The deal flow in the M&A market continues to remain strong, so we thought that it would be relevant to look at the different ways in which price certainty can be achieved, specifically when considering the Locked Box and Completion Account options.
We have seen parties give consideration to completing transactions under a Locked Box process rather than using the traditional Completion Account adjustment mechanism.
Alternatives for achieving price certainty in M&A transactions
The traditional Completion Account adjustment mechanism involves an adjustment to the purchase price following completion. The adjustment is based on the accounts at the Completion Date and is prepared based upon principles that have been negotiated between the parties (which are usually set out in the sale agreement).
When a Locked Box process is used, the parties determine the purchase price based on a set of accounts prior to signing the sale agreement and this price is not subject to any post-completion adjustment. Some of the benefits of a transaction completing on a Locked Box basis include price certainty and speed of execution.
What are the differences between a Locked Box and Completion Accounts approach?
The main difference in relation to each approach is the date on which the economic risk is transferred between the parties.
When undertaking a transaction using Completion Accounts, it is common practice for the economic risk to transfer on the Completion Date.
However, when a Locked Box process is used, the economic risk is actually determined at a certain agreed date prior to closing. This date is usually the date of the actual Locked Box Accounts (Effective Date). The purchaser will assume any benefit or liability that arises after the Effective Date.
Set below is an overview of the differences in the key steps and timing of each approach:
Due to the time period between the transfer of economic risk and legal title (Economic Exposure Period), the purchaser will usually seek to include restrictions in relation to the conduct of the business. The purchaser will seek greater control over the business to ensure there are no fundamental changes and minimise any potential leakage of value. These restrictions often limit the type of contracts the business can enter into and can also extend to what liabilities can be incurred.
When a purchaser is considering a proposed set of accounts, which are to become the Locked Box Accounts, significant weight is often placed on their date (as a measure of their currency and proximity to signing). Generally speaking the longer the time period, the greater the likelihood that a change to the business has occurred (e.g. debt in the business has increased).
Other matters that need to be considered when determining the appropriateness of a Locked Box process concern the nature of the business and industry in which it operates. Specifically, a Locked Box process might not be appropriate if there is significant fluctuation in working capital, or where the business operates in a cyclical industry or there will be significant expenditure or lumpy revenue from the Effective Date.
What are the advantages and disadvantages of a Locked Box process?
Set out below are what we believe to be some of the key advantages and disadvantages of undertaking a transaction via a Locked Box process:
|Price certainty||Time period between the economic and legal transfer|
the negotiation of the principles that govern Completion Account;
preparation of Completion Accounts; and
potential disputes that come with Completion Accounts.
|Negotiations focus on restrictions during the Economic Exposure Period|
|Speed of execution||Potential for the seller to extract or not maximise value during the Economic Exposure Period|
We often have parties query whether a seller under a Locked Box process would behave differently during the Economic Exposure Period, as they have little motivation to maximise performance, given that the benefits usually accrue to the purchaser. This query is usually put to bed when reminding the parties of the execution risk which has the potential result of the seller being left with the business. The other way parties can minimise this risk is to actively work to ensure that the Economic Exposure Period is reduced as much as possible.
When determining what approach is to be used, consideration also needs to be given to a financier's position (where applicable) and whether they have a preference for either approach.
If you are involved in an acquisition and want to further understand if a Locked Box process is suitable for you, please contact us.
We have the experience to assist at each stage of a transaction from providing advice on a suitable structure to undertaking due diligence and preparing the necessary documentation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.