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Completion accounts have traditionally been favoured as the mechanism under which a buyer and seller adjust the purchase price for a target company. However, what is known as a "locked box" pricing mechanism has become increasingly popular over recent years and it is important for the parties to understand how each mechanism works and who it most benefits.
With completion accounts, a target is usually valued on a "cash free, debt free basis assuming a normal level of working capital" (this is the headline price and is known as the Enterprise Value or EV). The EV is then adjusted after completion of the acquisition to arrive at the Equity Value (which is the final price). To determine the Equity Value, a set of completion accounts is prepared which compares the estimated levels of cash, debt and working capital of the target at the completion date against the actual levels. An upwards and/or downwards adjustment to the price is then made accordingly. These accounts are usually prepared by a buyer, with the seller(s) then agreeing or disputing the figures proposed. To limit disputes, specific accounting policies and the basis of preparation of the accounts are agreed between the parties before completion. An expert dispute mechanism is also decided upon if no agreement can be reached.
With a locked box mechanism, the Equity Value is fixed before completion based on a set of agreed accounts (the Locked Box Accounts). The target company is then "locked" to prevent any payments being made to a seller (or someone connected to them) between the date of the Locked Box Accounts and completion. This means that the purchase price is agreed up-front and there is no subsequent adjustment. Usually the parties agree an EV to Equity Value "bridge" that adjusts the underlying Enterprise Value to calculate Equity Value taking into account the level of cash, debt and working capital in the target at the date of the Locked Box Accounts.
In our 2018 M&A Market Monitor Report, 84.5% of the deals sampled included a price adjustment mechanism. Of this, 51.5% used completion accounts and 27% relied on a locked box mechanism.
Locked box pricing mechanisms are well embedded in the UK M&A market and are commonly used on auction processes and private equity exits, as they give greater pricing certainty to seller(s) and make it easier to compare competing bids.
Overseas buyers have historically been reluctant to use locked box mechanisms, but their use has increased due to the prevalence of the mechanic in the UK market. Our M&A Market Monitor Reports from 2016 and 2018 show a 50% increase in the number of deals with overseas buyers that used locked box mechanisms during that two year period.
Below is a summary of some key points to think through when considering whether a locked box mechanism is appropriate for a deal:
A seller is very likely to require for certain payments to be permitted after the locked box date (for example, salaries to individual sellers or inter-group charges for services provided by another seller group company).Any permitted "leakage" items should be clearly set out in the acquisition documentation and the price adjusted in the EV to Equity Bridge accordingly to reflect these payments.
The buyer will benefit from the profits of the target after the locked box date, so the parties usually agree a mechanism to "compensate" the seller(s) for the loss of such benefit.This can be done as an agreed % interest payment added to the price or as an estimated agreed daily rate of profit for each day from the locked box date until completion.Agreeing a daily rate can be difficult if the period between the locked box date and completion is long and the financial performance of the target is likely to vary during this period.
For a locked box mechanism to work, it is fundamental that the Locked Box Accounts are sufficiently robust for the buyer to be comfortable to agree pricing on that basis.Locked Box Accounts are not always audited, but the buyer will need to carry out financial due diligence which rigorously tests the accounts.The buyer will also be looking for strong warranties on the Locked Box Accounts (potentially stronger than usual management accounts warranties) to give additional comfort on accuracy of the information contained in the accounts.
If the target business or service line is being sold from a larger corporate group (even in a SPV) and there are no stand-alone historical balance sheets for the target, it may be more difficult to rely on Locked Box Accounts as the buyer may not be able to get comfortable with the group accounting information available on which to base pricing for a set of Locked Box Accounts.
Usually a buyer will want to keep the gap between the locked box date and completion as short as possible to minimise any changes to the target during this period which could affect the pricing of the deal.It may not be appropriate to use locked box accounts where there is likely to be a long period of time between exchange and completion.
In a locked box mechanism the seller(s) gives the buyer a £ for £ indemnity for any "leakage" of value to the seller(s) (or persons connected with them) between the locked box date and completion.The usual limitations on a seller's liability that apply to warranties in an acquisition agreement will not apply for locked box covenants, but separate (very limited) limitations may be agreed (usually only around the time period to bring a claim with no financial cap on liability).
A locked box mechanism can be difficult to use for a buyer who is repaying target debt at completion.A locked box mechanism will in effect fix the level of debt in the target at the locked box date, so if the amount of debt changes in the period between the locked box date and completion, the buyer will not have full visibility of the amount of funding required to repay the target debt at completion.
There is no "one size fits all" answer on whether parties should use completion accounts or a locked box mechanism. Clearly, however, it will be an important aspect of the deal for both buyers and sellers and they need to be comfortable with the position at an early stage.
This publication is intended for general guidance and represents our understanding of the relevant law and practice as at November 2019. Specific advice should be sought for specific cases. For more information see our terms and conditions.
11 November 2019
by Alice Gardner