Historically, M&A transactions typically used a completion accounts pricing mechanism. As the market has evolved, buyers and sellers have sought to reduce the often lengthy process of preparing, reviewing and potentially disputing final price adjustments derived from the completion accounts. As a result, the use of a locked-box mechanism has become an established feature of the deals market, particularly with private equity sellers. Over the past three years, based on circa 430 deals reviewed by PwC’s dedicated SPA team, we have noted that circa 50 per cent of deals have used a locked-box mechanism.
However, it is important to choose the right mechanism, as this is fundamental to protecting and maximising value in any transaction.
Overview of the mechanisms
While ultimately the appropriateness of a particular mechanism will depend on the deal specifics, based on the transactions sampled locked boxes are typically undertaken by:
- private equity sellers seeking a quick and clean exit;
- corporate sellers anticipating a buyer population primarily of private equity houses; and
- buyers looking to avoid overly onerous post-sale commitments, freeing up management to concentrate on the business.
Completion accounts have continued to be a feature of the deal market, particularly given the economic volatility of the past decade (in particular 2008 to 2010), and are often preferred:
- where the sale itself is complex, and there are structural complexities of the disposal group;
- where there is uncertainty over what the financial position of the business will be at completion; and
- by buyers who are more able to utilise the completion accounts process to extract value.
The locked box – how it works
A locked-box deal in its simplest form is a fixed price deal.
In the SPA, the final equity price is a known number, calculated based on a reference balance sheet (the locked-box balance sheet) at a pre-signing date (the locked-box date). Cash, debt and working capital are priced as at the locked-box date, and the final equity price is agreed between the parties and written into the SPA.
The SPA will also often include an ‘equity ticker’ or interest rate accrual mechanism to incorporate any increase in the value of the target business’ equity after the locked-box date up to completion. Theoretically, the net result using a locked-box mechanism (using an equity price at the locked-box date plus an equity ticker) should give rise to the same value as using completion accounts at the date of completion; however, the methodology and approach applied varies.
Buyers should give consideration to the equity ticker in relation to what they have already factored into their headline price valuation, as well as the need to diligence the ticker to test the robustness of the rate.
Locked box – why it works
The main reason buyers accept the use of a locked-box mechanism is that it protects a buyer from any value lost to the seller by the business (leakage) between the locked-box date and closing. The seller provides an indemnity that while there will be movements of value between assets and liabilities of the business (cash, debt or working capital) they will not extract value out of the business.
Parties will normally then agree certain permissible leakage items (permitted leakage). These amounts are then carved-out of the definition of leakage, and are specifically listed in the SPA. Common examples of permitted leakage are items like salaries or expenses paid to sellers, or items specifically priced in the equity price such as known dividends.
In the SPA, it is key that the seller properly discloses any known permitted leakage and for the buyer to appropriately diligence such matters and build this into their valuation.
The way these concepts are defined in the SPA becomes fundamental to whether the locked-box mechanism retains its integrity and all parties are kept value-neutral. Buyers will seek a broad definition of leakage, and a tightly specified definition of permitted leakage. Sellers would seek the converse.
Locked box – diligence considerations
For a seller, the key diligence considerations centre on presenting their view of the locked box balance sheet and directing how a buyer should arrive at an equity price, usually by producing a locked box memo. This memo would summarise the anticipated valuation approach in relation to cash, debt and working capital items, the target level of working capital and the equity ticker.
In Europe, we see sellers produce a vendor diligence report to streamline the process when multiple bidders are involved. Overall reliance on the report will go to the successful buyer. This report would typically cover the main trading performance of the business as well as adjusted earnings, net debt and normalised working capital.
From a buyer perspective and where there is no vendor report, buyers should look to focus their diligence on the following areas:
- the locked-box balance sheet;
- anticipated movements in the balance sheet between the locked-box date and proposed completion;
- the seller locked-box memo (including support for the interest rate ticker); and
- more focused diligence on pricing items that would affect valuation, such as their view of working capital and net debt to help determine their view of normal working capital.
Locked box – pros and cons
The locked-box mechanism is hugely beneficial to a seller:
- certainty of price: this is fixed at the time of signing the SPA;
- the buyer takes the forecasting risk: they pay for the expected profits between the locked-box date and closing, the downside risk of underperformance is borne by the buyer;
- competitive tension: all bidders are asked to show their hand before the SPA is signed and hence the competitiveness of their offer – the seller is in control of the deal tension;
- comparability: the seller is better able to compare offers as there is certainty over what bottom line equity price being offered; and
- speed and cost savings: when pricing is based on a locked-box balance sheet, there is no drawn-out debate over accounting policies, practices and preparation, there is no onerous review process and there is potentially no need to dispute a set of future completion accounts.
On the other hand, there are circumstances when it may not be appropriate to use a locked box:
- complex carve-outs or incomplete balance sheets: when there is a carve-out or poor financial reporting procedures, there is often no reliable, robust, historical financial information. Buyers are more reluctant to accept a locked-box principle where there is little certainty on what they are pricing at signing and for robustness regarding prevention and detection of leakage;
- declining business performance: a buyer would likely be resistant to accepting the locked-box principle if the target is loss-making, or if trading is volatile or in decline over the period to completion as negative equity tickers are very rare in SPAs;
- control over leakage: if the company has a large complex legal structure and operates cash-pooling arrangements or intercompany lending, then identification of leakage may become unduly onerous for the parties;
- bidder universe: some buyers are unwilling to use a locked box or are less familiar with the approach; and
- completion date: if there is expected to be a long gap to completion, the buyer may be unwilling to take on the forecasting risk. Typically we see a gap between the locked-box date and completion of around six to nine months.
Completion accounts – how they work
A completion accounts process allows the buyer to measure the value of the assets and liabilities they will inherit at completion. This is done by including specific rules and policies in the SPA that the parties must follow to prepare the completion balance sheet. A completion accounts SPA will typically reference an agreed headline price and a process and mechanism by which cash, debt and working capital adjustments are made to the headline price to get to a final equity price at completion. In determining how a particular item on the balance sheet will be treated, the SPA will tend to follow a three-tier hierarchy approach:
- reliance on specific policies (identified through diligence findings) and also additional policies to account for the fact that historical accounting practices will not always be appropriate for preparing a balance sheet for pricing purposes;
- consistency with past practice and application of policies, to the extent not contradictory to the specific policies; and
- accounting standards and generally accepted accounting principles as applied by the target business to the extent not covered by the specific policies and consistency.
When considering specific policies, we typically see a geographical split in the approaches taken. In Europe, deals tend to have greater focus on specific policies in the preparation of the completion accounts. Outside of Europe, deals tend to place more reliance on consistency and generally accepted accounting principles. The policies-based approach tends to lead to higher negotiation requirements pre-signing, whereas the consistency approach defers the need for negotiation to the completion accounts review process (see below).
As part of a completion accounts mechanism, consideration should also be given to who will prepare the completion accounts. We usually see the buyer prepare, as post-legal completion they control the business and therefore management. In general, it is preferable to be the preparing party as this allows the relevant party to set the tone of how the accounts are prepared and apply their interpretation of the policies – a first mover advantage. The opposing party is then given time to review and dispute elements of the completion accounts he or she deems to be non-compliant with the approach set out in the SPA. If unresolved, the parties refer the remaining matters to an independent expert (usually special practitioners at the larger accounting firms). The expert determination process is often onerous, requires time and is costly, and represents a further process to be managed. In Europe, independent experts act only as experts and not as arbitrators. Usually the process is drafted such that their view is final and binding and cannot be appealed unless there is manifest error.
While due diligence is undertaken by both the seller and buyer pre-signing, in general such procedures are less frequently scoped with completion accounts in mind. Therefore, increasing the scope of diligence to include an assessment of the judgemental accounting treatments implemented by the business and how this impacts valuation better informs parties in relation to SPA-specific policies.
Completion accounts – key considerations Accounting policies
Specific accounting policies form a key part of the SPA. Sellers prefer certainty, and may seek to use specific policies (rather than consistency) to create more certainty. To do this successfully, the seller needs to have sufficient knowledge and understanding of the underlying accounting and valuation issues to ensure a specific policy is defined that results in the desired outcome. Unintended consequences can materialise if the policies are drafted poorly or with an incomplete picture.
Completion accounts are prepared on a fully standalone basis for the sole purpose of determining the equity price of the transaction. They are not an opening balance sheet. Nor are they audited. Sometimes an audit is requested, and while this may give comfort to the relevant party, it does not impact pricing, as the SPA policies dictate the approach for the completion accounts.
Typically, the SPA will include a policy for reasonable access to books and records. In practice, buyers and sellers can have different views on what is ‘reasonable’. Sellers should plan ahead and ensure they have a good snapshot of the balance sheet position, together with supporting information, before handing over ownership.
In practice, it will be the management team who will be tasked with preparing, who are usually ‘GAAP’-focused and who may not take full consideration of the application of the SPA and specific accounting policies involved.
Manage the process
While sellers may not hold the pen on preparing, it is important that they take the initiative in managing the process. When significant value is at stake, it pays to determine and evidence one’s position as far as possible pre-completion, before access to books and records and influence of management shifts from seller to buyer.
When to negotiate and what to consider:
- Who is preparing the completion accounts? While practical considerations of who is best-placed to manage the accounting systems may prevail, in general it is preferable to prepare the completion accounts, as any potential areas of subjectivity can be approached to one’s satisfaction, with the counterparty being left to challenge these judgements through the dispute process.
- Will relying on consistency in the absence of specific policies result in a secondary price negotiation in the completion accounts process?
- Have the underlying accounting and other relevant issues been understood in sufficient depth to enable a specific policy to be defined without creating unintended consequences? Can the intended policy be applied by the target in practice?
- Control over management will switch. It is important for the seller to understand if this may impact management’s judgement when applying consistency clauses. Sellers should look to lock in the judgement where possible.
Value at stake in completion accounts and what gets disputed
Based on the transactions worked on by our dedicated completion accounts team over the past five years:
- post-completion, 64 per cent of deals identified previously unrecorded balance sheet liabilities;
- on average, 7 per cent of the headline price is adjusted through the completion accounts process;
- 7 per cent of completion accounts were referred to experts for determination; and
- in 71 per cent of our deals, accounting provisions and balances were the subject of disputes in the completion accounts; and
- errors are significantly more likely to occur in mid-month closes compared to than month-end.
It is critical, whether one is a buyer or seller, to:
- carefully consider the appropriateness of the price mechanism for the deal to minimise value and execution risk. It is important for parties to understand the key diligence needs under each mechanism;
- in particular under a locked box, buyers need to robustly test the historical locked box balance sheet and scrutinise forecast trading to completion. They also need to consider the valuation implications of any permitted leakage; and
- for completion accounts deals, greater diligence needs to be focused on judgmental accounting aspects such that a buyer or seller has a greater ability to draft and negotiate the right specific policies.