For the sale of a company using a European-style share purchase agreement governed by English law, the use of a 'locked box' as the seller's preferred pricing mechanism is now more commonplace than the traditionally popular closing accounts.
Traditionally, English law-governed share purchase agreements have provided for the purchase price to be varied by reference to the net assets of the target as at closing or sometimes by reference to some other measure, such as working capital.
Following closing, the buyer and its accountants would normally draw up a set of closing accounts used to calculate the net assets, with a pound-for-pound adjustment to the purchase price, to the extent that the actual net assets exceeded or were less than a target figure agreed by the parties prior to signing.
The 'locked box' is an alternative pricing mechanism to closing accounts, under which the parties agree a price payable for the target based on a balance sheet (the locked-box balance sheet) that is drawn up and settled between the parties on an agreed date in advance of signing (the locked-box date). This date is often the previous financial year-end date or the date of the most recently available management accounts.
Private equity sellers have driven an increasing trend, particularly in the secondary buy-out market but more generally in competitive sale processes, towards locked-box deals (or fixed price deals as they are also known).
For a private equity seller, the attraction of the locked-box pricing mechanism is that:
- it allows a seller to resist closing accounts;
- it avoids the potential post-closing disputes which can arise with the preparation of closing accounts; and
- the full proceeds of a sale can be remitted to the private equity fund's investors upon closing, without the need for any retention to cover a potential post-closing adjustment to the purchase price.
In other words, this mechanism prevents a buyer from using the closing accounts process (where the buyer would ordinarily expect to have control of the relevant information) to renegotiate price.
In European deals, a locked-box mechanism is commonly stipulated up front in controlled auctions or other situations where a seller is in a position to dictate the terms of the share purchase agreement.
In general terms, the mechanism works as follows:
- the price is set by reference to the agreed locked-box balance sheet (essentially by adding cash and deducting debt and debt-like items represented on that balance sheet from the headline price to give the equity price);
- the selling shareholder confirms that it has received no 'leakage' from the locked-box date in the period up to signing and is restricted from doing so in the period between signing and closing;
- the buyer takes the benefit of trading from the locked-box date; and
- there will often also be some form of interest or purchase price adjustment mechanism applied to the equity price in the period from the locked-box date to closing. This is intended to reflect the delayed receipt of the sale proceeds by the seller and is often calculated by reference to the expected earnings of the target in that period, expressed as a percentage of the equity price (often referred to as the 'ticking fee').
In addition, a buyer may also be required to agree to repay or procure the target's repayment of indebtedness, which may include the repayment of shareholder loans.
For a seller, key considerations regarding the use of a locked-box mechanism will include whether:
- the equity price is fixed (plus the interest or daily earning amount);
- it ensures as clean a break as possible (ie, it avoids the need for a closing accounts process and the potential for drawn-out closing accounts-related disputes);
- it can enable a private equity seller to remit the full proceeds of a sale to its fund investors at closing;
- there needs to be a robust locked-box balance sheet to enable the buyer to price the deal and ring-fence and protect the business's assets to lock the box from the locked-box date to closing; and
- any restructuring of the target or carve-out transactions must be completed prior to the locked-box date, as a buyer will accept only financial information which represents the business that it will ultimately acquire on closing.
For a buyer, key considerations regarding the use of a locked-box mechanism include whether:
- it will be riskier for a buyer as there will be no opportunity to adjust the price (other than through a warranty claim, if applicable) once it has acquired the target and had a chance to verify its financial position – in particular, a buyer will not know at signing the precise level of target working capital and debt at closing (yet may have an obligation to repay such target debt at closing);
- a buyer may also be attracted to the clarity around the purchase price; however, in terms of funds required on closing, the equity price may not represent the full picture (eg, a buyer might also be obliged to fund the repayment of target indebtedness);
- a seller has control over the preparation of the locked-box balance sheet and a significant informational advantage; and
- a buyer bears the risk (and possible reward) of the target's performance in the period between the locked-box date and closing.
Ultimately, with the use of a locked-box mechanism, a buyer will need to become comfortable through its due diligence investigations with the locked-box balance sheet (this may require more financial or accounting due diligence than that undertaken when the buyer has the comfort of a post-closing true-up).
To assist, a buyer will usually seek a warranty as to the accuracy of such balance sheets, although private equity sellers have been increasingly successful in limiting the warranties and indemnities that they give. A buyer will also require a number of protections in the share purchase agreement to prevent the seller from being able to extract value (referred to as 'leakage') from the locked-box date to closing, other than any pre-agreed value extraction that can be factored into the purchase price (referred to as 'permitted leakage').
'Leakage' typically includes (other than agreed as permitted leakage):
- dividends from a target company;
- other distributions or returns of capital by a target company and any other sums paid to the seller or its connected persons which are not paid on arm's-length terms and in the ordinary course of business;
- fees and expenses incurred by the seller or its connected persons in connection with the transaction and other costs being put inappropriately through the target group;
- other payments made (including management, consulting, monitoring and directors' fees) or assets transferred to or liabilities assumed, indemnified or incurred for the benefit of the seller or its connected persons;
- the waiver or forgiveness of any amount owed to a target company by the seller or its connected persons;
- the waiver of any claim by a target company against the seller or its connected persons;
- loans made or interest paid by the target group to the seller or its connected persons; and
- the entering into of any agreement or arrangement by a target company with or for the benefit of the seller or its connected persons or giving any commitment for their benefit.
The leakage protections referred to above (and given by the seller at signing) generally take the following forms:
- a warranty that there has been no leakage since the locked-box date;
- an undertaking that there will be no leakage from signing until closing (together with other more usual pre-closing covenants – eg, that the business will be conducted in the ordinary course and no material acquisitions, disposals, commercial arrangements and/or restructurings will be entered into without the buyer's consent); and
- where there is leakage that is not permitted, the seller will make a pound-for-pound payment to the buyer or relevant target company (the buyer may also want to consider whether interest should accrue on this amount and/or whether it should lead to any walk-right).
For further information on this topic please contact Will Pearce or William Tong at Davis Polk & Wardwell London LLP by telephone (+44 20 7418 1300) or email ([email protected] or [email protected]). The Davis Polk & Wardwell website can be accessed at www.davispolk.com.
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