Completion or Locked Box
The prevalence of private equity in M&A transactions has led to an increasing trend in the UK to using the “locked box” approach to determine the final price for a target business rather than completion accounts.
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 at completion in accordance with a post-completion pricing adjustment. The final price is not known for some time after completion.
The economic risk and benefits of the business pass to the buyer from the date of the 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 “determined” 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.
The pros and cons of completion accounts:
- Pros for seller: A quicker deal as the 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.
- Cons for seller: Less control over the adjustment process, delay in ascertaining final price, and costs of preparing completion accounts and any potential disputes.
- 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 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:
- Pros for seller: Certainty of price, increased control over the process, 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, if any, is not enough to compensate the seller for the loss of earnings.
- Pros for buyer: Certainty of price, simplicity and avoids cost of completion accounts.
- 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:
- As the locked box date is pre-signing, the buyer takes the risks and rewards of trading by the business in the period between the locked box date and completion.
- The sale and purchase agreement must provide for “leakage”, being any transfer of value from the target business to the seller between the locked box date and completion including, for example, dividends and other distributions, and management bonuses. Other items such as capital expenditure might also require adjustments specified in the sale and purchase agreement.
- 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.
- A Locked Box mechanism can more readily accommodate a mid-month completion date.