A recent article notes an increasing trend in the United Kingdom and European M&A market to using the "locked box" approach to determine the price for a target business in the context of a private M&A transaction instead of the conventional completion accounts approach. (O'Sullivan, McNaughton, Doe, "Pricing Mechanisms: Locked Box v. Completion Accounts", see here). We summarise the article below.
The primary difference between the two mechanisms is the date of transfer of economic risk. When a completion accounts mechanism is used, the buyer will pay for the actual level of assets and liabilities of the target as at completion in accordance with a post-completion pricing adjustment. The final price is not known for some time after completion. In contrast, a locked box mechanism involves the parties agreeing a fixed equity price calculated using a recent historical balance sheet of the target prepared before the date of signing of the sale and purchase agreement. Cash, debt and working capital as at the date of the locked box reference accounts are therefore known by the parties at the time of signing and there is no post-completion adjustment (other than for agreed "leakage" – see below). The economic risk and benefits of the business pass to the buyer from the date of the locked box reference accounts.
Each mechanism has advantages and disadvantages, some of which we summarise below.
The pros and cons of completion accounts include:
- Pros for seller: May speed up negotiations and conclusion of a deal as a buyer needs less comfort on the balance sheet before completion, and the seller retains the economic benefit in the business including the profits right up until completion
- Pros for buyer: Only pays for what it gets because price is adjusted, and in full control of business when compiling and checking completion accounts
- Cons for seller: Lless control over the adjustment process, takes economic risk of business up to completion, delay in ascertaining final price, and costs of preparing completion accounts and any potential disputes
- Cons for buyer: Delay in ascertaining final price, and costs of preparation of completion accounts and any potential dispute.
The pros and cons of a locked box mechanism include:
- Pros for seller: Certainty of price, increased control over the process, simplicity and avoids cost of completion accounts
- Pros for buyer: Certainty of price, simplicity and avoids cost of completion accounts
- Cons for seller: Does not get full benefit from continued operation of business in the interim period, and post-locked box interest rate, if any, is often insufficient to compensate the seller for the earnings of the target during the interim period
- Cons for buyer: Enhanced due diligence (particularly financial) often necessary, increased reliance on warranties, risk of business deteriorating between locked box date and completion, need to debate items such as debt and working capital earlier in the sale and purchase process.
Key issues that arise using a locked box mechanism include:
- The sale and purchase agreement must provide for "leakage", being any transfer of value from the target business to the seller or its connected parties between the locked box date and completion including, for example, dividends and other distributions, and management bonuses. The parties will need to negotiate what constitutes leakage and other categories of payment which are permitted (including, for example, inter-group payments in the ordinary course, agreed dividend payments, payroll)
- As a target business is priced as at the date of the relevant reference accounts and this is the date on which economic risk and reward passes to the buyer, sellers may ask for a specified rate of interest on the equity price, particularly when disposing of a profitable business (given the level of profits generated would remain in the business unless otherwise agreed).