M&A Vocabulary – Expert Insights: “Permitted Leakage”

Permitted Leakage (permissible value outflow or allowed liquidity outflow) refers to specifically agreed-upon actions in M agreements that, exceptionally, may lead to a outflow of funds from the target company. This concerns value outflows at a stage where the buyer already bears the economic risk of the target company, but legally the seller is still the owner of the target company and can thus control it. However, since the consequences of a value outflow at this stage ultimately affect the buyer, it is essential for the buyer that only those value outflows are permissible (so-called Permitted Leakage) that they have taken into account when determining the company purchase price.

The reason for the buyer bearing economic risk without legal ownership of the target company lies in the point in time at which the buyer calculated the purchase price and when it is determined. This is because, in company transactions, purchase price determination can be linked to different points in time.

Firstly, the purchase price can be determined based on an exact valuation of the company at the time of legal completion (so-called Closing), i.e., at the time of the legal transfer of ownership to the buyer. In this case, the economic effective date (so-called Effective Date), on which the purchase price ultimately to be paid by the buyer is determined, and the closing date coincide. Since the final purchase price is calculated as of the closing date, it is generally irrelevant for the buyer’s purchase price determination whether distributions to the seller or other value outflows from the target company occur before the closing date. Such value outflows are taken into account as part of a purchase price adjustment as of the closing date.

Alternatively, the purchase price can also be agreed upon as a fixed purchase price at the time of signing the purchase agreement (so-called Signing). In these cases, the buyer calculates the fixed purchase price based on the company’s key figures as of a specific economic effective date (so-called Effective Date) in the past (so-called Locked Box Date). Often, the last balance sheet date of the target company (so-called Locked-Box mechanism) is used.

However, the buyer only becomes the legal owner of the target company upon completion of the company purchase agreement, i.e., at a time that may be long after the Locked Box Date. By agreeing to the fixed purchase price, the buyer already bears the economic risk from the Locked Box Date, and the target company is managed by the seller on behalf of the buyer from that point on. The buyer must therefore contractually protect themselves against value outflows outside the ordinary course of business that they did not include in their purchase price calculation based on past company key figures. For example, if profit distributions were made to the seller, related parties, or affiliated companies between the Locked Box Date and the closing date, this would economically represent a unilateral increase in the purchase price for the buyer without their ability to influence it. Such impermissible value outflows can take many forms, such as the granting of transaction bonuses or payment of transaction costs by the target company, the assumption of guarantees or sureties towards the seller, or contracts between the target company and the seller, as well as their affiliated companies, that do not stand up to an arm’s length comparison (so-called At Arm’s Length principle).

To protect against unplanned value outflows outside the ordinary course of business when agreeing on a fixed purchase price based on historical company key figures, the company purchase agreement must therefore, on the one hand, contain a guarantee for the period between the economic effective date and the signing date, in which the seller assures that no value outflows have occurred during this period that were not part of the ordinary course of business or specifically named (so-called No-Leakage Guarantee). On the other hand, a so-called No-Leakage clause is required, which prohibits value outflows between the signing date and the closing date. This is a behavioral obligation of the seller (so-called Covenant) that no outflows of funds outside the ordinary course of business occur, unless they are exceptionally permitted as Permitted Leakage.

For the buyer, it is therefore important that only those items are included as Permitted Leakage that they have considered in their purchase price calculation. Furthermore, these items must be precisely defined to avoid future disputes, especially regarding their nature, subject matter, amount, and timing of the outflow of funds.

The seller should note that a breach of the No-Leakage clause, depending on the specific contractual arrangement, can lead to claims for damages or indemnification obligations. Sometimes, to protect the buyer, it is also agreed that impermissible outflows of funds, of which the buyer becomes aware before the closing date, entitle the buyer to a reduction of the purchase price by the amount of the impermissible value outflow.

In summary, Permitted Leakage refers to an exceptionally permissible value outflow from the target company, specified in the company purchase agreement, which occurs at a time when the buyer already bears the economic risk of the target company, but due to a lack of legal ownership, cannot yet control and determine the affairs of the target company. The agreement of a Permitted Leakage always requires the inclusion of a No-Leakage clause, which prohibits other outflows of funds outside the ordinary course of business between the signing date and the closing date.

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