In Canada, private M&A transactions have long followed a familiar structure: the parties settle on a “cash free, debt free” price, which then must be adjusted post-closing to account for the target’s actual cash, debt and working capital (or other measures such as net assets) in an effort to reach the true “equity value” of the business. Calculating and settling these post-closing adjustments to the purchase price can frequently take many months and is one of the main causes of acrimony between buyers and sellers.
In light of these frustrations, it is perhaps unsurprising that one recent trend that has been gaining momentum—particularly in the UK and EU—is the use of “locked box” pricing to generate greater deal certainty.What is a locked box?
A locked box transaction at its most basic is a fixed-price deal. Under a locked box structure, the purchase price is set at signing and is calculated based on a recent balance sheet at a pre-signing date (the Reference Date). Cash, debt and working capital as at the date of the Reference Date are therefore known by the parties at the time of signing, and will often have been subject to independent audit review. Accordingly, there is no need for drawn out debate over which accounting policies and procedures are to be followed in calculating the post-completion adjustment, or with respect to the process by which those adjustments are to be reviewed (and potentially disputed).
From the Reference Date onwards—i.e. once the “box is locked”—the buyer effectively takes on the economic risk of the target business. The profits or losses made on the target business go to the buyers’ benefit or detriment. To compensate sellers for the opportunity cost of transferring their economic interest in the business at the Reference Date without being paid until closing, locked box transactions typically include an interest charge on the purchase price during the interim period.Benefits & key considerations
The most obvious benefit of using a locked box structure is that it provides certainty of price for both buyer and seller at the time of signing. Long popular for this reason among financial/private equity sellers, it is also increasingly favoured in the corporate world for allowing sellers to avoid the potential disputes that arise with the calculation of post-closing adjustments under the traditional approach. In an auction scenario, the ability to offer a fixed purchase price payable on completion can offer a significant competitive advantage for buyers. If asked for by sellers in the same context, it can also greatly simplify the process of comparing competing offers.
Yet while the locked box can drive value by providing simplicity of process and cost certainty, any buyer utilizing such a structure should be careful. With no ability to test and dispute a target’s reference balance sheet after the purchase price has been set, a purchaser must be comfortable that the balance sheet it is committing to is reliable. Thus, not only should a buyer ensure that it has comprehensively diligenced the reference balance sheet before committing to a price, it should also require that the reference balance sheet be sufficiently supported by appropriate warranties.
A further key task for buyers using this transaction structure is to ensure that the box is in fact “locked”. The concept behind a locked box is that between the Reference Date and closing, any changes in working capital will be mirrored by equal movement in net debt. However, for this to work, it is essential that no value “leaks” from the target business back to the seller during the interim period.
Therefore, buyers will need to ensure that, apart from leakage that is expressly negotiated (e.g., payments for management bonuses or target transaction costs) or otherwise permitted (e.g., transactions with affiliates on arm’s-length terms), no payments have been made that could benefit the seller. Thus, the seller will typically be required to undertake that, for instance, no distributions, dividends, payments or returns can be made to the seller or that no shareholder loans may be repaid, with recourse to be had if these provisions are violated. Where the target business is highly integrated into the operations of the seller’s larger corporate group, the task of “locking the box” can be quite difficult and may require a line item by line item review of which cash flows are arms’ length/ordinary course and which need to be subject to restrictions.
A final consideration is that locked boxes also do not normally provide the buyer with protection from ordinary course changes in the value of the business. Because buyers take on the economic risk and reward of the business following the reference date, a seller will not bring current the majority all warranties at closing thereby leaving the buyer with fewer rights of withdrawal. As a result, the structure may not be appropriate where the target business is of a seasonal or otherwise highly variable nature or where the interim period between the Reference Date and closing will be overly long.