Most acquisitions of private companies include a working capital
adjustment. This is often a very sensitive part in the negotiation
of a private M&A deal. However, it is possible to do away with
it entirely by using the locked box mechanism. Under this method
the purchase price is determined based on a date that precedes the
closing date. A closing date balance sheet is not prepared and
there are no post-closing purchase price adjustments on account of
working capital. This method is popular in Europe and is gaining
favour in North America. If you are looking for purchase price
certainty and want to reduce post-closing price disputes, or are at
an impasse in settling a traditional working capital mechanism, the
locked box mechanism is something you should consider.
Traditional Working Capital Adjustment
Typically, the vendor and buyer in a private acquisition
determine a target working capital amount that the target company
must have on closing. To the extent the closing date working
capital is greater than the target working capital, there is a
positive adjustment to the final purchase price and vice versa if
there is a deficiency. Typically, the buyer pays the closing date
consideration based on an estimated closing date working capital.
Afterwards, a closing date balance sheet is prepared within a
specified time and an adjustment takes place, either disputed or
undisputed, to true up (or down) the estimated closing date
purchase price. This results in either the purchaser paying more or
the vendor returning closing proceeds (or foregoing proceeds in
escrow or held back).
Issues with Traditional Working Capital Adjustments
The working capital adjustment is a sensitive part of all
private M&A deals. The adjustment is critically important since
it directly impacts the purchase price – usually on a
dollar-for-dollar basis. Negotiating the target working capital is
fraught with disagreements, particularly in respect of seasonal
businesses. There are complexities with "normalizing"
working capital, determining an appropriate target and determining
the line items that should be included in, and excluded from, the
calculation. The process of negotiating disputes can be tricky.
Preparing a closing date balance sheet is expensive, as is dealing
with post-closing disagreements. Both sap management time and
How a Locked Box Mechanism Works
Under the locked box mechanism the buyer determines the value of
the company as of a date that precedes closing. This date, referred
to as the "reference date", is usually the end of a
fiscal period for which financial statements have been prepared.
The purchase and sale agreement is drafted so as to
"lock" the risks and rewards of the target company's
business from the reference date to the closing date. The vendor
represents as to the quality of the reference date financial
statements as well as to any "leakages" from the
reference date, such as dividend payments or below market
dispositions. Leakages are scheduled and reduce the purchase price.
Furthermore, the vendor covenants, among other things, not to
permit or cause any leakages from the signing date to the closing
date. The buyer pays the vendor additional consideration to account
for the time value of money between the reference date and the
closing date, typically in the form of a per diem akin to a daily
interest rate. Crudely, the final purchase price equals the
reference date determined purchase price, less the monetary value
of any leakages from the reference date, as scheduled, plus an
amount to compensate the vendor for the time value of money from
the reference date to the closing date. After closing, the buyer
has recourse against the vendor (ideally from the first dollar)
through the purchase and sale agreement's indemnities for any
leakages that are unaccounted for or are not permitted.
If the working capital negotiation is derailing your private
M&A deal, if you want more purchase price certainty or want to
limit expensive post closing price determinations, then a locked
box mechanism is something you should consider and speak with an
experienced professional about.
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.
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Under the Income Tax Act, the Employment Insurance Act, and the Excise Tax Act, a director of a corporation is jointly and severally liable for a corporation's failure to deduct and remit source deductions or GST.
Under the Income Tax Act, the Employment Insurance Act, the Canada Pension Plan Act and the Excise Tax Act, a director of a corporation is jointly and severally liable for a corporation's failure to deduct and remit source deductions.
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