Locked box transactions: Understanding the locked box mechanism

What is the locked box mechanism?

The locked box mechanism is a pricing approach used in company acquisitions that simplifies the deal by fixing the purchase price in advance: the buyer and seller agree on a price for the target company before the transaction’s completion.

The price is usually based on a specific set of pre-completion accounts, known as locked box accounts. These accounts can take various forms, such as audited year-end financial statements, recently available management accounts or a specially prepared pro forma balance sheet for the deal. The primary objective is to eliminate the need for price adjustments after the transaction is finalised.

Benefits and implications of locked box mechanism

Using the locked box mechanism offers several advantages:

  • Price certainty: Both parties involved can be certain about the amount they are paying and receiving.
  • Negotiation avoidance: Both parties avoid post-completion negotiations related to issues that may arise from completion accounts mechanisms.
  • Time and cost savings: Both parties save time and expenses by avoiding the drafting, negotiation and application of such mechanisms. They also reduce the risk of having to find additional funds after the transaction for post-completion payments.

However, there is a risk for the buyer when using the locked box mechanism. Although the economic risk shifts to the buyer from the locked box date, the seller retains ownership and control of the target until completion. Economic conditions affecting the target can change, leading to potential financial risks, similar to those in split exchange and completion deals.

Locked box transactions are most suitable for standalone businesses where the locked box accounts can accurately reflect the target company’s capital and debt. If the business is a division of the seller, using the locked box mechanism may be too complex to manage. Additionally, it is typically only applicable to share sales.

Locked box vs. completion accounts

The main alternative to the locked box mechanism is the use of completion accounts, which was traditionally more common. With completion accounts, the purchase price paid at completion (which can usually only be based on historic information) is adjusted by reference to the actual net assets of the target on the completion date (including its cash, debt and working capital) which are established after completion by the completion accounts. The adjustment can result in the buyer paying more for every pound over the expected net asset value (and/or over the target’s cash, debt and working capital) or less for every pound under.

Completion accounts are agreed upon (or determined by an independent accountant in the absence of agreement) after the transaction is completed.

While completion accounts are more common, they may lead to disputes about their calculation after completion. Buyers will need to find additional funds if the net asset value is adjusted upwards, while sellers may have to reimburse funds if it is adjusted downwards.  Both parties may want security for those post-completion payments.

Using locked box transactions provides a far simpler approach with almost total certainty and a real reduction in time and expense. However, since all financial risks and benefits transfer to the buyer from the locked box date, the buyer must be prepared to accept those risks and should conduct more financial due diligence. The buyer must also be protected from “leakage”.

Preventing leakage in locked box transactions

Buyers in locked box transactions aim to prevent any unauthorised value extraction or “leakage” from the target by the seller.   There is a distinction between “permitted leakage” and “leakage.” Permitted leakage includes payments in the ordinary course of business and specified items agreed upon in the accounts, which do not result in a price reduction.

Unsanctioned leakage, on the other hand, must be prevented (and remedied by an indemnity). Unsanctioned leakage include dividends, capital reduction, new management fees, inappropriate expenses, transfer of assets to shareholders, waivers of loans owed by the seller(s), unusual intra-group payments, and more..

Defining leakage and permitted leakage can be challenging as can identifying it once it occurs.

Seller protections in locked box transactions

Sellers, while transferring the risk and reward to the buyer from the locked box date, retain control of the target until completion. To compensate for this arrangement, sellers may seek daily charges or interest from the date of the locked box accounts until completion, to avoid a profit adjustment. This is particularly relevant when selling a highly profitable target, as the seller could have withdrawn profits by paying pre-sale dividends without appropriate covenants.

However, buyers typically agree to such compensation only when there is a substantial gap between the locked box accounts date and the completion date. The purpose of the locked box mechanism is to avoid using price adjustment mechanisms, and this approach helps maintain that objective.

How our corporate solicitors can help

With a strong sellers’ market and increased involvement of private equity firms in transactions, locked box transactions have become more prevalent. Evaluating the specifics of each deal is crucial to selecting the best ways to manage risk and improve the chances of success. The corporate team at Moore Barlow is available to assess your deal’s attributes, to help you select the right purchase price mechanism and to guide you through the process.