M&A: Locked Box, Completion

Accounts, Purchase Price

Allocation (PPA)
Part 3
Joris Kersten, MSc RAB
Location: Kersten Corporate Finance

June 16th 2020

Uden/ The Netherlands
Topics
Topic 1: Introduction to “net debt” (part 1 – June 3rd 2020);

Topic 2: Net debt/ cash and debt free (part 1 – June 3rd 2020);

Topic 3: Adjusted net debt – Cash like items (part 2 – June 5th 2020);

Topic 4: Adjusted net debt – Debt like items (part 2 – June 5th 2020);

Topic 5: M&A closing mechanisms – Locked box & Completion accounts (part 3 – June
16th 2020);

Topic 6: Consolidation of M&A targets and purchase price allocation (PPA) (part 3 –
June 16th 2020);

Topic 7: How to adjust for “operating lease” (under Dutch GAAP) (part 3 – June 16th
2020).
 About the trainer: Joris Kersten MSc BSc RAB
40 years old, living together with my girlfriend “Debby” and daughter “Floor” and
“Sophie”. Living in Uden (in the South of the Netherlands, about 100 km from city
Amsterdam, close to city Eindhoven).
Work
•Owner of ”Kersten Corporate Finance”, I work as an independent consultant
within the field of Mergers & Acquisitions (M&A);
•Co-owner of ”Samenwerkingsverband Kersten”: Real estate in DIY sector.
•Lecturer Corporate Finance at Tias Business School Tilburg/ Utrecht;
•Lecturer Corporate Finance at Nyenrode Business University in Breukelen;
•Lecturer Finance & Accounting at the Maastricht School of Management (MSM)
(and partner Universities in Peru/ Lima, Mongolia/ Ulaanbaatar, Surinam/
Paramaribo and Kuwait/ Kuwait City);
•Lecturer Corporate Finance at SP Jain School of Global Management in
Sydney/ Australia (and its locations in Mumbai, Dubai and Singapore).
Contact details:
•Trainer Corporate Finance/ Financial Modelling @ AMT Training London/ New
York/ Hong Kong at leading “bulge bracket” Investment Banks; joris@kerstencf.nl
•Trainer Corporate Finance @ Leoron Dubai/ Arab States of the Gulf at leading www.joriskersten.nl
institutions/ corporates in Kuwait, Bahrein, Saudi Arabia, Oman and United Arab +31(0)6 8364 0527
Emirates.
Education
•Education background: Master of Science (MSc) Strategic Management,
Bachelor of Science (BSc) Business Studies, both from Tilburg University (The
Netherlands).
•Registered Advisor Business Acquisitions – tax & legal (RAB);
•Degree in didactic skills in order to lecture at University;
•Right now following the “Executive Master in Business Valuation” to become a
“Registered Valuator” (RV).
Sources used
Investeren & Financieren: 2nd edition. Author:
Taco Rietveld (2017). Publisher: Vakmedianet.

(Ps. This book of “Rietveld” is highly recommended

to read for every corporate finance professional. In
my opinion it is one of the best books available on
M&A and valuation).

Winstbegoocheling – Handboek voor de kritische

controller (2016). Loek Radix. Publisher: Eburon.

Dealing with operating leases in valuation (1999).

Aswath Damodaran. Stern School of Business New
York.
Topic 5

M&A closing mechanisms –

Locked box & Completion
accounts
Source used:
• Winstbegoocheling – Handboek voor de kritische controller (2016). Loek Radix.
Publisher: Eburon.
• Investeren & Financieren: 2nd edition. Author: Taco Rietveld (2017). Publisher:
Vakmedianet.
Closing a M&A transaction
In a buy side M&A process, so when you try to buy a
company, you place a first bid on a company based on
“enterprise value” (EV).
And then later after the “due diligence” (DD) the
“adjusted net debt” ( * ) is deducted from EV. This in
order to get to the price of the shares or equity value.
When final agreement is reached about the terms and
conditions of a M&A transaction, then lawyers can draft
the share purchase agreement (SPA).
Concerning the SPA there can be two different flavors for
the "closing mechanisms":
1. “Signing date” is the “effective date”;
2. “Closing date” is the “effective date”.
Let’s now take a look at these two options in more detail.
“Signing date” is the
“effective date” (Locked box)
In this type of contract, the signing date of the contract is
the fictitious date of the M&A transaction.
A “final” price is then determined and the business is
then exploited (economically) on account of the buyer.
From then on no more cash is added to, or subtracted
out of, the business, and this is the “locked box”.
The problem with this “closing mechanism” is that the
business is already (economically) exploited by the buyer,
but (legally) he/ she is not the owner yet. Technically he/
she is only the ‘economic’ owner.
And the buyer only gets true ‘control’ at the date of the
‘legal’ delivery of the shares. At this date, the legal
closing date, the final purchase price can be determined.
“Signing date” is the
“effective date” (Locked box)
But this can cause some confusion.
Let’s imagine that in the SPA a price of 100 million euro is
agreed on for the shares. And let’s imagine that the
company has 20 million euro in net debt. The enterprise
value is than obviously 120 million euro.
But what if the company has generated 5 million in cash
in between the signing date and closing date. Technically
then net debt is reduced, which makes the EV 115 million
euro.
And what if 10 million is invested in this in between
time? Then EV would become 125 million euro.
This implies that in a locked box mechanism reservations
should be made concerning the price (in terms of EV) at
signing date. Since the EV at closing date forms the input
for the PPA (‘purchase price allocation’) of buyer.
“Closing date” is the “effective
date” (completion accounts)
With this technique of agreement the price is temporarily set
at the signing date.
And afterward the business is also formally (legally &
economically) exploited by the buyer.
But the risk is that the seller misuses the company until this
closing date, they can for example:
· Don’t invest in necessary assets anymore;
· Don’t do any maintenance on the buildings;
· Don’t pay of the suppliers;
· Collect the money from accounts receivables dis-
proportionally;
· Etc.
So with “completion accounts” these risks need to be
addressed in the contracts.
“Closing date” is the “effective
date” (completion accounts)
Basically actions/ activities that lower the value of the
business need to be taken up in the contracts, like:
· Taking out cash;
· Building down net working capital;
· Maintenance under a certain minimum;
· Not paying taxes;
· Taking up loans;
· Losing key personal;
· Etc.
Although, most of these risks are “automatically”
addressed with using the concept “adjusted net debt”.
I will get back to this when I summarize this method
(completion accounts) later on in this article.
Summarized: Locked box &
completion accounts
So we have concluded that the price for the shares
of companies are generally based on:
1. A fixed enterprise value (EV);
2. An effective date;
3. (Adjusted) net debt.
From the “effective date” on the business is
exploited on behalf of the buyer (economically). At
this moment in time he/ she is not the ‘legal’
owner yet, but he/ she is the ‘economic’ owner.
The (adjusted) net debt is taken from the balance
sheet 1 day before the “effective date”.
Summarized: Locked box &
completion accounts
So until this “effective date” the seller is the ‘economic’
owner.
When the “effective date” is BEFORE the date of the
legal delivery of the shares, then the buyer takes over
the company economically backwards.
(he/ she becomes economic owner first, and
subsequently he/ she becomes the legal owner)
Otherwise the “effective date” is 1 day after the legal
delivery date of the shares and balance sheet date.
And obviously: Price = EV – (adjusted) net debt at date
of the acquisition balance sheet.
Let’s now summarize the two closing mechanisms:
1) Locked box and 2) completion accounts.
Summarized: Locked box
With a “locked box” the price of the shares is fixed, because
of an available balance sheet for the acquisition.
The ‘legal’ delivery date of the shares is AFTER the “effective
date” (this is the “locked box date”).
The effective date is 1 day after the balance sheet date. Often
the balance sheet date is 31st December and the effective
date is often January 1st.
So from the effective date the buyer gets the cash flows (he/
she is the economic owner). But buyer possibly pays an
interest for the time in between effective date and legal
delivery date.
From the 1st of January (effective date) the buyer does NOT
have control yet, he/ she will only gets this at the legal
delivery date.
This “problem” of (no) control is taken care of with
prohibitions for “value leakage” in the contracts until the legal
delivery date.
Summarized: Completion
accounts
And with this method the seller will deliver the shares at the legal delivery
date for a provisional price.
This provisional price is based on an “adjusted net debt” of for example
the last annual report, or it is based on an estimated acquisition balance
sheet.
At least here the effective date is 1 day after the legal delivery date.
Within weeks after the legal delivery date a final balance sheet is put
together with unchanged valuation principles for the line items in the
balance sheet.
These valuation principles are written down very detailed in the contracts
(e.g. the principles to calculate adjusted net debt).
So due adjustment in the final price it does not make any sense for a seller
to for example pay out a dividend, or to build down net working capital,
before the legal delivery date.
This because the enterprise value is fixed already! And the rest will just be
settled anyway with “adjusted net debt”.
So after the legal delivery date, and after the acquisition balance sheet is
constructed, buyer pays (or gets) euro-for-euro when the “adjusted net
debt” is decreased (or increased).
Topic 6

Consolidation of M&A targets and

purchase price allocation (PPA)

Source used:
Winstbegoocheling – Handboek voor de kritische controller
(2016). Loek Radix. Publisher: Eburon.
M&A consolidation: An
introduction
How to consolidate a target company when you have bought
it is very complex from a bookkeeping/ accounting
perspective.
An important question is at what moment in time you can
consolidate a target company. The rules are here that it
should be done like with “normal” consolidation, so when you
have “control” in the target.
But with M&A there in general is a large gap between the
closing date of the deal an the first agreement on the
acquisition.
And even when you own the company already from an
“economic perspective”, this is not a criteria for consolidation.
The criterium here is still “control”, so the earnings that are
for the buyer (before you have legal control) need to be
deducted from the purchase price of the acquisition.
The opening balance sheet
Back in the old days you could just take the book values of the
acquisition target in your own balance sheet.
And then deduct the goodwill (difference acquisition price
and book values) from your equity.
Later on goodwill was put on the balance sheet and
amortized. But still goodwill was the difference between the
purchase price and the book value of the assets.
Nowadays (with IFRS) you need to look at the purchase price,
and you need to allocate this price to the bought assets first.
What is then left in the end in called “goodwill”.
But here fore you need to re-value all the assets of the bought
company to the actual value.
This including “assets” that are NOT on the balance sheet YET
(pre deal), so intangible assets.
Let’s now take a look at the most important assets that we
come across.
Inventories
The inventory of finished products need to be valued
on market value minus the costs that still need to be
made to sell those inventories.
The idea is that for the profit inside the inventory of
finished products is paid already in the acquisition
price.
And with a FIFO system (“first in first out”
administrated in the “costs of goods sold”) these
inventories are sold first post-acquisition. Which
means no profits in the first period after the
acquisition.
Fixed assets
All fixed assets need to be re-valued to real value.
Often for this external (asset) valuators need to be
consulted.
A higher value of the assets basically means more
depreciation and a lower profit.
So for an inhouse controller it is very important to
check, and understand, the asset valuation reports
carefully since it will impact the P&L.
Intangible assets
Basically here one (IFRS law makers) believes that the profit earning
capacity of a company is the result of two factors.
One, there are “hard” variables like the fixed assets, but also
intangible assets like:
· technological knowhow, software, patents, brand-names,
licenses, recipes, customer lists etc.
On the other side there are variables that are really immaterial like:
· the quality of people, accumulated knowledge and experience,
business culture etc.
After an acquisition there are many categories of intangible assets
that need to be identified:
1. Marketing related (e.g. brand names, logos);
2. Customer related (e.g. customer lists, customer contracts);
3. Contract related (e.g. licences);
4. Technology related (e.g. patents, recipes).
Intangible assets
The valuation of these intangible assets after an acquisition is
work of specialists. And this is often done by external
specialists.
We as M&A consultants, valuators and financial modellers
make assumptions here.
But be careful, because as mentioned, your assumptions have
an effect on for example the “accretion/ dilution” in a M&A
model.
So get advise from accountants, lawyers and PPA specialists
here when you are building you financial valuation model!
Although, for the specific valuation of the bought assets,
future cash flows are isolated and allocated to these specific
assets (so called “asset write ups”).
After that you get intangible assets of a certain amount, and
amortization takes place on this amount.
Goodwill
When after the re-valuation of the assets is
something left (real value of the assets minus
purchase price), then we can speak of “goodwill” on
your balance sheet post deal.
Goodwill does not have to be amortized. But yearly a
company needs to conduct an impairment test on
this goodwill.
This is a sort of yearly valuation of the company/
business unit (think of a DCF valuation).
And this in order to check whether the goodwill is
still appropriate and legitimate.
Deferred tax liabilities (DTL’s)
Post-acquisition new assets (or asset write ups) are
realized, like intangible assets (or write ups) and fixed
assets (or write ups).
And over the new assets or “write ups” a DTL is
formed on the balance sheet.
From a bookkeeping perspective the asset write ups
are depreciated and amortised.
And the tax effect of this is yearly subtracted from
the DTL until it’s gone from the balance sheet.
Topic 7

How to adjust for “operating

lease” (under Dutch GAAP)

Source used:
Dealing with operating leases in valuation (1999). Aswath Damodaran. Stern
School of Business New York.
Operating lease and valuation: An
introduction
As mentioned, I am from the Netherlands. And under Dutch GAAP
(the Dutch bookkeeping/ accounting rules) we can still put
“operating lease” as an expense in the P&L.
And we can keep the debt involved with the operating lease “off
balance” for non-listed firms.
This in contrast to the IFRS (the European bookkeeping/ accounting
rules for “listed” firms), since IFRS 16 tells us to show the debt
involved with lease on the balance sheet.
In the Netherlands I still get questions from professionals on how to
treat “operating lease” in valuations. And this specific for non-listed
firms with annual reports under Dutch GAAP.
So I have decided to write this blog about it.
The source used for this blog is the classic article of “Aswath
Damodaran”:
· Dealing with operating leases in valuation (1999). Aswath
Damodaran. Stern School of Business New York.
In case you have not read the article, it is highly recommended!
Operating lease in the P&L
Leasing is an alternative of borrowing money and
buying the assets.
This also means that lease payments are financial
expenses and not operating expenses.
And this obviously will have an impact on income,
debt and overall profitability.
So let’s take a look at how we need to adjust
“operating lease” since we can still find this expense
in annual reports under Dutch GAAP (in contrast to
IFRS).
Operating lease capital
adjustment
When operating lease is considered a financing expense,
then the present value of the future lease payments has
to be treated like “debt”.
To convert operating lease commitments into an
equivalent debt amount we need to discount them back
to the present. And here fore we use the pre-tax cost of
debt of the company.
The book value of equity of the company is unaffected by
this!
So the adjusted book value of capital = Book value of
capital + present value of future (operating) lease
payments.
Operating lease income
adjustment
If operating lease expenses represent fixed commitments
for the future, then they have to be treated as financing
expenses and not operating expenses.
This will have a big impact on operating income since
current “operating lease” expenses all sit in the operating
expenses.
So taking operating lease out will increase the operating
income!
Let’s take a look at the formula on how to calculate this:
· Adjusted pre-tax operating income = EBIT + imputed
interest expenses on capitalized lease.
Operating lease income
adjustment
But moving all “operating lease” costs to below EBITDA should have
no effect on “net income”.
This since we change the operating lease amount to:
1. Interest;
2. Depreciation.
And both items are “above” net income (so no effect in the end).
The only thing that can happen is that there are “timing effects”
with the net income earlier in the years being lower, and later in the
years being higher as a result of the re-categorization.
So the net income after the adjustments for operating lease with
look as follows:
· Net income = net income + operating lease expenses –
imputed interest expense on capitalized lease – depreciation on
capitalized lease asset.
Operating lease free cash
flow (FCF) adjustment
When operating lease expenses are treated as financing
expenses not only operating income is affected but also
the “net capital expenditures” (capex).
So to be consistent with the treatment of operating lease
as financing expenses, also specific capital expenditures
need to be taken into account.
We do this by looking at the present value of lease
expenses over time.
And then we take the yearly “delta” of the present value
of the lease expenses as a capex.
Let’s show this with a formula:
Net capex (t) = present value operating lease (t) – present
value operating lease (t – 1).
The effect of “cleaning
operating lease” on discounted
cash flow value
Firms with increasing operating lease expenses over time will have
net capital expenditures reflecting this growth.
The final effect on free cash flow (to firm) of treating operating
lease expenses as financing expenses will depend on two factors:
1. The reclassification of "operating expense" to "finance
expenses" will increase the free cash flow to the firm;
2. Any increase in the present value of operating lease expense
over time will have a negative effect on cash flow because it will be
treated as an additional capex.
And in the end there is no effect on free cash flow (to equity) with
this reclassification (operating lease expense to financing
expenses).
This because the increase in “capital expenditures” (created by the
change in present value of operating lease expenses) will be exactly
offset by the increase in “net debt” created by this reclassification.
The effect of “cleaning
operating lease” on discounted
cash flow value
Converting operating lease expenses into financing expenses
affects the firm by changing:
1. Operating income;
2. Net capital expenditures (capex);
3. Level of debt (and the “cost of capital”/ WACC).
Concerning valuation, we look at the “enterprise value” (EV).
We calculate this EV with the modified inputs and then we
take out the “net debt”.
And obviously net debt includes the debt associated with
“operating lease” as well!
And now we can conclude that changing operating lease into
a financing expense has no impact on the equity value.
When we value with “multiples” then this is another story, so
let’s now look at that situation!
Operating lease adjustments
to multiples
Many of the same issues as we have discussed before also
apply to “valuation multiples”.
“Multiples” are used all over the world to value companies
relatively easy.
If the multiple is an “equity multiple” (e.g. price/ earnings or
price/ book value) then there should be no effect from re-
categorizing operating lease.
But if the multiple is on firm value, in other words on EV, than
you really need to be careful!
We all know the multiple: Enterprise value/ EBTIDA.
When we have re-categorized operating lease this would look
as follows:
· Enterprise value/ EBITDA = (Market value equity + Market
value Debt + Present value operating lease payments) /
(EBITDA + operating lease payments expenses)
Operating lease adjustments
to multiples
Whether the EV/ EBITDA multiple will increase, or decrease, depends on
whether the “un-adjusted” EV/ EBITDA multiple is greater than, or lesser
than, the ratio of the “present value of operating lease expenses” to the
“annual operating lease expense”.
The implications for analysis where firm value multiples are compared
across companies can be profound in any of the following scenarios:
1. When some firms lease assets and other firms buy their assets;
2. When some firms treat leases as capital leases while other firms
qualify for operating leases.
In both situations converting (adjusting) operating leases to equivalent
debt will make EV multiples comparable!
So the rule with “financial statement analysis” and “valuation” is to always
adjust for operating lease!
Especially with multiples it is important to adjust for “operating lease”
first! 😊
This is not an issue anymore with IFRS (because of IFRS 16), but for Dutch
companies under Dutch GAAP this still needs to be done, as mentioned at
the start from this article! 😊
End …

Any questions …
Sources used
Investeren & Financieren: 2nd edition. Author:
Taco Rietveld (2017). Publisher: Vakmedianet.

(Ps. This book of “Rietveld” is highly recommended

to read for every corporate finance professional. In
my opinion it is one of the best books available on
M&A and valuation).

Winstbegoocheling – Handboek voor de kritische

controller (2016). Loek Radix. Publisher: Eburon.

Dealing with operating leases in valuation (1999).

Aswath Damodaran. Stern School of Business New
York.
More info on valuation …
About 60 articles on “Business Valuation” can be found on my linkedin page
under “articles”:

www.linkedin.com/in/joriskersten

Or visit my website for training in valuation (worldwide) & investment

consulting (M&A + Valuation):

www.joriskersten.nl

Joris Kersten, MSc RAB

Phone: +31 (0)6 8364 0527

Email: joris@kerstencf.nl
Training programs (real life)
The open training programs of Joris Kersten in The Netherlands/ abroad take place at the
dates below.
And for registration just write an email (joris@kerstencf.nl) or look at www.joriskersten.nl.

• 17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring.
Location: Uden/ The Netherlands;
• 24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring.
Location: Uden/ The Netherlands;
• 19, 20, 21, 22 and 23 July 2020: 5 days – Training with Certificate in Investment Banking.
Location: Dubai/ United Arab Emirates;
• 16, 17, 18, 19 and 20 August 2020: 5 days – Training Master Financial Modelling Specialist.
Location: Riyadh/ Saudi Arabia;
• 28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal
Structuring. Location: Amsterdam Zuidas/ The Netherlands;
• 16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam
Zuidas/ The Netherlands.
100% online training program
On December 1st 2020 you can start (100% online) with obtaining your “Certificate
Investment Management” given out by “Kersten Corporate Finance” in The Netherlands.
In 19 webinars (19 topics) of about 3 hours each, I will teach you the key elements of
“investment management”. And this in 6 main themes.
After the webinars you practice with cases and exercises yourself, including questions from
past CFA exams (level 1, 2 and 3). In the cases and exercises I will also teach you to actively
use “Microsoft Excel” since this is an important tool in Corporate Finance.
The correct answers of the cases and exercises are also presented to you by webinars,
worked out in detail. This in order to check your own work.
When you have finished the 19 webinars and have practised with the exercises and cases (all
online), then there is an online exam to take (whenever you feel ready).
And when you pass the exam then you will receive the “Certificate Investment Management”
of “Kersten Corporate Finance”. (pass = grade above 5.5 on a scale of 10)
Your name, and certificate number, will then be mentioned in the register on
www.joriskersten.nl.
So for example your employer can then verify that you obtained the “Certificate Investment
Management” of “Kersten Corporate Finance”.
100% online training program
Level training:
Participants get from a "foundation" level to "intermediate" level. This takes about 1 month
to 3 months, depending on your own speed.
Foreknowledge needed for the training: A basic understanding of the Profit & Loss statement,
cash flow statement and balance sheet. Moreover, a basic understanding of Microsoft excel.
The “course manual” with all info and conditions of the training will be available in the week
of June 8th 2020.
And registration & subscription will also start in the week of June 8th 2020.
The 19 topics of the webinars, divided over 6 main themes are:
Theme 1: Key elements of investments
1) Asset classes and financial instruments. 2) Securities markets. 3) Mutual funds and other
investment companies.
Theme 2: Portfolio theory
4) Risk, return and the historical record. 5) Efficient diversification. 6) Capital asset pricing
model and arbitrage pricing theory. 7) Efficient market hypothesis.
100% online training program
Theme 3: Debt securities
8) Bond prices and yields. 9) Managing bond portfolios.
Theme 4: Security analysis
10) Macroeconomic and industry analysis. 11) Equity valuation. 12) Financial Statement
Analysis.
Theme 5: Derivative markets
13) Option markets. 14) Option valuation. 15) Future markets and risk management.
Theme 6: Active investment management
16) Evaluating investment performance. 17) International diversification. 18) Hedge funds.
19) Taxes, inflation and investment strategy.

The “course manual” with all info and conditions of the training will be available in the week
of June 8th 2020.
(will become July 2020 due to very busy agenda “after” corona)