M&A and Corporate Advisory Director at RSM Poland
Locked box is a formula for closing M&A transactions that is proving increasingly popular in recent years and tends to replace completion accounts. What is essential for the locked box arrangement is that the transaction price is determined on the basis of the historical balance sheet at a pre-signing date and is not then subject to any post-completion adjustment. Thus, it is a fixed-price deal. This approach it totally different from completion accounts, where price adjustments are the key element of the mechanism for setting the final deal price. I will try to discuss the completion accounts arrangement in a separate article.
As I have already mentioned, the basis for any locked box calculations is the historical balance sheet. What should be noted here is that the reference date (known as the locked box date) may be negotiated between the parties to the transaction. In particular in cases where the time gap between the balance sheet date and the date of the deal price calculation is so big that the data cannot be considered up to date. Such a calculation would make the acquisition price unreliable.
Bonus for the seller …
The locked box mechanism is primarily about a fixed price. However, according to the common knowledge and expectations of the parties to the transaction, business performance should improve over time. Therefore, it may seem that ruling out price negotiation options will mean that the seller will not benefit from the increased company value over the time (a couple of months, usually) that passes between the preliminary agreement and the final deal. In a nutshell: the seller will lose. In order to prevent it, the locked box provides for an extra consideration due to the seller and calculated for the said period in intervals agreed by the parties, e.g. monthly.
…and something for the buyer
Even though the acquisition price is locked, the seller may receive additional consideration regardless. What are the benefits of the locked box mechanism for the buyer? In simple terms, with the locked box the buyer protects himself from any unwanted actions the seller could take prior to the final transfer of the ownership of the target business to the buyer. As I have pointed out earlier, the equity value should increase over time, so the buyer wants to prevent a situation in which the seller could try to reduce this value in the course of certain actions.
It is pretty much standard for any acquisition transaction that the buyer secures his position through all kinds of statements and assurances required from and made by the seller for transaction purposes. In the locked box mechanism, the buyer receives protection primarily from leakage. Leakage refers to all kinds of extractions of value (outflow of funds, assets) of the target business between the locked box date and the date of completing the transaction. These may be, for example, dividends (actual or implied), management fees, and the transfer of undervalued assets and the write-off of receivables/liabilities. Clearly, the parties may agree on a permitted leakage that will cover any elements agreed and defined by them. What should be noted is that permitted leakage may, but does not have to, result in a price reduction. For example, any dividend paid out to the seller after the locked box date will diminish the price, whereas the payment of remuneration to employees in the course of regular business operations should not affect the price.
Locked box – doable or not?
As you can see, the locked box formula offers many benefits both for the seller and the buyer, the chief one being the fact that the final price is locked and there is no option of any later adjustments. This brings price certainty for both parties to the transaction, while the mechanism itself, as compared to completion accounts, is much simpler. The locked box formula is often used in the process of selling companies when there is a number of potential buyers involved. And even though the locked box has recently become very popular for closing transactions, you need to remember that this is not a solution that can be applied at all times and to any transaction.
The locked box formula cannot be used if there is no relevant balance sheet available that would permit a reliable price calculation.
The same goes for a situation in which there are many transactions covered by leakage in a given business. If that is the case, the buyer will most probably opt for completion accounts to calculate the price. One may also expect completion accounts to be applied more often in times of greater uncertainty, i.e. during a pandemic, for example. This results from greater caution on the part of the buyers and the need to constantly monitor the risk in the business environment of the target company (from the initial agreement to the final deal), as this may have a significant impact on the price. Under the circumstances of a pandemic, such risks include rapid changes of the relevant industry regulations in force.
The mechanisms used to determine the price in M&A transactions make a difficult element of the entire process; therefore, it is a good idea to rely on the support of a professional advisor. We encourage you to learn the details of our M&A advisory offer and to contact us.
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