the Generally Accepted Accounting Principles of the United States of America (US-GAAP), International Financial Reporting Standards (IFRS) or according to the German Commercial Code (HGB) can lead to different results in the profit and loss statement and balance sheet. Therefore, earnings are more vulnerable to manipulations than cash-flow. Cash-flow on the other hand reflects the economic and financial reality of the company.^[92]

A specific feature of the DCF-method is the consideration of company taxes. If expenditures for debts are tax deductible, they will reduce the tax burden of the company.^[93] Like in Germany for instance, financing the company through debts has the benefit of tax reduction. By financing the company through debts, the company was until the end of 2007 entitled to reduce the Earnings Before Interest and Tax (EBIT), by half of the interest’s payable for long term debts on the calculation of business tax.^[94] For the calculation of corporate tax, companies were entitled to reduce the EBIT by 100% of the interest’s payable for long term debts, less business tax.^[95] Put in simple words, if a company’s EBIT is 50 million € and its interest’s payable for long term debts are 5 million €, the taxable profit for the calculation of business tax will be reduced to 47.5 million € (50 million – 50 % of 5 million), while the taxable profit for the calculation of corporate tax will be reduced to 45 million € (50 million – 100 % of 5 million), less business tax. Since 2008, this procedure has changed, due to a reform concerning company taxes. For the calculation of business tax, companies are now entitled to reduce the EBIT by 75 % of the interest’s payable for long term debts while 25 % of financing portions for leasing, rental and license fees have to be added.^[96] For the calculation of corporate tax, companies are still entitled to reduce the EBIT by 100 % of the interest’s payable for long term debts, while business tax cannot be reduced anymore.^[97] That means for the example above, the taxable profit for the calculation of business tax will be reduced to 46.25 million € (50 million – 75 % of 5 million), less 25 % of, for example, leasing fees if there are any. The taxable profit for the calculation of the corporate tax will be 45 million €, like calculated above since business taxable are not deductable anymore.

According to that, interests on borrowed capital have a tax reducing effect, which is referred to as tax shield. The tax shield is discounted for the calculation of the free cash-flow but it will be part of the calculation of the discounting factor and hence accounted for in the second step.^[98]

The DCF-method can be distinguished into two approaches, the entity approach and the equity approach. While the entity approach can be separated into the WACC-approach and the Adjusted Present Value (APV) approach. The WACC-approach and the APV-approach indirectly lead to the market value of equity (shareholder value) of a company, which represents the cash-flows going to investors/shareholders.^[99] This is because they first calculate the enterprise value, where the market value of debts has to be subtracted. The equity approach on the other hand, directly results in the equity value of the company.^[100] Although, the three different approaches use diverse discounting rates, absolute measurements and proceedings, they result in the same market value of equity.^[101]

3.2.2.1 Weighted Average Cost of Capital Approach

The WACC-approach is the most often used the variation of the DCF-methods.^[102] It determines the enterprise value of the company by calculating the total operating free cash-flows going to shareholders, as well as to lenders, and discounting them by a mixed interest rate of the costs of equity and the costs of debts, the WACC.^[103] Due to the fact that the tax shield is not part of the cash-flow calculation, it is accounted for in the WACC calculation.^[104] This WACC calculation differs from the WACC calculation of the entity approach under the capitalization of earnings method, where tax is adjusted in EBI and not at WACC. Nonetheless, the first step is to calculate the operating free cash-flows, which is done as follows.

EBIT serves as the initial point which can be taken from the profit and loss statement. The income tax has to be subtracted from this amount, while depreciation and the dissolution of accrual have to be added. The result is called Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) or Earnings Before Interest, Tax and Amortisation (EBITA), or simply called operating cash-flow (cash inflow from operating activities). Before ending up with the operating free cash-flow, investment in fixed assets and the increase in working capital^[105] have to be subtracted from the operating cash-flow (see Figure 5).^[106] Do not mistake operating free cash-flow with operating cash-flow. All future operating free cash-flows are discounted by WACC in a further step, therefore WACC has to be determined.

The calculation of the WACC is the same as mentioned at the capitalization of earnings method, just that the tax shield has to be included. The determination of cost of equity stays the same like above, only the determination of cost of debt differs (see Figure 5). The provision for tax is done on the cost of debt side. The cost of debt rate is adjusted by the tax shield^[107] and multiplied with the debt portion of the value of the company (see Figure 5).

The result of the discounted operating cash-flows by WACC is the net present value of operating cash-flows. The net present value of non-operating cash-flows has to be added, in order to obtain the total enterprise value. To end up with the market value of equity of the company, the market value of debts has to be subtracted.^[108]

illustration not visible in this excerpt

Figure 5: WACC-Approach

Source: Cp. Ernst D., Häcker J. “Applied International Corporate Finance” (Vahlen Verlag, München 2007), 387.

3.2.2.2 Adjusted Present Value Approach

The theoretical concept of the APV-approach is based on the value of a notional, self-financed company, modified by successive finance and tax effects.^[109] Similar to the WACC-approach, the APV-approach is calculating the operating free cash-flows going to shareholders as well as to lenders in a first step.^[110] The difference lies in the applied discounting rate. The APV-approach does not use WACC as discounting rate, but the cost of equity rate of the company, which is achieved by using the CAPM described above.^[111] The application of a different discounting rate leads to a different net present value of operating free cash-flows compared to the WACC-approach.

Another similarity to the WACC-approach is that the net present value of non-operating free cash-flows are calculated separately and added to the net present value of operating free cash-flows in the second step (see Figure 6).^[112] The result of that second step is the total enterprise value of a self-financed company. Since there is no significance of the tax shield during the capitalisation process, the tax shield is now separately considered.^[113] This is because the costs of debts do not occur in a notional, self-financed company and hence no tax adjustment of them. During this third step, the tax shield, which reflects the tax shelter of a debt financed company due to deductible interest rates of long term debts, has to be added to the total enterprise value of the notional company.^[114] The sum is the total value of an indebted company.

The market value of debts has to be subtracted from the total enterprise value of an indebted company to achieve the market value of equity (see Figure 6).^[115] The APV approach is used for the valuation of companies with an altering financial structure, like companies, valuated in terms of a leveraged buyout.^[116]

illustration not visible in this excerpt

Figure 6: APV-Approach

Source: Cp. Hölters W. “Handbuch des Unternehmens- und Beteiligungskaufs“ (6. Auflage, OVS Verlag, Köln 2005), 114.

3.2.2.3 Equity Approach

The equity approach focuses on the idea that only the cash-flows going to investors, flows to equity, are relevant for the valuation. Cash-flows going to lenders are not taken into account. The consequence is that the market value of equity is achieved directly and not indirectly via the subtraction of the market value of debts from the enterprise value, like in the two approaches described above.^[117] The flow to equity reflects the operating free cash-flows adjusted by interest of borrowings, including resulting tax shelter and the change of debts.^[118] This means that the tax shield and the change of debts are directly included in the calculation of the cash-flows and not part of a second or third step, like in the other two approaches.^[119] The cost of equity of an indebted company is the discount factor, whereby the flow to equity is capitalised. Adding the net present value of non-operating cash-flows, which is separately valuated, to the resulting net present value of flows to equity, the market value of equity will be the conclusion (see Figure 7).

The direct calculation of the market value resembles the calculation of the capitalisation of earnings method.^[120] Flows to equity correlate to earnings of the capitalisation for earnings method, if the latter are calculated on the basis of cash-flow surpluses.^[121] This valuation method is best suited for companies of the financing industry, like banks or insurance companies.^[122]

illustration not visible in this excerpt

Figure 7: Equity Approach

Source: Cp. Peemöller V. “Praxishandbuch der Unternehmensbewertung” (3. Auflage, Verlag Neue Wirtschafs-Briefe, Herne/Berlin 2005), 70 et seq.

4 GUARANTEES

This section of the paper discusses guarantees, the first tools which can directly influence the purchase price of an M&A transaction. Generally, guarantees have the purpose of minimising the risk to the buyer for a specific period of time.^[123] In the case of a very quick and hence imprecise performed due diligence, the buyer cannot get as much information about the target as desired. It is common to limit the time for performance of due diligence and when the transaction is a large-cap, there are lots of data to go through. Due to the limited time, not all information can be gathered; getting a general overview of the target as opposed to a resourced consuming detailed information. Under these circumstances, the buyer acquires the target without having all the information he prefers to have. He bears the risk that something unforeseen and unexpected will occur after the deal is made. To limit this risk, the seller issues guarantees at the expense of a higher purchase price. If the due diligence period is short, the buyer is well advised to ask for guarantees and therefore pays a higher purchase price. If the due diligence period is extended, the buyer does not need a plenitude of guarantees, because he can gather all the information he needs to reduce his risk and hence pays a lower purchase price. Therefore, the rule is, the more comprehensive and precise the due diligence of the target is performed by the buyer and the more transparent it is documented, the less guarantees will be issued by the seller.^[124]

A guarantee usually ensures the quality or characteristics of the object of purchase and is limited to a certain period of time. Generally, until closing, since the buyer has no control or influence over the target until this date, or for a certain period after the closing date (post-closing guarantees).^[125] The buyer can ask for various kinds of guarantees and the seller can issue the same.

4.1 Forms of Guarantees

According to the general principle of freedom of contract, the parties are independent to choose the form, quantity and the scope of guarantees. It is up to the parties in deciding how detailed the guarantee clauses ought to be. From a seller’s point of view, guarantees are a way to raise the purchase price at the expense of increased liability risk. If the seller feels confident that all the data provided to the buyer are correct, complete and not manipulated in anyway, he should be happy to issue guarantees. In cases where the parties have not agreed to all terms in the M&A contract or there is an argument about the purchase price, this move might persuade the buyer to agree and convince him that his concerns are limited by these guarantees. From the buyer’s point of view, guarantees are a helpful tool to overcome uncertainties which have occurred during due diligence or negotiations.

Guarantees that can influence the purchase price are not only issued for retrospective qualities or characteristics, but also for future ones. Typical forms of guarantees include: equity guarantee, working capital guarantee, asset guarantee, debt-free guarantee, guarantees concerning parts or the complete financial statements, and the non-realisation of certain risks in the future.^[126] Some of them will be discussed at the following in detail.

4.1.1 Guarantee of Financial Statements

Probably one of the most important guarantees is the one about financial statements.^[127] Regardless of which method of purchase price adjustment is used, all of them depend on the numbers in the financial statements. Therefore, these statements must be reliable. A guarantee typically involves the preparation of the financial statements according to GAAP, in compliance to formal and material continuity of past prepared financial statements, and its completeness and correctness.^[128] From a buyer’s perspective, this type of guarantee should always be drafted in an M&A contract as it builds the foundation for post-closing adjustment and earn-out clauses. That also ensures the buyer about the numbers that build the basis for the company valuation. The guarantee of the financial statements goes hand-in-hand with other purchase price adjustment tools.

4.1.2 Equity Guarantee

An offset of the guarantee of the financial statements is the equity guarantee. Both parties agree to an estimated balance of equity at a certain future point-in-time. The estimated balance of equity could, for example, be calculated by taking the book value of equity of the last balance sheet, increased by the planned profit.^[129] If the estimated balance of equity equals the actual balance of equity by that time, the purchase price falls due. If there are any variances in terms that the actual balance of equity is higher or lower as the estimated balance of equity, purchase price adjustments will take place. As a consequence, the purchase price which the buyer has to pay can increase or decrease. It is commonly accepted that a negative purchase price, which stands for an additional payment by the seller in case the actual balance of equity does not reach the estimated balance of equity at the point in time when the object of purchase is handed over, is contractually excluded.^[130]

This kind of guarantee does not only take solely the equity into account. It also considers other assets of the balance sheet. To name a few, the buyer can reduce the following risks: distribution of company profits by the seller after the signing date, withdraw of cash of the target by the seller after signing date, reduction of profit through exercising an option with regards to items included in the financial statement after the signing date (for example, alteration in accruals) or the reduction of revenue reserves.^[131]

An equity guarantee is a very attractive guarantee for a buyer, since it leads to an intense minimisation of his risk. It is not so attractive for the seller, because his ability to calculate future revenues is limited by the guarantee and he has partially to bear the risk of future business development.^[132] Therefore, this guarantee will lead to an increase in purchase price to equalise the seller’s risks.

A legal counsel drafting this kind of guarantee has to be aware of the conceptual scope of the term ‘equity’. Equity in terms of a legal, economic or commercial context can be distinguished and include different financial assets.^[133] The term must be precisely defined in order to prevent future misunderstanding.

4.1.3 Working Capital Guarantee

The working capital guarantee when compared to the equity guarantee is not as comprehensive and therefore easier to reach an agreement between the parties. It is also an offset of the guarantee of the financial statements. Working capital guarantees insure against fluctuations in the company’s operational current assets. It is preferred by companies that have comparatively high fluctuations in operational current assets, like the consumer goods industry.^[134] The objective of a working capital guarantee is that the seller assures a certain amount of working capital at the closing date. This assures the buyer that there will be no outflow of liquidity until that date.^[135]

Similar to equity, working capital is ambiguous. It is not clearly defined what exactly can be subsumed under ‘working capital’. All definitions agree that ‘working capital’ represents the current assets financed by long-term debts, or in other words, the difference of current assets and current liabilities. Various definitions take diverse balance sheet items into account. Here are some definitions of working capital:

- “Operating working capital comprises of operating cash, accounts receivable, stocks (inventories), and other current assets (such as prepaid expenses) less accounts payable and other current liabilities (such as tax payable).”^[136]
- Working capital is cash, marketable securities, accounts receivable and inventory, less accounts payable, accrued liabilities and short debt.^[137]
- Working capital is the sum of stocks, operating liquid assets, accounts receivable and other current assets, less trade accounts payable, other accounts payable and deposits received.^[138]
- “[Working Capital] refers to current assets less current liabilities... Current assets include cash, marketable securities, debtors and stock. Current liabilities are obligations that are expected to be repaid within the year.”^[139]
- “Short-term or current assets and liabilities are collectively known as working capital.”^[140] Current assets include but are not limited to cash, marketable securities, accounts receivable and inventories. Current liabilities include but are not limited short-term loans, accounts payable, accrued income taxes and current payments due on long-term debt.^[141]

It is essential for the drafter of this clause to define precisely which items are included in ‘working capital’ and which are not. That is the only way to avoid any ambiguity after the closing about the calculation of the purchase price. A detailed scheme should be enclosed as an annex of the contract, stating the relevant items of the balance sheet which identify working capital.

Comparable to an equity guarantee, the working capital guarantee has a purchase price adjusting effect if the guaranteed working capital is not given at the closing date. Depending on the fluctuations, the purchase price can be higher or lower. The drafting counsel must be aware of the fact that the working capital guarantee alone cannot prevent manipulations. On the basis that working capital is only a result of a mathematical mixture of current assets and current liabilities, it is easy to manipulate the amount of it. For example, long-term assets and long-term debts are not part of the various working capital definitions. An accounting exchange on the asset side can take place, where long-term assets, like machines, can be sold. The liquidity increases and hence the working capital increases as well. At the closing date, the working capital would be higher than the guaranteed one and the purchase price would be increased. The consequence is that the buyer pays a higher purchase price for the company that is of a lower value, since assets are sold. Another possibility is to create bank debts, which are usually not covered under the working capital definitions, that increases the liquidity and ultimately the working capital. Through these manipulation possibilities, the seller can influence a higher purchase price. Therefore, legal counsels should use a combination of guarantees that collude to prevent manipulations.

[...]

^[1] Cp. Kunisch S. “M&A-Markt 2007 in Deutschland – Zwei unterschiedliche Jahreshälften” M&A Review, 2/2008, 57.

^[2] Cp. Handelsblatt “Erstes Quartal schockt Investmentbanken” 23.03.2008, 24; Handelsblatt “M&A-Markt kühlt sich ab” 21.11.2007, 25.

^[3] M&A International Inc. is the largest international organisation of independent M&A consulting firms for mid-market M&A’s. See M&A International Inc. (MAI) at <http://www.mergers.net/index.php>, last accessed 14.04.2008.

^[4] Cp. Landgraf R. “Fusionsgeschäft verlagert sich” Handelsblatt, 03.12.2007, 37

^[5] Deutsche Bank expects in the current year eight big M&A deals in the United States of America with a volume of at least $ 10 billion. Cp. Eberle M., Landgraf R. “Günstige Gelegenheit” Handelsblatt, 05.03.2008, 2.

^[6] Cp. Adel R. “The Purchase Price Adjustment Process – Protections and Pitfalls” Orange County Business Journal, Jul 31-Aug 6, 2006, B-42.

^[7] To simplify writing, the male formulation is used to describe a person in this paper, although there is a female counterpart for each. No sexist innuendo is intended.

^[8] Cp. Various definitions of M&A in Wirtz B. “Mergers & Acquisitions Management – Strategie und Organisation von Unternehmenszusammenschlüssen”, (Gabler Verlag, Wiesbaden, 2003), 11.

^[9] Cp. Napier, N.K., Simmons, G., Stratton, K. “Communications during a merger: The experience of two banks”, HRP, Vol 12, No. 2, 1989, 105; Ansoff H.I., Weston F.E. “Merger objectives and organisation structure”, Quarterly Review of Economics and Business, Vol. 2, No. 3, 1962, 56.

^[10] Cp. Achleitner A.-K. “Handbuch Investment Banking” (3. Auflage, Gabler Verlag, Wiesbaden 2002); Wirtz, above No 8, 15.

^[11] Cp. Wirtz, above No 8, 15.

^[12] Cp. Wirtz, above No 8, 16; An example is the merger of Daimler Benz AG and Chrysler Corporation to the newly-created DaimlerChrysler AG in 1998.

^[13] Cp. Picot G. “Handbuch Mergers & Acquisitions – Planung, Durchführung, Integration”, (3. Auflage, Schäffer-Pöschel Verlag, Stuttgart 2005), 20. Other authors do not share the view that company co-operations are included under the term M&A, but rather an alternative to M&A. Cp. Ernst D., Häcker J. “Applied International Corporate Finance”, (Vahlen Verlag, München 2007), 6.

^[14] Cp. Picot, above No 13, 20.

^[15] Cp. Carter S. “CIM Coursebook – International Marketing Strategy”, (Butterworth-Heinemann, Oxford 2002), 93; Joint Ventures with local companies are an interesting option for companies to enter a foreign market when the foreign government (like China, India or South Korea) restricts foreign ownership.

^[16] Cp. Carter, above No 15, 93.

^[17] To get a detailed overview of the various forms of German companies as well as some major typs of foreign companies, please refer to Memento Rechtshandbücher “Gesellschaftsrecht für die Praxis 2008”, (9. Auflage, Memento Verlag, Freiburg 2007).

^[18] Cp. Schlechtriem P. “Kommentar zum Einheitlichen UN-Kaufrecht“ (3. Auflage, C.H. Beck Verlag, München 2000), Art 1. Rz 36; Share deal and asset deal have to be distinguished. A share is an ownership right that does not fall in the category of goods. Stocks and shares are explicitly excluded under article 2d of the CISG. If the transaction is done by an asset deal, one opinion is that the CISG is not applicable, while another opinion, pre-dominant in US-American practice literature, considers it possible. Different arguments for both opinions are stated in Merkt H. “Internationaler Unternehmenskauf” (2. Auflage, RWS Verlag, Köln 2003), 231 et sqq.

^[19] Cp. Holzapfel H.-J., Pöllath R. “Unternehmenskauf in Recht und Praxis – Rechtliche und steuerliche Aspekte” (9.Auflage, RWS Verlag, Köln 2000), 91.

^[20] In Germany for example, real estate is transferred according to articles 873 et seqq. German Civil Code, objects according to articles 929 et seqq. German Civil Code and rights according to the relevant provisions.

^[21] Cp. Rock H. “Checkliste Asset Deal”, M&A Review 1/2000, 8.

^[22] Cp. Rock H. “Checkliste Share Deal”, M&A Review 4/2000, 145.

^[23] Cp. Wirtz, above No 8, 57.

^[24] Cp. Wirtz, above No 8, 58.

^[25] Cp. Wirtz, above No 8, 59.

^[26] Cp. Wirtz, above No 8, 73.

^[27] Cp. Wirtz, above No 8, 73.

^[28] Cp. Borgman M., Kalnbach P. “Bilanzgarantien in M&A-Verträgen”, M&A Review, 5/2007, 227.

^[29] Cp. Lappe T., Schmitt A. “Risikoverteilung beim Unternehmenskauf durch Stichtagsregelungen” Der Betrieb, Heft 03 vom 19.01.2007, 153.

^[30] Cp. Lappe, above No 29, 153.

^[31] Cp. Bruski J. “Kaufpreisbemessung und Kaufpreisanpassung im Unternehmenskaufvertrag”, Betriebs-Berater (BB), 60. JG., BB-Special 7, Heft 30, 19, 20.

^[32] Cp. Schultze W. “Methoden der Unternehmensbewertung: Gemeinsamkeiten, Unterschiede, Perspektiven“ (2. Auflage, IDW-Verlag, Düsseldorf 2003), 16.

^[33] Cp. Wirtz, above No 8, 231.

^[34] Cp. Bruner R. “Applied Mergers & Acquisitions Workbook” (Wiley & Sons, New Jersey 2004), 49.

^[35] Cp. Ballwieser W. “Unternehmensbewertung – Prozesse, Methoden und Probleme” (Schäffer-Poeschel Verlag, Stuttgart 2004), 182; Behringer S. “Unternehmensbewertung der Mittel- und Kleinbetriebe” (2. Auflage, Erich Schmidt Verlag, Berlin 2002), 66.

^[36] There are various reproduction values that can be calculated. For a full list please consult Ernst D., Schneider S., Thielen B. “Unternehmensbewertungen erstellen und verstehen” (Franz Vahlen Verlag, München 2003), 4 and Hölters W. “Handbuch des Unternehmens- und Beteiligungskaufs“ (6. Auflage, OVS Verlag, Köln 2005), 133.

^[37] Cp. Hölters, above No 36, 133; Peppmeier K., Graw H. “Unternehmensbewertung – Unternehmen in der Krise richtig bewerten “ Kredit & Rating Praxis, 04/2002, 16, 17.

^[38] Cp. Ernst, above No 36, 3; Hölters, above No 36, 133.

^[39] Cp. Ballwieser, above No 35, 181.

^[40] Cp. German Commercial Code (HGB), s 248; The German legislator is planning a reformation of the current valid accounting principles. After the reformation it should also be allowed to activate non-purchased industrial property rights. Cp. Handelsblatt “Was das neue HGB-Recht bringt”, 12. November 2007.

^[41] Cp. Ballwieser, above No 35, 181.

^[42] Cp. Peppmeier, above No 37, 17; Ballwieser, above No 35, 182.

^[43] Cp. Peppmeier, above No 37, 17; Ballwieser, above No 35, 182.

^[44] Cp. Peppmeier, above No 37, 17; Ballwieser, above No 35, 182.

^[45] Cp. Behringer, above No 35, 66.

^[46] Cp. Behringer, above No 35, 66.

^[47] Cp. Hölters, above No 36, 133.

^[48] Cp. Behringer, above No 35, 66.

^[49] Cp. Behringer, above No 35, 66.

^[50] Cp. Behringer, above No 35, 67.

^[51] Cp. Ballwieser, above No 35, 182.

^[52] Cp. Behringer, above No 35 70.

^[53] Cp. Behringer, above No 35, 70.

^[54] Cp. Koch W., Wegmann J. “Praktiker-Handbuch Due Diligence” (2. Auflage, Schäffer-Poeschel Verlag, Stuttgart 2002), 159.

^[55] Cp. Koch, above No 54, 161.

^[56] Cp. Behringer, above No 35, 70.

^[57] Cp. Ernst, above No 36, 5.

^[58] Cp. Koch, above No 54, 161.

^[59] Cp. Peppmeier, above No 37, 17.

^[60] Cp. Ernst, above No 36, 5.

^[61] Cp. Bruski, above No 31, 20

^[62] Cp. Ballwieser, above No 35, 9

^[63] Cp. Bruski, above No 31, 20

^[64] Cp. Ernst, above No 36, 9

^[65] Cp. Hölters, above No 36, 96

^[66] The market approach method uses market values or stock exchange values of comparable companies as a basis to calculate the value of the relevant target. It is also possible to use multiples, which usually are also calculated out of the stock exchange value, to calculate the company value. This method is mainly used for small and medium-sized transactions in practice, but is not further examined in this paper. The result of the purchase price adjustment would not be different by using multiples. Depending on the multiple used, manipulations have to be prevented. Therefore, it can be referred to chapters 5.1.4 and 5.2.1.3 where manipulation possibilities are discussed, which can also be applied for multiples. Cp. Hölters, above No 36, 9; Bruski, above No 31, 23.

^[67] Cp. Hölters, above No 36, 96.

^[68] In the past, it was regulated by law for certified public accountants to use the capitalisation of earnings method for the valuation of a company in Germany. This has changed through the growing influence of Anglo-American valuation procedures, so that the DCF method is more often used method also in Germany. Cp. Bruski, above No 31, 20; Ernst, above No 36, 11. According to an obsolete survey, the capitalisation of earnings method was used in Germany to 39 % for company valuations, compared to the usage of 33 % of DCF-method. Nowadays, especially in international M&A transactions, the DCF-method prevails by 95%, followed by the multiple valuation method (73 %) and the capitalization of earnings method (46 %). Cp. Peemöller V. “Praxishandbuch der Unternehmensbewertung” (3. Auflage, Verlag Neue Wirtschafs-Briefe, Herne/Berlin 2005), 204, 206.

^[69] Cp. Kästle F., Oberbracht D. “Unternehmenskauf – Share Purchase Agreement” (C.H. Beck Verlag, München 2005), 51.

^[70] Cp. Bruski, above No 31, 20.

^[71] Cp. Hail L., Meyer C. “Unternehmensbewertung”, Der Schweizer Treuhänder 6-7/02, 573, 578.

^[72] Cp. Peemöller, above No 68, 204.

^[73] Cp. Koch, above No 54, 159.

^[74] Cp. Volkart R. “Corporate Finance – Grundlagen von Finanzierung und Investition” (2. Auflage, Versus Verlag, Zürich 2006), 313.

^[75] Cp. Kästle, above No 69, 53.

^[76] Cp. Kästle, above No 69, 54.

^[77] Cp. Volkart, above No 74, 314.

^[78] Cp. Hölters, above No 36, 100.

^[79] Cp. Chapter 3.2.2.3 of this paper.

^[80] Cp. Volkart, above No 74, 315.

^[81] Cp. Chapter 3.2.2.3 of this paper.

^[82] Cp. Kästle, above No 69, 51.

^[83] Cp. Betsch O., Groh A., Lohmann L. “Corporate Finance” (2. Auflage, Vahlen Verlag, München 2000), 212.

^[84] Cp. Betsch, above No 83, 212.

^[85] Cp. Copeland T., Koller T., Murrin J. “Unternehmenswert – Methoden und Strategien für eine wertorientierte Unternehmensführung” (3. Auflage, Campus Verlag, Frankfurt/New York 2002), 174.

^[86] Cp. Copeland, above No 85, 174.

^[87] Cp. Kästle, above No 69, 52.

^[88] Cp. Bruski, above No 31, 21.

^[89] Cp. Ernst, above No 36, 35.

^[90] Cp. Copeland, above No 85, 212.

^[91] Cp. Bruski, above No 31, 21.

^[92] Cp. Kästle, above No 69, 51.

^[93] Cp. Bruski, above No 31, 21.

^[94] Cp. Hölters, above No 36, 107

^[95] Cp. Peemöller, above No 68, 351.

^[96] Cp. Unternehmenssteuerreform 2008, <http://www.finanztip.de/recht/steuerrecht/unternehmenssteuerreform.htm>, (last accessed 9. January 2008).

^[97] Cp. Unternehmenssteuerreform 2008, above No 96.

^[98] Cp. Hölters, above No 36, 107.

^[99] Cp. Kästle, above No 69, 52

^[100] Cp. Wirtz, above No 8, 212.

^[101] A detailed example is given at Peemöller, above No 68, 350, to show the differences of the three approaches which lead to the same result.

^[102] Cp. Peemöller, above No 68, 73.

^[103] Cp. Kästle, above No 69, 52.

^[104] Cp. Hölters, above No 36, 108.

^[105] Working capital is regarded as the difference of current assets and current liabilities. But there is no uniform definition what specific current assets and current liabilities are included in this calculation. This highly depends on each company what they want to have included. The problems arising from this open definition will be explained in a later chapter 4.1.3.

^[106] Cp. Wirtz, above No 8, 212.

^[107] Cp. Hölters, above No 36, 111.

^[108] Cp. Kästle, above No 69, 52.

^[109] Cp. Hölters, above No 36, 114.

^[110] Cp. Kästle, above No 69, 52.

^[111] Based on the assumption that the company is self-financed and has no debts at all, the beta factor will be a different one compared to a debt financed company by applying the CAPM to calculate the cost of equity. Cp. Hölters, above No 36, 116.

^[112] Cp. Peemöller, above No 68, 71.

^[113] Cp. Hölters, above No 36, 108; It will be hard to find a totally self-financed company without any debts in reality. Therefore, to get an realistic enterprise value, the tax shield has to be added to the total enterprise value of this notional company.

^[114] Cp. Ernst, above No 36, 10.

^[115] Cp. Kästle, above No 69, 52.

^[116] Cp. Copeland, above No 85, 171.

^[117] Cp. Peemöller, above No 68, 69.

^[118] Cp. Peemöller, above No 68, 69.

^[119] Cp. Kästle, above No 69, 52.

^[120] Cp. Hölters, above No 36, 107.

^[121] Cp. Peemöller, above No 68, 70.

^[122] Cp. Copeland, above No 85, 171.

^[123] Cp. Borgman, above No 28, 227.

^[124] Cp. Dill C., Vigelius C. “Kaufpreisanpasungsklauseln in der M&A-Praxis – Oder: Wer trägt das Risiko des zu zahlenden Unternehmenskaufpreises?“, Going Public, Heft 11/2004, 50-53.

^[125] Cp. Rittmeister M. “Gewährleistung im Unternehmenskauf“, (Lang Verlag, Frankfurt 2005), 206; Lappe, above No 29, 154; Vischer M. “Earn out-Klauseln in Unternehmenskaufverträgen”, SJZ 98 (2002) Nr. 21,509, 511.

^[126] Cp. Borgman, above No 28, 227; Vischer, above No 125, 511,Rittmeister, above No 125, 208; von Braunschweig P. “Variable Kaufpreisklauseln in Unternemenskaufverträgen”, Der Betrieb, Heft 35 vom 30.08.2002, 1815. The given list is not exhaustive.

^[127] Cp. Bruski, above No 31, 23. For purposes of this paper, financial statement includes, but is not limited to balance sheet, profit and loss statement and cash-flow statement.

^[128] Cp. Holzapfel, above No 19, 320; See an example of a model clause in Bruski, above No 31, 23.

^[129] Cp. Borgman, above No 28, 227.

^[130] Cp. Borgman, above No 28, 227.

^[131] Cp. Borgman, above No 28, 227.

^[132] Cp. Borgman, above No 28, 227.

^[133] Cp. Borgman, above No 28, 227.

^[134] Cp. Bruski, above No 31, 26.

^[135] Cp. Borgman, above No 28, 227.

^[136] Cp. Koller T., Goedhart M., Wessels D. “Valuation – Measuring and Managing the Value of Companies”, (4. Edition, John Wiley & Sons, New Jersey 2005), 262.

^[137] Cp. Shapiro A., Balbirer S. “Modern Corporate Finance – A Multidisciplinary Approach to Value Creation” (Prentice-Hall, New Jersey 2000), 29.

^[138] Cp. Copeland, above No 85, 576.

^[139] Cp. Pike R., Neale B. “Corporate Finance and Investment – Decisions & Strategies” (5th edition, Pearson Education Limited, Essex 2006), 337.

^[140] Cp. Brealey R., Myers S., “Principles of Corporate Finance” (6th edition, McGraw-Hill Higher Education, Boston (et al.) 2000), 856.

^[141] Cp. Brealey, above No 140, 857.