A critical period in the timeline of any M&A share transaction is the period between signing the Share Sale and Purchase Agreement and completion.
During the period between signing and completion, a buyer will be keen to ensure that the target business continues to operate as usual and without any events transpiring which could have a detrimental impact on the target’s operations or value.
A buyer will look to manage this risk in a number of ways. From a contractual perspective, in addition to imposing certain standard covenants which restrict the seller’s behaviour as regards the target post-signing, pricing mechanisms can (to varying degrees) help avoid any significant disconnect arising between the price paid and the actual value of the target as at completion of the deal.
Our business advice team takes a look at two types of pricing mechanisms used in M&A share transactions – the completion accounts mechanism and the locked box mechanism – as well as the relative benefits of each approach for parties to an M&A share transaction.
Completion Accounts Mechanism
In the context of an M&A share transaction the completion accounts mechanism is a common approach. In broad terms, this involves a new set of financial statements being prepared with respect to the target entity specifically for the purposes of the sale. Often a deal may provide for an initial completion payment and a subsequent adjusted and final payment, based on the specifically prepared completion accounts. In this way, the final price paid (sometimes by way of ‘top up’ by the buyer or alternatively by repayment by the seller) is retrospective and based on the target’s actual figures as contained in the final completion accounts.
Specific timelines, procedures and associated definitions for the completion mechanism will need to be agreed upon in the transaction documents, noting that generally this mechanism allows for disputes or challenges to the interpretation of the completion accounts (often with the involvement of an independent expert) and therefore the process does have the potential to extend the timeframe for conclusion of a transaction. Often a contentious area of the completion accounts, which is routinely challenged during this process, is the calculation of the working capital amount for the target.
For a buyer, particularly one which has not undertaken significant due diligence on a target, the completion accounts mechanism helps to provide a degree of comfort that the ensuing price adjustment to be made is based on a true, accurate and current ‘snapshot’ of the business as recorded in the completion accounts, even if it takes some time for this process to be finalised post completion.
Locked Box Mechanism
Conversely, in a locked box scenario the purchase price is calculated based on a balance sheet of the target which is dated prior to the deal completing. The purchase price is fixed (or ‘locked’) with reference to the earlier balance sheet date. In addition, from the locked box date the seller agrees not to engage in any activities which would result in any ‘leakage’ – which typically covers any transactions, payments or disposals resulting in the shifting of value outside of the target. The seller will typically look to negotiate certain ‘permitted leakage’ carve outs to the leakage provisions.
The locked box approach is helpful to sellers looking for clarity in pricing prior to completion. The locked box approach avoids lengthy or ongoing discussions between the parties around completion accounts and any associated adjustments of price arising from such accounts. This is particularly useful for sellers that are transacting in the context of a competitive bid or auction process, as the pricing mechanism gives a degree of certainty in the purchase price (as they are effectively pin pointing the pricing based on the locked box date prior to completion), meaning it is easier for bids to be compared against one another.
From the buyer’s perspective, as it does not have the comfort of the final adjustment accuracy which would otherwise be provided by a set of updated completion accounts, it is crucial for the buyer to ensure that there are strong protections in place preventing leakage from the locked box as well as adequate warranties, covenants and indemnities to ensure the target’s value is not eroded between the locked box date and the date of completion for the deal.
Competing commercial interests of buyers and sellers will lead to different price mechanics being used in different instances – and decisions are often dictated by the relative negotiating positions of the parties and the overall deal structure. In addition to a consideration of whether to use a completion accounts or a locked box approach, parties may elect to use other pricing mechanisms to structure payments including deferred consideration, earn outs and escrow arrangements. As with all M&A transactions, careful structuring of the deal and the use of pricing mechanics is one of a number of areas to address in the deal context to ensure a satisfactory outcome for both parties.