Locked Box Mechanism or Completion Accounts: What’s Best for Me?
November 16, 2022
In a seller-friendly market, there is often a move towards a fixed price or locked box mechanism on a company sale. The locked box pricing mechanism works on the premise that the price payable for the target company or business is calculated before the acquisition agreement is signed, based on a set of pre-completion accounts drawn up to an agreed date. The agreed date is typically referred to as the ‘locked box date.’
There is no prescriptive form that locked box accounts need to follow but they are typically end of year accounts, recently available management accounts or a pro forma balance sheet specifically prepared for the transaction. Once the price has been determined by reference to the locked box accounts, the purchase price is fixed. It is worth noting that this has two key implications:
- The transaction is completed on the basis of a fixed equity price. This approach does provide certainty to both the buyer and the seller as at the time the acquisition agreement is signed, both parties know how much is to be paid or received. This approach may also be appealing to the seller because it avoids any post-completion price adjustments. It may also be appealing to the buyer as it does not have to incur any time and expense with negotiating a set of completion accounts, or the possible need to raise additional capital to fund a post-completion adjustment payment.
- Economic risk and reward flowing from a target’s performance pass to the buyer on the locked box date. This will mean that the buyer will often carry out extensive due diligence as it will not have the opportunity to test the level of assets once it has acquired control of the target. As this risk passes to the buyer whilst the target is still under the control of the seller, the buyer will typically require contractual provisions limiting the number of unauthorised payments or liabilities that the target can make or incur between the locked box date and completion of the transaction.
A locked box mechanism is typically less time consuming to draft because provisions relating to completion accounts are not required but there are two key areas that must be addressed in any acquisition agreement:
- Leakage. Economic risk of the target’s performance passes to the buyer on the locked box date but as the seller still continues to own and control the target, the buyer usually requires additional comfort in the form of undertakings from the seller to prevent any leakage of value from the target after the locked box date. The seller will typically then indemnify the buyer (i.e. pay to the buyer on a pound-for-pound basis) an amount equal to any leakage, subject to any agreed carve-outs. These carve-outs are usually called ‘permitted leakages.’ The acquisition agreement needs to clearly define leakages and permitted leakages, but examples of those leakages which are not typically permitted might be dividends or other distributions, returns of capital or payments to directors or connected parties. Any acquisition agreement also needs to cater for any payments that the target needs to make in order to operate in the ordinary course of business which would not be considered leakage. For example, payment of salaries should not be considered as leakage as that is a payment in the ordinary course. Ensuring these provisions are accurately drafted provides the buyer with comfort that the seller will not asset strip between the locked box date and completion and provides the seller with comfort that it can operate the business in the ordinary course.
- Pre-completion accrued value. Under a locked box mechanism, both the risk and reward of the target’s business pass to the buyer on the locked box date, but the seller does not actually receive the purchase price until the transaction completes. As compensation for this, the seller may require the buyer to pay daily interest throughout the period between the locked box date and completion, such interest being calculated on the purchase price.
Completion Accounts
When the buyer and the seller agree to adopt a completion accounts structure, the final purchase price is calculated after the transaction completes by reference to completion accounts. This allows the buyer to test, and ultimately adjust, its valuation by reference to the actual balance sheet that is prepared as at the date of completion. This differs from a locked box mechanism whereby the purchase price is fixed before the acquisition agreement is signed and completion of the transaction.
Completion accounts are commonly used for:
- Confirming consistency of a target’s financial position at completion. The buyer will typically base the price it is willing to pay on recently prepared financial statements. As the financial statements will reflect a historic position on completion, completion accounts enable the purchase price to be re-calculated to reflect the actual position at completion.
- Testing any financial assumptions underpinning the buyer’s offer and the seller’s acceptance. For example, if the purchase price is agreed on the assumption of a net asset value, if the completion net asset value is less than the assumed net asset value, the purchase price paid by the buyer will be reduced, and if the completion net asset value is more than the assumed net asset value, the purchase price paid by the buyer will be increased.
What do completion accounts measure?
The type of deal transaction will dictate what assets and liabilities are to be measured in the completion accounts and a range of factors can influence the buyer’s decision regarding financial metrics, such as:
- the buyer’s validation method for calculating its offer price;
- the nature of the target’s business; and
- the key value drivers in the target’s business.
Commonly adopted price adjustments
The most commonly adopted price adjustments based on completion accounts include:
- a net assets adjustment (i.e. an adjustment based on a pre-agreed net asset value to be achieved on completion and the actual net asset value on completion);
- a working capital adjustment (i.e. an adjustment based on a pre-agreed working capital value to be achieved on completion and the actual working capital value on completion); and
- a cash free/debt free (or net debt) adjustment (i.e., an adjustment based on the level of cash/debt of the target).
Structuring of completion accounts
Completion accounts serve a practical function rather than a statutory one and, as a result, the format, content and basis for preparation of these are driven solely by the demands of the transaction. The mechanics governing the preparation of the completion accounts are set out in the acquisition agreement. As to who prepares the completion accounts, this is a discussion point for the buyer and the seller as commercially it may be more appropriate for one party to draft them over the other. As there is no set form of completion accounts, it is essential that the acquisition agreement contains the basis on which the accounts are to be prepared. The period to which the completion accounts relate will be a negotiation point for the buyer and the seller, but they typically cover the period from the date to which the target’s last accounts were prepared, to the date of completion. It may be appropriate to also set a time of day to which the completion accounts are prepared, but that will depend on the nature of the business.
Whilst the final purchase price will not be known until the completion accounts have been agreed or determined, the buyer will typically pay a substantial provisional sum to the seller on completion as a payment on account of the purchase price. Once the completion accounts have been agreed or determined, there is then a further payment to (or a repayment by) the seller to the extent that the provisional price exceeds or falls short of the finally determined purchase price.
It is in both parties’ interests to ensure that the provisional amount paid by the buyer to the seller on completion is as close to the final purchase price as possible. From the buyer’s perspective, it does not want to have to rely on the clawback mechanisms within the acquisition agreement. In addition to the wasted costs and negative impact on cash flow caused by funding the initial overpayment, the buyer will also be exposed to the risk that the seller may be unable (or unwilling) to comply with its obligations under the clawback provisions.
From the seller’s perspective, apart from the obvious cash flow drawback, an underpayment at completion also carries a similar credit risk concerning the buyer’s ability to make the necessary top-up payment under the price adjustment mechanism.
Further information
David Salisbury is a partner in Teacher Stern’s corporate department. You can contact David at d.salisbury@teacherstern.com.
Arran Brooker is a senior associate in Teacher Stern’s corporate department. You can contact Arran at a.brooker@teacherstern.com.
David and Arran act for public and private corporates, institutions, individual entrepreneurs and management teams on a broad range of corporate transactions, including mergers & acquisitions, private equity and venture capital investments, joint ventures and shareholder structures in a variety of sectors including hospitality, sport and real estate.
