Type : Focus Paper
A 'locked box' is an alternative approach to preparing completion accounts, in the context of calculating the purchase price for private M&A transactions. Locked box mechanisms rose in popularity in the UK in the mid-2000's, particularly for private equity exits. Although we suspect the underlying mechanism has been in quiet use for some years in Australia, the 'locked box' phrase has recently gained in recognition here. Locked mechanisms will likely become more common as M&A activity picks up in favour of sellers, so it is thus timely to look at their advantages and the factors to consider when employing them.
What is a Locked Box?
To illustrate, consider the following common structure for a private M&A transaction:
- the target is acquired on a 'debt free/cash free' basis, where the equity value equals enterprise value less net debt;
- the target is acquired with what the buyer considers to be a normal level of working capital;
- the enterprise value of the target is determined as a multiple of what the buyer believes to be the target's sustainable earnings, often a normalised EBITDA multiple; and
- there is a settlement period or 'gap period' between the signing date and the completion date, to allow for conditions to be satisfied prior to consummating the transaction, or for other reasons.
Under a traditional completion accounts approach, the purchase price is commonly expressed as a formula in the sale and purchase agreement (SPA) and paid as an estimate at completion. The purchase price is then adjusted after completion based on the difference in the working capital1 of the business between the figure used in determining the estimated purchase price (or some other reference figure) and the actual figure calculated from a set of special purpose completion accounts prepared as at the completion date.
Under a locked box mechanism, the purchase price is fixed by reference to accounts dated prior to signing the SPA, commonly called the 'effective date' or the 'locked box date'. Economic exposure to the target transfers from the seller to the buyer at the effective date, rather than at the completion date. There is no completion adjustment to the purchase price in the SPA.
The 'locked box' refers to the purchase price being locked in a box at the effective date, with no value leaking from the box through to the completion date.
We note at the outset that locked box mechanisms are not the revolution that some practitioners suggest, nor in our view are the benefits as pronounced. A locked box mechanism differs from a completion accounts mechanism more in terms of timing than the way in which the target is valued. Although a locked box mechanism may avoid some of the issues which affect a completion accounts mechanism, it will give rise to its own issues. These issues are explored below. Nonetheless a locked box is a useful alternative to traditional completion accounts approach, particularly for sellers.
The Benefits of a Locked Box
The main benefits of a locked box mechanism are:
- the purchase price is fixed at signing – giving the parties certainty;
- no provisions are required in the SPA to deal with completion accounts, which can be lengthy and heavily negotiated – saving the parties time and costs, and preserving goodwill in the negotiations; and
- the parties are not required to prepare completion accounts and deal with subsequent disputes – again saving time and costs, and allowing management to focus on the target business.
In addition, a locked box approach may make it easier for a seller to compare bids in an auction, as the tenderers will be asked to submit a fixed price based on a set of effective date accounts supplied by the seller in the due diligence pack.
The Seller's Agency
The Seller's Agency Explained
Under a locked box approach, the buyer prices the target as at the effective date. Thereafter the buyer accepts the risk and reward of owing the target in economic terms. The seller will continue to own the target until completion in legal terms. In essence (if not legally) the seller is operating the business as the buyer's agent during the gap period. We refer to this as the 'Seller's agency'.
The Seller's Position
Will the seller behave differently during the gap period
compared with a completion accounts approach?
There is little motivation for the seller to maximise the target's performance during this period, as the profits will accrue to the buyer (the exception being if the seller has the opportunity to receive an earn-out). However, the seller will be far from disinterested, as conditions to completion may not be satisfied, or completion may not otherwise occur, meaning the seller will retain the business.
One advantage of a locked box mechanism for buyers is that a seller is not motivated to manipulate the target business during the gap period to exploit any loopholes in the completion accounts adjustment, for example by delaying capex to boost cash. This problem does not arise under a locked box mechanism as balance sheet items at completion are irrelevant to the purchase price.
However a locked box mechanism may give rise to another issue. The seller may be motivated to exploit any potential 'leakage', or improper transfer of value from the target to the seller, in the period from the effective date to the completion date. This could be as obvious as a dividend or as subtle as incurring transaction costs, which the parties have agreed are for the seller's account, in the target. Leakage is discussed below.
The Buyer's Position
Will the buyer behave differently during the gap period compared with a completion accounts approach? Buyers normally hold concerns about the way in which the target business is run during the gap period. The Seller's agency will likely heighten these concerns. Buyer protections or 'gap controls' which address these concerns are discussed below.
Further, if the target's performance deteriorates in the gap period, the buyer may experience a stronger feeling of buyer's remorse than if such poor performance was for the seller's account. If so, the buyer may be more likely to try to walk away or renegotiate.
When is a Locked Box Mechanism Appropriate?
First and foremost, the buyer needs reliable effective date accounts to commit to a locked box mechanism. The buyer will not have the chance to test the target's balance sheet through completion accounts. Consequently the buyer will seek accounts that are not out of date at signing, and will want them audited. The seller should also expect the buyer to:
- undertake thorough financial due diligence on the effective date accounts;
- require strong warranties relating to the effective date accounts;
- require strong warranties relating to the target's operations and performance since the effective date.
Under a completion accounts approach, the buyer will usually be in control of preparing the completion accounts. Unless the SPA contains specific rules about these things, the buyer is in a stronger position to put forward its view of the appropriate value for certain items, like distressed inventory or doubtful debtors. With a locked box, the seller is in control of preparing the effective date accounts. Even after thorough financial due diligence the buyer may still be taking a risk on the value of the assets shown in the effective date accounts. This may be an advantage to the seller. Then again, the buyer can simply price in this risk through a lower purchase price.
If special purpose effective date accounts are required, this may cancel out the benefit, under a locked box mechanism, of not having to prepare completion accounts. Management time will be spent preparing, explaining and negotiating the treatment of effective date accounts, rather than completion accounts. Moreover, the warranties relating to the effective date accounts may give rise to subsequent disputes that merely take the place of disputes over the completion accounts.
A locked box mechanism will not be appropriate if:
- the buyer does not trust the seller or the incumbent management team to run the business during the gap period, or otherwise wants full control over the target – this is an obvious consequence of the Seller's agency issue, although it may only be relevant for turnaround or management buy-in deals. Otherwise, the management and the way they have run the target will commonly be one reason that the buyer is investing;
- the buyer believes that value has leaked from the target between the effective date and signing, or the buyer is otherwise uncomfortable with the target's activities or performance during this period – although the buyer can seek warranty protection on these matters, it will be easier to insist on completion accounts rather than to pursue the seller for warranty claims post transaction;
- the transaction involves a long or uncertain gap period – this will likely make the buyer anxious about the length of time during which the Seller's agency persists.
Some commentators have stated that a locked box will be inappropriate if the target is part of a larger corporate group. This may be the case if the buyer fears that the seller will exploit any opaque arrangements between the target and the seller group between the effective date and the completion date. Otherwise, the buyer will need to be comfortable with the strategy to 'disconnect' the target from the shared services provided by the seller group, and the consequences to the target's cost base, at the time of signing the transaction. This is true whether the parties agree to a locked box or completion accounts. The more important question to determine if a locked box is appropriate is whether the effective date accounts give a reliable picture of the target as a stand-alone entity.
Some commentators have also stated that a locked box will not be appropriate if the target has volatile working capital or earnings. In our view this does not necessarily follow. Firstly, the volatility of the working capital will need to be reconciled with what is considered 'normal' by the buyer. Again, this is the case whether working capital is calculated by reference to effective date accounts or completion accounts. Secondly, the volatility of the earnings is reflected in the price, usually a reduced profit multiple. Aside from the Seller's agency issue, there is no magic in the gap period – the buyer will own those volatile earnings long after the gap period has passed.
Considerations When Using a Locked Box Mechanism
As mentioned above, leakage refers to the seller extracting value from the target in the period from the effective date to the completion date. The parties will need to identify possible sources of prohibited leakage, and the sellers obligations in this respect are usually backed by an indemnity.
However, not every transaction between the target and a member of the seller's group will be improper, and the parties will also need to identify permitted leakage. There is ordinarily no reason why arm's length transactions between the target and the seller's group which are priced fairly should not be allowed to continue, at least until completion. Even leakage that is viewed by the buyer as being in excess of fair value or a value shift to the seller may be permitted by the buyer, provided it is visible and certain at signing, and there is a corresponding reduction in the purchase price.
If the target owes shareholder or intra-group loans, expect the buyer to control any increase in these loans during the gap period, not only for possible leakage but also to understand the proposed use of the funds.
Possible sources of 'leakage' include:
Possible sources of 'permitted leakage' include:
The buyer will normally insist that the SPA contain extensive covenants and indemnities to protect against prohibited leakage. The buyer will also demand that the monetary limits for warranty claims do not apply to claims for breach of such covenants and indemnities. In return the seller should demand a shorter time limit for bringing such claims (such as six months) than the time limit applying to warranty claims (normally at least one audit cycle).
'Gap controls', or covenants on the seller to ensure that during the gap period the target conducts its business in the ordinary course, and does not undertake certain actions without the buyer's consent, are almost always required by buyers under completion accounts deals. There is a tension between the seller wanting to get on with business during the gap period, particularly if there is a real chance that the deal will fall over, and the buyer wanting a say on material decisions affecting the business. These considerations will be heightened under a locked box deal, owing to the Seller's agency issue.
We note that lengthy negotiations on gap controls will erode to some extent the benefit under a locked box mechanism of avoiding lengthy negotiations on completion accounts provisions.
The buyer will request regular information flows during the gap period to monitor the target, although again this is also common under completion accounts deals. For example the buyer will seek to track movements in net debt, particularly if the target's performance from the effective date to the completion date may affect any proposed acquisition financing structure.
Proxy Profit Payment
The seller should seek to be compensated for the fact that the buyer receives the profits of the target from the effective date, but pays the purchase price at the completion date. This compensation payment could be viewed as a proxy for the forecast profits to be earned by the target during this period (albeit with forecast profits locked in, risk free to the seller), or a proxy for interest on the purchase price had it been paid at the effective date. Either way this is a matter for negotiation.
Summary of Pros and Cons for Locked Box Mechanisms
Locked box mechanisms are a useful alternative to a completion accounts approach, particularly for sellers. In the right circumstances, a locked box mechanism can save the parties time and costs, give the seller more certainty and allow the buyer to get on with business post completion. Notwithstanding, locked box mechanisms give rise to their own problems which mean the benefits can be overstated. For these reasons, they are likely to be most useful to sellers seeking a quick sale, or exiting target companies that are sought after and will generate competitive tension through an auction process.
Expect to hear more about locked box mechanisms as this overseas trend migrates to Australia and M&A activity increases.
1 Sometimes the adjustment encompasses a movement in the value of all net assets, not just working capital. The extent of the adjustment will depend on the type of business carried on by the target. There may also be an adjustment for any difference in capital expenditure against budget, again depending on the target's business.
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.