M&A Transaction: Balance Sheet Guarantees

- a gateway for damage claims in german law!

A comment by attorney Christian Mattlage, expert for M&A Transactions in Hamburg, Germany

In M & A consulting practice and especially with regard to downstream disputes, so-called balance sheet guarantees play a prominent role from both the buyer's and the seller's point of view. The balance sheets and annual financial statements of a company often represent an essential element, if not the most important element, of the due diligence performed by a buyer.

With the exception of start-up or turn-around transactions, where the target companies do not show any profit in their balance sheets, the results of a company are in most cases the starting point and the decisive indicator for determining the purchase price to be paid by a seller.

As a rule, purchase prices in business valuations are determined by applying multiples to earnings (EBIT or EBITDA). In other words, the amount of the purchase price correlates with the amount of earnings generated.

Protecting the buyer by issuing balance sheet guarantees

In this respect, buyers of companies have a strong interest in using balance sheet guarantees, which are to be issued by the seller, to protect themselves against the possibility that the reported earnings of the company are too high and that the buyer has paid too high a purchase price. In this respect, the form of such balance sheet guarantees is of major importance from both the seller's and the buyer's point of view.

Hard or soft balance sheet guarantees

Balance sheet guarantees can be structured in two ways. On the one hand, there are the so-called hard balance sheet guarantees, where the balance sheets must be measured against an objective standard. The objective balance sheet guarantee is based on the perspective of an omniscient balance sheet preparer.

On the other hand, there are subjective, i.e. soft, balance sheet guarantees. The subjective accounting guarantee is not based on the perspective of an omniscient preparer, but merely requires a certain standard of care in determining the facts and estimates relevant for the annual financial statements.

The form of the balance sheet guarantees is quite essential for the corresponding legal consequences in the event of a breach of such a guarantee. Buyers regularly have an interest in hard (objective) balance sheet guarantees, while sellers prefer balance sheet guarantees that are as soft and subjective as possible.

Calculation of the amount of damages

The decisive difference between the legal consequences of a breach of an objective or subjective balance sheet guarantee is that the amount of damages to be paid by the seller is calculated completely differently.

According to a decision of the OLG Frankfurt am Main from 2015, in the event of a breach of a hard balance sheet guarantee by the seller, the purchaser is to be placed in such a position as if he had known of the actual, less favorable earnings situation of the company and for this reason possibly negotiated a lower purchase price.

This decision is of great significance in that the purchaser can assert a significantly higher claim for damages in the event of a breach of an objective balance sheet guarantee.

Advice from our consulting practice

In our consulting practice, our attorneys specializing in commercial and corporate law repeatedly find that the guarantees with regard to the balance sheets, which are included in the purchase agreement, are often treated quite neglectfully.

At this point, a pronounced economic and also financial understanding of the lawyer present in the purchase agreement can pay off for the client in particular.

Our consulting practice has shown that the interdisciplinary cooperation between our lawyers specializing in commercial and corporate law and our tax and accounting experts is one of the most important levers for achieving the optimal negotiation result for our clients.