Best Practices in Pricing: Locked Box Mechanism vs Completion Accounts

In M&A deals, deciding how to structure the share purchase agreement (locked box mechanism vs. completion accounts) is key. The locked box fixes the price based on past accounts, while completion accounts adjust it post-closing. This article examines their pros, cons, and factors affecting the choice.

Key Takeaways

• The locked box mechanism offers price certainty by using historical accounts with no post-completion adjustments, making it favored by sellers, while completion accounts allow for post-deal adjustments based on actual performance, appealing to buyers seeking accuracy.

• Using a locked box mechanism simplifies transactions, reducing negotiation time and costs; however, it can expose buyers to risks of value leakage if sellers make changes prior to completion.

• Factors like transaction specifics, bargaining power, and due diligence requirements heavily influence the choice of purchase price mechanisms in M&A transactions, highlighting the importance of tailoring the approach to each unique deal.

Understanding Purchase Price Mechanisms

At the heart of any M&A transaction lies the purchase price mechanism, a critical component that determines the final purchase price for the target company. This mechanism is not just about setting a price; it’s about managing value erosion and ensuring that both parties get a fair deal. The purchase price adjustment mechanism is designed to address fluctuations in value between the signing and closing of a deal, making it an essential tool in the M&A toolkit.

Different transactions have unique characteristics that influence the choice of purchase price mechanism. Factors such as the financial health of the seller and prevailing market conditions can significantly impact whether a locked box or completion accounts are preferred. Buyers often lean towards completion accounts due to their post-completion accuracy, while sellers favour the locked box mechanism for the certainty it provides.

The right purchase price mechanism mitigates risks and ensures the final purchase price accurately reflects the business’s value. It provides a transparent approach that addresses fairness and risk management, making it a cornerstone of successful M&A transactions.

Overview of Locked Box and Completion Accounts

Purchase price mechanisms like the locked box and completion accounts play a pivotal role in defining and agreeing upon the final purchase price in M&A deals. These mechanisms are designed to ensure that both buyers and sellers receive a price that accurately reflects the value of the business.

The locked box mechanism and completion accounts method are two well-established approaches that provide transparency and fairness in determining the final purchase price. Each method has its unique features and benefits, making them suitable for different transaction scenarios.

Let’s delve into each mechanism to understand how they work.

Locked Box Mechanism

The locked box mechanism is a fixed-price deal based on historical accounts, where the purchase price is determined using recent pre-completion accounts. This mechanism is often favoured by private equity firms because it offers a high degree of certainty on the acquisition price, eliminating the need for post-completion price adjustments.

A locked box mechanism is effective when the purchase price is agreed upon at the locked box date and the ‘box’ is tightly locked to prevent any value leakage by sellers. Buyers also require indemnity for any value leakage, ensuring the integrity of the agreed financial terms remains intact.

In this scenario, the buyer assumes the risk of falling value of the asset while benefiting from any increase in value before the completion date.

Completion Accounts Method

The completion accounts method provides a more accurate picture of company value at completion. This approach allows the purchase price to be recalibrated based on financial figures established after the deal closes.

Completion accounts and produced post-completion. In short, completion accounts are a financial report on the target business as of completion. The parties will negotiate who is responsible for the production of the accounts. Generally, it is preferable to be the party producing the completion accounts, as this affords you greater control.

Key components of completion accounts include a closing balance sheet, profit and loss account, and detailed definitions for cash, debt, and working capital to avoid disputes. The Sale and Purchase Agreement (SPA) must include provisions for the preparation and validation of completion accounts, ensuring clarity and accuracy in determining the final acquisition price.

Types of Completion Accounts Bases

There are two main kinds of completion accounts bases: cash free debt free basis, and Net Asset Value (NAV) basis.

Cash free debt free basis

In short, under the cash free debt free basis, the purchase price is:

• increased if there is excess cash above the Target Working Capital (amount of working capital that the seller should leave with the business) (the cash-free element);

• decreased if there is a deficit in cash below the Target Working Capital; and

• decreased if there liabilities left in the business (the debt-free element).

Usually, the adjustments are made £ per £; e.g., if there is a surplus of £50k, then the purchase price is increased by £50k.

Net Asset Value basis

In short, under the Net Asset Value basis, the parties agree to a Target Net Asset Value figure. If the actual Net Asset Value as of completion (calculated according to the completion accounts), is:

• higher, then the surplus is added to the purchase price.

• lower, then the shortfall is reduced from the purchase price.

The surplus or shortfall adjustments can be made £ per £, or according to the multiple used to calculate the value of the business.

Key Differences Between Locked Box and Completion Accounts

The choice between a locked box mechanism and completion accounts often hinges on the specific context of the transaction, including factors like urgency for completion and the nature of the target business. Each mechanism has its own set of strengths and weaknesses, making them suitable for different scenarios.

One of the primary differences is how these mechanisms handle price certainty and accuracy. Let’s explore this in more detail.

Price Certainty vs Accuracy

The locked box mechanism provides purchase price certainty by prohibiting any post-closing price adjustments and relying on financial statements from a pre-determined locked box date.

On the other hand, the completion accounts method offers a more accurate final purchase price determined later, as it allows for adjustments based on actual financial performance at the completion date. While this method provides accuracy, it lacks the upfront certainty of the locked box mechanism, which can be mitigated by including a ‘cap’ and a ‘collar’ for price adjustments.

Complexity and Cost

The locked box method often simplifies the transaction process, leading to reduced negotiation time and costs. Agreeing on a final price upfront eliminates the need for ongoing adjustments, streamlining the transaction process. This simplicity is particularly advantageous in transactions requiring quick closure.

In contrast, completion accounts can be more complex and costly due to the calculations and reviews required to determine the final price post-completion. While this method provides precise adjustments, it also involves significant resources and time, making it less suitable for transactions where certainty and speed are crucial.

Pros and Cons of Each Mechanism

Understanding the benefits and drawbacks of each purchase price mechanism is essential for making an informed choice. Each method has unique advantages and potential pitfalls that can significantly impact the outcome of an M&A transaction.

Benefits of Locked Box Mechanism

The locked box mechanism allows for a predetermined price based on the latest financial statements, eliminating post-completion price adjustments. This provides less scope for uncertainty and dispute compared to completion accounts.

Additionally, the locked box mechanism is favored in transactions requiring quick closure without post-completion adjustments, saving time and costs by eliminating post-completion negotiations related to pricing.