What's different in a locked box transaction?
How a locked box mechanism works
The locked box concept is an increasingly common way of dealing with the inherent uncertainties in predicting the shape of the business balance sheet at completion without resorting to a post completion adjustment process.
The principal objective in doing so is to give certainty on the cash consideration at the point the deal is signed, and to eliminate the distraction and resource commitment of a lengthy completion accounts process.
The locked box concept involves the vendor providing, and generally warranting, a balance sheet for the business being sold at a point in time (the ‘Effective Date’) before signing of the SPA, but generally as close as practicable to the potential completion date.
This Effective Date balance sheet is used to fix the equity price in respect of the cash, debt and working capital actually present at the Effective Date.
The resulting equity price is written into the agreement as an amount and paid by the purchaser at completion. This price is not adjusted further following completion, and the sale and purchase agreement will not require the preparation of any completion accounts.
As a result, the purchaser effectively takes on the financial risks and rewards of ownership of the business from the Effective Date. The vendor then ‘holds separate’ the business to be sold in terms of accounting for and capturing the value from its continuing business activities.
The overall approach leaves the buyer relying on contractual protection for the period from the Effective Date to Completion to ensure value is not stripped out of the business by the seller, for example through dividends, management fees etc. The seller typically indemnifies the buyer for specifically defined “leakage” transactions to provide a degree of comfort over this.
The vendor also typically agrees, via the sale and purchase agreement, to some restriction of its conduct of the business between Effective Date and completion in respect of activities that could significantly impact the value from the business, for example requiring consent of the vendor prior to payment of dividends, agreement of large or long-term contracts, purchasing large fixed assets etc.
Where the ‘stub period’ between the Effective Date and legal completion is long, the vendor will of course be keen to ensure they receive value for the element of profits between the Effective Date and completion. However, it is not desirable to introduce a price adjustment mechanism in respect of this stub profit period – to do so would effectively move back to preparation of a completion balance sheet.
Instead, it is common to include either a fixed daily amount of additional consideration to be payable for the period from Effective Date/signing to completion, or to agree that interest on the consideration for the business (net of Effective Date debt) will be payable for that period in addition to the consideration.
The rationale for this is that the purchaser otherwise has the benefit of the profit without, during this stub period, having the cost of servicing the acquisition cost.
In addition, the purchaser then settles the inter-company balances outstanding with the vendor at completion (just as they inherit the obligation to settle all other liabilities of the business at completion).
When a locked box mechanism is appropriate
The Effective Date balance sheet must accurately reflect the configuration, and resulting working capital and debt, of the business in the form in which it will be delivered to the purchaser.
The business being sold must therefore be stand-alone in terms of having separate accounting records and separable balance sheet balances, and in particular separate banking of cash and treasury management, at least from the Effective Date. The approach becomes far more complex if the business being sold does not stand alone from other operations of the Seller from an operational or accounting perspective.
Ideally there should be as few transactions as possible between the business being sold and the vendor group post the Effective Date.
Key elements in addressing purchaser concerns are likely to include the length of time between the base balance sheet and the likely completion date, the level of warranty and extent of due diligence available on the Effective Date balance sheet, and comfort on the ring fencing and accurate recording of profits and losses (critically the capture of cash), in the period from the Effective Date to completion.
The level of seller undertakings in relation to management of the business post-Effective Date are a critical element of protection for the purchaser, and a credible package of undertakings must be able to be provided (and adhered to).
In particular, purchasers will also need to be comfortable that the amount of inter-company balance they must settle at completion will be reasonable – typically either through a commitment that such amounts (in particular intra-group loans or financing balances) will not change following the effective date, or via strict limitations on the nature and extent of transactions between the business being sold and the vendor.
What does this mean for the negotiation and agreement of price?
The key difference for a locked box transaction, as opposed to one using a completion price adjustment mechanism, is that the balance sheet on which the equity value is based is available before signing. However, the equity value still needs to be calculated in the same way as for a deal with “traditional” completion price adjustment for debt and working capital. There will still need to be discussion and agreement of the impact of debt and debt-like items on the price, and the level of working capital at the Effective Date as compared to a “normal” level required by the business.
However, neither the buyer nor the seller will usually have any recourse after signing in the event they change their view on these elements of value. This means that both parties must factor their required work (to be comfortable as to the nature of the balance sheet items and working capital requirement of the business being sold) within the time limitations of the deal process to signing, or at least explicitly accept the risk resulting from any process limitations on their ability to do so.