Originally used predominantly by private equity investors looking for a clean separation at the conclusion of a transaction, the locked box pricing mechanism continues to gain traction in the South African and global M&A market. This article summarises the mechanism, considers its usefulness in transactions and explains how a purchaser can ensure adequate protection under this traditionally seller-friendly mechanism.
What is the locked box mechanism?
The locked box mechanism is a type of pricing structure used in M&A transactions. It is a way of determining the purchase price of a company based on its financial position at a specific point in time, known as the "locked box date". The locked box date selected will typically be the most recent accounting milestone date (eg year-end or half-year) which precedes the signature of the sale agreement. Occasionally, the locked box date can be after the signature date, but this is less common as this structure usually then results in a hybrid between the locked box mechanism and the other widely-accepted pricing mechanism, the completion accounts-based mechanism.
There are a few factors to consider when deciding on the locked box date:
- Timing of the transaction: to ensure that the financial position of the company at the locked box date is a good reflection of its value at the time of closing, the period between the locked box date and closing should be kept as short as possible.
- Stability of the company's financial performance: if the financial performance of the company is expected to be relatively stable, a longer period to closing can be accommodated.
- Audited vs unaudited accounts: the ideal is to select a locked box date at which the target's accounts are audited, as using reviewed or management accounts adds complexity and risk to the parties. In general, the risk of using reviewed and management accounts rather than audited accounts increases when the target has a higher accounting complexity.
- Other considerations: each transaction is unique and is likely to have its own specific considerations when deciding on the locked box date, such as the availability of financial information or type of information available, the need to allow for any necessary approvals or consents or taking into account a potentially seasonal business.
The fundamental commercial principle of the locked box mechanism is that the risk in, and the reward of, the business transfers to the purchaser from the locked box date. The parties will agree a fixed purchase price for the company based on its financial position at the locked box date, which will not be adjusted for subsequent changes in the financial performance or condition of the company after that date. The seller then typically assumes the risk that the company is as it is represented to be in the financial statements at the locked box date. This risk will commonly be placed on the seller through warranties, indemnities or other contractual means, but could also be done commercially through, for instance, the seller taking out warranty and indemnity insurance. The purchaser in turn then assumes the risks, and enjoys all of the benefits, that materialise to the company on and after the locked box date.
The locked box mechanism is often compared with the completion accounts mechanism. The completion accounts mechanism is based on the core principle that the risk and reward of the company transfers from seller to purchaser at the time of closing. Under this mechanism, the purchase price of a company is then determined based on its financial performance at the date of the closing of the transaction, either on the basis of an agreed methodology (eg a multiple of EBITDA) or on an agreed baseline price which is then adjusted, up or down, based on the performance of the business between the signature date and the closing date, or a combination of the two. The reason it is referred to as a completion accounts mechanism is that the determination of the price adjustments occurs after the closing date, with reference to the accounts prepared at that date.
The completion accounts mechanism thus calculates the purchase price by comparing the actual financial performance of the company during the accounting period against a set of agreed-upon financial targets or benchmarks. If the company meets or exceeds these targets, the purchase price may be adjusted upwards. If the company falls short of the targets, the purchase price may be adjusted downwards.
What are the advantages of the locked box mechanism and when should it be used?
One of the key benefits of the mechanism is that it is simple to implement and clearly delineates price, risk and reward. This reduces the areas for contractual dispute and eliminates the often complex post-closing process involved in the completion accounts mechanism. As the completion accounts methodology is based on a date in the future, it has to cater for a variety of possibly complex fact patterns that can arise, in addition to having to establish and clearly document detailed accounting methodologies from which to determine the price adjustment. Implementing a completion accounts mechanism can also be a time-consuming strain on management in the post-closing period, when they are also focusing on a smooth transition to new ownership. In a bid scenario, or even bilateral negotiations, the overall simplicity of the locked box mechanism therefore often enables the parties to reach agreement on the deal faster than when completion accounts are used.
The mechanism gives both sellers and purchasers greater certainty of the funds flow at closing and affords sellers the ability to distribute the full proceeds of sale without any requirement for a retention to cover post-completion adjustments. This can be beneficial for sellers who intend to use the capital raised from the disposal for other corporate purposes. Finally, because the price is known in advance, it makes it easier for the purchaser to plan, source funding and secure the authorisations required for the purchase.
In a bid scenario, the fixed price element of the locked box mechanism also allows for a simpler comparison of the economics behind various offers. The differing adjustment terms related to offers using the completion accounts-based mechanism can make offers, even with a similar headline price or pricing mechanism (eg the price multiple), more time consuming to compare.
The mechanism is often appropriate for less complex transactions, as the complexity and cost of preparing detailed completion accounts is avoided and no post-signing discussions or disputes over these accounts occur. When using the alternative completion accounts mechanism, the seller continues to be involved after completion, even though it no longer owns or benefits from the target after completion, preventing a clean break.
When should an alternative pricing mechanism be used?
A completion accounts mechanism that better reflects a change in value is often more appropriate in situations where: (i) the financial performance of the company is expected to be volatile; (ii) the purchaser is not willing to take the business risk prior to completion; or (iii) the seller is confident that the target's future performance will yield it a better price. The use of the locked box mechanism should be carefully considered if the timespan between the locked box date and completion will be too long, due to the greater risk that the target's performance will change. Despite the purchaser taking the risk of the company pre-closing, as the seller remains in control and continues to run the company, there is a risk that value may be given away by the seller. Certain measures, such as a ticking fee or value accrual, can mitigate this for sellers, and a bring-down set of warranties on closing can mitigate this for purchasers, but the inclusion of these concepts is often complex and highly negotiated, reducing the relative simplicity benefit of the mechanism.
An alternative mechanism should also be considered in carve-out transactions. When the target has recently been carved out, the risk of leakage and of disputes relating to the locked box accounts is significantly increased due to the lack of stand-alone accounts. If the carved-out company being sold was highly integrated with the parent company, it will be substantially more difficult to separate the company's financials, resulting in uncertainty around its value. In such cases, an alternative mechanism that allows for adjustments to be made based on the company's future performance or the actual value of its assets is more appropriate. Additionally, if the company being sold has a significant amount of intangible assets which are not reflected in the financial statements (such as intellectual property, brand or customer base) then an alternative mechanism should be included with the locked box, or used on a stand-alone basis.
How can a purchaser ensure protection when the locked box mechanism is used?
As economic risk in the target passes to the purchaser at the locked box date, the primary concern for the purchaser is ensuring that it is sufficiently protected from the target deteriorating in value through either leakage or poor management. Leakage is the process of the seller extracting value (through cash flows or other value transfers to the benefit of the seller, such as dividends, management charges or other intragroup payments of a non-commercial nature) from the target in the period between the locked box date and completion. Leakage is usually protected contractually by securing undertakings from the seller to ensure that no leakage occurs, other than specifically agreed types or amounts (known as permitted leakage). If leakage occurs, the purchase price will usually be adjusted by the amount of the leakage (adjusted for percentage shareholding sold), either through an adjustment at closing, where the leakage is known at that time, or at post-closing, where the leakage is determined after closing.
To further mitigate against leakage and value loss due to poor management, the purchaser can include the concepts discussed below in the sale and purchase agreement (SPA) to preserve the target's value:
1. Restrictions on the seller
Through a comprehensive set of covenants, the purchaser can include restrictions upon and requirements for how the seller should operate the target between the locked box date and completion. Restricting the seller from operating the target in a way that could materially decrease the value of the target can ensure that the locked box price accurately reflects the target's value at completion. Examples of possible restrictions are preventing the conclusion or termination of material contracts, requiring consent of the purchaser for dividends and limiting the target to only ordinary course business.
Although the purchaser should ensure that the covenants are rigorous enough to protect against leakage and value loss, the covenants should be carefully drafted to permit the typical operation of the target. If drafted too stringently, the target may struggle to retain value in the period from the locked box date to completion.
2. Accurately recording leakage
Permitted leakage refers to the amount of cash or other assets that the purchaser can withdraw from the target after the locked box date, but before completion. Typical permitted leakages include ordinary course dividends (which can be an alternative to price escalations) and ordinary course intragroup supplies of good and services. The purchaser should ensure that the definitions of leakage and permitted leakage are defined as unequivocally as possible, granting permitted exceptions while securing value in the target after the locked box date. The seller and all potential related parties within the locked box provisions must also be accurately defined to prevent value being extracted in favour of a person not captured under the leakage provisions.
3. Warranties and indemnities
The SPA should include warranties in which the seller confirms that there has been no leakage from the target in the period between the locked box date and the signature date of the SPA, supported by a right to claim the amount leaked. This, coupled with covenants preventing leakage (other than the specifically-defined permitted leakage) up to completion, protects the purchaser for the entire risk period.
In addition to standard warranties, a purchaser may also seek more comprehensive warranties for the period between the locked box date and completion. These may include provisions addressing the required levels of working capital, payment of suppliers, the level of net assets, debt collection consistency, or any other areas of concern that would typically have been adjusted for through completion accounts, such as stock valuation or bad debts.
However, sellers may resist providing these warranties as they can dilute the fixed price concept of a locked box. As a result, it may be more challenging for a purchaser to secure this level of protection in a competitive or time-sensitive transaction.
The locked box mechanism has advantages that makes the mechanism useful in situations where the financial performance of the company is expected to be relatively stable over the short term, the seller requires a quick or clean exit, and for less complex transactions. Where the financial performance of the company is expected to be more volatile, or where the purchaser and seller want to take the company's future performance into account in determining the purchase price, an alternative mechanism is usually more appropriate. It is therefore important that the characteristics of the transaction and the preferences of the parties are carefully considered when deciding upon the pricing mechanism to be used in the SPA. If the conclusion is that a locked box mechanism should be used, purchasers should include the concepts discussed above in the SPA to ensure that they are sufficiently protected against leakage.