Purchase price adjustment mechanisms are common in private M&A transactions to determine the final price to be paid by the buyer. However, the manner in which the price adjustment is made varies by jurisdiction. In the United States, it is common practice to adjust the purchase price in cash, any excess or shortfall of net working capital against a required level of net working capital, unpaid debts and unpaid transaction costs of target business at closing, with an adjustment made at closing based on estimates and followed by a post-closing adjustment. In the UK and Asia, what is commonly referred to as the “locked box” approach is more frequently used, particularly in auction processes, corporate exclusions and private equity transactions .

What is a locked pricing mechanism?

The parties agree on a fixed price by reference to an agreed set of historical accounts – this is usually the latest set of audited financial statements, but sometimes it is unaudited management accounts or a set of accounts prepared specifically for these purposes – called “locked accounts.” Closed accounts price equity with respect to the cash, debt and working capital actually present in the target business on the date of the closed accounts and determine the price of equity that is written into the sales contract and purchase (SPA).

From the date of the closed accounts, known as “locked box date“, the target company is essentially considered to be managed for the benefit of the buyer – at least from a financial risk point of view – and worthless, or”leak”, is authorized to leave the company in favor of the seller. The box is therefore “locked”. Provided the box remains locked (more on that below), the SPA would include no purchase price adjustment and there would be no post-closing adjustment. This is a key feature of the “locked box” mechanism: the financial risk and advantage in the target pass to the buyer on the date of the locked box.

To assure the buyer that there has been no extraction of value by the seller or anyone related to the seller since the date the vault was closed (i.e. the vault remained locked ), the SPA will generally include protection for the buyer in the form of a dollar-for-dollar “no-leakage” indemnity. In practice, the seller confirms that there will be no leakage from the business in the period from the date of foreclosure until the date on which closing takes place by including a non-leakage clause in the SPA (which could also be backed up by safeguards), which may be subject to certain exceptions in the SPA agreed to by the parties, referred to as “leakage allowed.” In transactions where there is a gap between signing and closing, sellers also typically agree to additional protections for the buyer in the form of restrictions on their conduct of the business during the pre-closing period, such as requiring buyer’s consent before accepting large long-term contracts, purchase of major fixed assets, etc.

In return for operating the business between the closing date and the closing date for the economic benefit of the purchaser, the seller may sometimes request an upward adjustment of the consideration for this “capital gain”. In practice, the cash flow generated by the target company in the period between the blocking date and the closing date is often taken as the basis for determining the adjustment value. An alternative approach is an interest-based valuation adjustment applied to the equity value using an agreed rate of return to the seller for the period up to the closing date – this is sometimes called a “tick tock fee.“The rationale for these upward adjustments is that the buyer benefits from any profit made during the lock-in period without incurring the cost of maintaining acquisition costs. accrued value or listing fees – and we see this less when the target is a loss-making business – adjustments tend to be heavily traded.

When is a locked box approach to purchase price appropriate?

Depending on the situation, using a locked box approach for a purchase price may or may not be appropriate.

  1. Autonomous company: A lock box mechanism is more appropriate when the target is a stand-alone business in terms of maintaining separate accounting records with a history of reliable financial information, including when the target is a group of businesses (i.e. say there is a suitable box to block). It is less likely to be appropriate for a seller with multiple businesses that are spun off (eg, a spin-off or corporate restructuring) or with many affiliated transactions due to the increased risk of leakage.
  2. Seasonal Trade: A locked box approach is less appropriate for a target business that is subject to significant seasonality or a business whose short-term financial performance is uncertain, making it difficult to price the seller’s compensation for operating the business during the period prior to closing.
  3. Decline in commercial performance: From a buyer’s perspective, a locked box mechanism is less appropriate if there is a risk that the performance of the target company will deteriorate in the period leading up to the close.
  4. Long gap between signing and closing: A locked box mechanism is less appropriate if there is an expectation of a long gap between signing and closing.

Issues to consider

Locked accounts

The integrity of locked accounts is essential. From the buyer’s perspective, audited accounts will provide more comfort that a third party (the auditor) has reviewed and given an opinion on the quality of these accounts. In all cases, the Buyer will need to perform additional financial due diligence on locked accounts to ensure that it and its advisors are comfortable with the basis for the preparation and accuracy of such accounts. In this regard, if the time or ability to perform a financial check is limited for some reason, the locked account approach may not be suitable for the buyer.

Definition of leaks and authorized leaks

The SPA will contain detailed definitions of “Leak” and “Permitted Leak”. These terms are a key area of ​​negotiation, as they are the buyer’s primary protection against the seller and anyone connected with the seller stripping the target, and they provide the contractual basis upon which the seller will be able to make in-the-money payments. normal of things. – authorized leakage – between the closing date and closing.

Generally, leaks are defined to cover any transfer of value from the target to the seller (or its affiliates) between the lock date and the close. This may include items such as dividends and distributions; capital repayments; transaction fees; payments to directors; transaction-related bonuses and other unusual intra-group payments. Permissible leaks will depend on the nature of the target business, but generally include intra-group payments in the normal course of business and at arm’s length; identified items agreed between the parties and factored into the purchase price (eg dividend coupon/surveillance fees); payment of wages in the ordinary course of business; and debt-breaking fees, such as bonds purchased.

Funding issues

Third-party bank indebtedness, intra-group indebtedness and cash balances of the target business will vary through closing as they reflect, among other factors, the business activities of the target business, accrued and paid interest , loan repayments and additional borrowings. Although the firm’s actual cash and debt levels at closing are not relevant from a valuation perspective in a lock-in mechanism, the seller will not be responsible for funding cash and debt requirements. after the lockout date. The buyer will need to fund the target company to enable it to repay existing intra-group debt at closing and may need to fund the repayment of bank debt, depending on change of control issues and its own ownership structure. funding. The business will also need to maintain enough cash to continue operations. These issues mean that it will be important for a buyer – in particular, a private equity or other financial buyer using a leveraged finance buyout structure – to understand expected cash and debt flows and to forecast financing needs for closing, in order to be able to properly structure its financing arrangements at closing.

Tax protections

Sellers are unlikely to offer specific tax protection for the tax consequences of business operations after the lock-in date. Complex questions arise regarding the interplay between tax protections (eg a tax clause) and the locked box pricing mechanism, which will require detailed discussions with the seller’s advisors.

Advantages and disadvantages of a locked box construction

From the seller’s and buyer’s perspective, the locked box mechanism has a number of advantages and disadvantages related to value and process.

Is building the locked box the way forward for sellers?

Overall, locked box construction is sometimes seen as a seller-friendly option, given the greater certainty of value it offers, although the seller may lose the benefit of the anticipated growth of the business by closing unless it is captured in the title. price or whatever. While there is some truth to this idea, the full picture is more complex, and using a locked box construction can benefit both buyer and seller with the right set of facts and of circumstances – and whether they have appropriate advisers to help navigate the process. Private equity bidders on both sides of the pond tend to be comfortable with the locked box mechanism, and we continue to see cross-border private equity deals conducted on this basis. We have yet to see the same adoption of strategic acquisitions and – given the slower pace of deals in 2022 and the more cautious approach taken by strategic acquirers, especially state-owned companies – moving away from the comfort of a full adjustment after closing can take sometimes.