EP200 · Economy · first published 2023-07-03
Closing and Structure in M&A | Tero Nummenpää, Ilkka Liljeroos | Negotiator 200
In the channel's two hundredth episode Tero Nummenpää, chair of Translink Corporate Finance, and Ilkka Liljeroos, managing partner at DLA Piper, work through the mechanics of the last day of an acquisition. First the bridge from enterprise value to equity value, and the misunderstanding that arises when a buyer names a number without saying which he means. Net debt covers interest-bearing debt, shareholder loans and tax liabilities but not trade payables; the working capital adjustment prevents gaming and evens out seasonality by comparing closing against a twelve-month average. Two things the tweezers of a business transfer cannot leave behind: employment liabilities and competition law liability. The open question is whether SaaS prepayments are working capital or net debt. Then closing accounts versus locked box, the rise in earn outs in DLA Piper's report, the multiple effect of an accounting error — a hundred thousand on the balance sheet is a million at ten times — and why the seller's leverage sits in the letter of intent and nowhere after it. Published 3 July 2023.
Closing and Structure in M&A | Tero Nummenpää, Ilkka Liljeroos
Summary: In the channel’s two hundredth episode Sami Miettinen works through the mechanics of the last day of an acquisition with Tero Nummenpää (chair of the board of Translink Corporate Finance) and Ilkka Liljeroos (managing partner at DLA Piper): what price is actually being discussed, how net debt and the working capital adjustment carry you from enterprise value to the bank account, and when to choose closing accounts over a locked box. Published 3 July 2023.
Start at the end
The episode is deliberately built backwards: nothing has happened unless the deal closes and the money lands in the account. So the first thing on the table is the bridge from enterprise value to equity value.
Nummenpää’s observation is that this is where most misunderstandings arise before anything is written down. A buyer tells a seller he will pay twenty million for the company, hands are shaken — and later it emerges that nobody knows whether the conversation was about equity value or enterprise value (EV). The difference can be large. His own practice is unambiguous: when he says the value of a company, he means EV.
The building blocks from EV onwards:
- Net debt. Add cash, subtract interest-bearing debt. Trade payables do not belong here, because they are not interest-bearing. Shareholder loans do. So do tax liabilities: if the company has made three million in profit in the first half and no prepayments have been made, part of that belongs to the tax authority even though no assessment has arrived.
- The working capital adjustment. More on this below.
Miettinen points out the asymmetry that determines where the negotiating effort should go: EV is a multiple and therefore geared, whereas net debt and working capital are balance sheet items and more static. The items are not worth the same.
Share deal or business transfer
Liljeroos’s distinction: in a share deal the shares are bought from the shareholders; in a business transfer the business is bought from the company itself. Miettinen’s description lands it: in a share deal you buy a security and with it the whole household, debts, liabilities and employees included; a business transfer is surgical work, picking the transferring items out with tweezers.
Two exceptions to the tweezers principle, which Liljeroos raises:
- Employment liabilities — accrued holiday pay and other employment-related liabilities follow the employee by operation of law.
- Competition law liabilities — cartel liability follows the business it belongs to. A deal therefore cannot be structured as a business transfer in the hope that the liability stays behind. Asked whether a very long specific indemnity could have moved it, Liljeroos is sceptical: you can agree such a thing, but is there cover behind it when the sums are large.
In large groups the business being sold may sit across several companies and have to be carved out — which on the investment banking side means a pro forma calculation of the transferring items.
The working capital adjustment: why it exists
Nummenpää starts from the question sellers almost always ask: we have two million in receivables — surely we get those too, on top? No. Receivables are a factor of production in the same way the factory machines are; they will still be turning over next year.
The adjustment prevents two things.
Gaming. Without it a seller would have an obvious incentive to delay paying suppliers and accelerate invoicing just before the deal, accumulating extra cash that would inflate the price.
Seasonality. For most companies sales swing over the year, and receivables and payables swing with them.
The mechanics: working capital at closing is compared with, say, the average of the preceding twelve months. If the average is 500k but at closing receivables stand at a million, it is fair that the seller is credited the difference — that money is about to arrive. For payables it works the other way round.
Liljeroos’s admission here is the most honest moment in the episode: the price mechanism is personally the hardest part of a purchase agreement for him to draft, and he still builds himself model calculations with very simple numbers and checks the pluses and minuses by hand. Both recommend the same practice: attach a model spreadsheet and two worked examples to the agreement, so that both parties read the mechanism the same way. Few people read the lawyer’s text — but it is precisely that text which gets read if things go wrong.
SaaS prepayments: working capital or net debt?
This is the episode’s most interesting open question, and both say so plainly: there are many opinions and no single right answer. A customer has paid a year in advance for the right to use software. Is that a debt owed to the customer (a net debt item) or working capital?
The money at stake is significant: as net debt the prepayments would be deducted in full. Nummenpää’s position as seller’s adviser is that it is a working capital item — the service is partly delivered, contracts do not provide for refunds, and in a growing company the item simply grows. Miettinen offers a common-sense criterion: does it turn on when the cost was incurred? If SaaS gross margins run around 89 per cent but half a year of service is still undelivered, that points one way; if the cost was front-loaded (installation), the other. Liljeroos adds that this is where negotiation begins.
The practical instruction from both: build a monthly model in which working capital, cost level and invoicing are modelled separately. Without it an adviser does not understand even the sign of the adjustment, let alone the monthly effect.
Closing accounts or locked box
Closing accounts. EV is agreed in advance, the buyer pays slightly less than the estimate at closing (19 million against an assumed 20 in the example), and the exact figure is calculated afterwards using the formula in the agreement, once the auditor has reviewed the numbers. The underpayment is deliberate — nobody wants to be refunding purchase price.
Locked box. The price is fixed in advance on a given balance sheet, whatever the balance sheet looks like at closing. It typically comes with a leakage covenant (the owners do not move money to themselves after the lock date), a business-as-usual undertaking, and a locked box interest compensating for the interim return.
Which to use? The episode gives not one answer but two criteria.
- Elapsed time. Liljeroos notes that with the merger notification threshold lowered there are more filings, and that in his experience the Finnish Competition and Consumer Authority is relatively slow — even simple matters can take a while, and recent cases he has been involved in have gone to a second phase. Under a locked box the business risk has passed to the buyer from the lock date, so a long delay is a risk for both sides.
- Accuracy. Closing accounts generally produce a price that is more nearly right relative to the target’s state at closing.
There is a dispute of its own around locked box interest, which Miettinen recognises from the zero-rate years: some took the word “interest” literally and concluded that under negative rates it too should be negative. Nummenpää’s position on the sell side is that the interest represents the probable return over the interim period after tax, not a two per cent coupon on the purchase price. The risk-free rate is a powerful anchor even where it should not be.
Both find that disputes over these matters are rare in Finland, which they attribute to a good advisory profession and to parties who understand the adjustment items.
Earn outs — and what goes wrong
The trend. Liljeroos cites DLA Piper’s Global M&A Intelligence Report: 800 transactions from last year, 200 of them Nordic, compared against 2,500 deals from earlier years. Earn outs were clearly more common in 2021 than in 2020, and in 2022 about 20 per cent more common than in 2021. The explanation is uncertainty: when a seller promises a doubling of EBITDA the buyer does not swallow it whole, but is happy to pay more if it materialises. An earn out closes the valuation gap that always exists — the buyer wants to buy tin and the seller wants to sell gold.
Nummenpää’s counterweight: a good monthly forecast model can remove the need for an earn out.
The risks worth handling in the mechanism: a second-year earn out carries a lot of gearing, and a buyer with control could in principle have an incentive not to run EBITDA hard. Both treat this as rare in practice — a listed buyer does not want to report a weaker quarter just to reduce a deferred payment, because it shows in its own share price. Liljeroos’s observation over the years: where there have been post-closing disputes, they have most often concerned deferred consideration — but very rarely relative to how many deals carry one.
The multiple effect. Nummenpää’s example of an accounting error is the most instructive passage. A bookkeeper has recorded as a receivable an item that is in fact a liability; a year later he notices his own mistake, does not dare tell management, and corrects it the wrong way, doubling the error. On the balance sheet it is a hundred thousand — but because it feeds through to profit and the price is ten times EBITDA, it is a million euros.
From which follows Liljeroos’s point: this is no longer damage to the company but the fact that the seller’s warranty about the accounts was untrue and the buyer overpaid. The difficulty is evidential — can the buyer show that the damage is calculated on the multiple? Is it a hundred thousand, or a million? And was the price based on the year the error concerned at all? The Finnish market has matured here, in his view: ten years ago people argued about direct versus indirect damage, where the field now understands the question to be what was reasonably foreseeable.
The letter of intent is where the leverage is
The clearest practical lesson in the episode. For Liljeroos the central element of an LOI is that expectations, deal structure and valuation are pinned down — so that it is not left unclear whether the conversation is about enterprise value or something else. A second element matters when there are several candidate buyers, some of them foreign, whose expectations of market practice may differ from the Finnish one.
A note on the source. There is a gap of about 28 seconds in the audio at 00:40:20, right at the start of this section. Nothing has been guessed to fill it: Nummenpää’s argument is reported below from the point at which the recording resumes.
Nummenpää makes the same case from timing: in a large deal the due diligence and the purchase agreement negotiation can cost a buyer a million, and nobody invests that without knowing the terms. The strongest negotiating position is when the LOI is being negotiated with seven or ten parties at once — after exclusivity has been granted the position is weak. So everything that matters to the seller, non-competes included, should be settled then. Liljeroos considers this reasonable from the buyer’s side too: it is a fair expectation that the seller will not set up a competing company next door, and it serves nobody for the point to surface as a surprise in the final metres.
Miettinen’s summary: Translink’s LOI is not an indication with an exclusivity agreement riveted to it, but a summary of the transaction’s key terms.
In passing, both note that management employment contracts are always left until last, even though they touch people most personally and provoke the strongest reactions — and even though far less money is at stake in them. Similarly, salary adjustments should be raised early, because they affect EBITDA and therefore run through the multiple; they should not be raised the day before signing.
Advice to an owner-entrepreneur
Nummenpää: first understand how the price is determined and what affects it. He also notes that a twelve-month average may not be a sensible normal level of working capital if the business has doubled in a year — a growing e-commerce business can add a million euros of inventory in a year. Take an adviser into these conversations, and if not us then somebody else.
Liljeroos: ask every question you have. If you do not understand what the lawyer or the banker is saying, ask — explaining it is their job, and if they cannot, they have failed at it.