In many acquisitions the parties will seek to agree the inclusion of an appropriate price adjustment mechanism. Often the aim is to test the valuation which is to apply to the target business and the mechanism may, for instance, be designed to test profitability, net assets or cash free, debt free and normalised working capital. In recent years transactions have adopted a locked box mechanism as an alternative to the previously more typical completion accounts mechanism for the testing of valuation.
This briefing note seeks to discuss some of the principal issues to consider when negotiating a completion accounts mechanism or a locked box mechanism. It will illustrate some of the similarities and some of the differences between the two approaches and, in consequence, will provide some guidance in relation to several matters to watch out for when considering either mechanism.
Where there is a completion accounts mechanism the reference accounts for the price adjustment will be the completion accounts, which are prepared following completion but which will speak as at completion. As a result, the extent of any price adjustment will not be known until sometime after completion when the completion accounts have been prepared and settled in accordance with the provisions of the agreement. A well constructed completion accounts mechanism will articulate (sometimes in significant detail) the rules for preparing, challenging and settling the completion accounts and in consequence there are several matters which the seller(s) and the buyer will need to negotiate and agree in an attempt to reduce the scope for post completion uncertainty and dispute.
In contrast where there is a locked box mechanism the reference accounts for the price adjustment will be the locked box accounts, which will have been prepared in advance of signing and which will speak as at the date of the locked box accounts (e.g. the prior financial year end date). Whilst there may be some discussion between the parties prior to signing concerning the contents of the locked box accounts they will be fully settled by the time of signing. In consequence there is no post completion discussion of the locked box accounts, no need for extensive provisions concerning the preparation, challenge or settlement of the locked box accounts and no post completion adjustment of the price.
Notwithstanding this contrast, a completion accounts mechanism and a locked box mechanism are fundamentally similar in that the parties in both scenarios need to agree how various matters are to affect the price. The principal difference is that in a completion accounts mechanism the effect of these matters is resolved by work before completion (agreeing the provisions of the agreement and the headline price) and work after completion (preparing and settling the completion accounts and calculating any required adjustments to the headline price to give the price) whilst in a locked box mechanism the effect of these matters is resolved by work (agreeing the provisions of the agreement and the price) before signing.
Areas to address
A well constructed completion accounts mechanism will set out the rules for preparing, challenging and settling the completion accounts. Certain aspects of these provisions, such as who prepares the draft completion accounts, who may challenge the draft and how a dispute is to be settled etc, are fairly mechanical. Other aspects, such as the applicable hierarchy of accounting polices (normally 1st: specific policies in the agreement, 2nd: policies adopted by the target business in its last audited accounts and 3rd: recognised accounting standards such as GAAP or IFRS) are relatively un-contentious. Nevertheless, there are often several matters which will be the subject of discussion and negotiation and which will, once agreed, fall to be specifically recorded as part of the agreement.
The extent to which any particular matter is contentious is often dependent on the nature of the target business but the most common areas for discussion include fixed assets, stock and work in progress, cash and debt definitions and debtors.
Fixed asset valuation The value of fixed assets may be based on historic cost, market valuation or economic value in use. This may yield a range of values and the parties will want to understand which basis is to apply. The seller(s) will be keen to avoid any impairment which may lead to a price reduction whilst a buyer will be keen to avoid any upwards revaluation which would result in a price increase. In addition, it will be advisable to clearly describe the applicable depreciation policy.
Stock and work in progress Whilst the policy for valuing stock is often something akin to “the lower of cost and net realisable value” there is still some room for subjectivity here and the parties may disagree (e.g. in relation to what may be included within cost) as to the required level of clarification. In addition, the parties may have divergent views as to what should constitute slow moving or obsolete stock for these purposes. Similarly, valuing work in progress can also give rise to disagreements between the parties.
Cash and Debt If a cash free, debt free mechanism is required then the definitions of these concepts will be extremely important. The definition of cash will need to ensure that cash and “cash equivalents” are appropriately included whilst, in international transactions, potentially excluding “trapped cash” if such cash is not freely available to be used by the target business. Whilst including principal, interest and other repayment fees in relation to bank borrowings within the debt definition will not usually be contentious the potential treatment of finance leases, swap break and other mark to market costs and pension scheme deficits as debt items may be subject to more debate and negotiation.
Debtors The parties will need to agree an appropriate level of provisioning for bad and doubtful debt. The seller(s) will want to minimise the extent of any provisioning and the corresponding reduction of the price whilst the buyer will want to avoid paying for debtors which ultimately prove uncollectable. The proposed policy in relation to post balance sheet events may also be relevant here if a particular debtor does actually go bad in the period between completion and the preparation (or settlement) of the completion accounts and this is to be taken into account.
A completion accounts mechanism requires that the parties record their understanding and agreement as to how these various matters are to be treated in the completion accounts and therefore how they are to potentially adjust the price. A locked box mechanism requires a similar level of understanding in relation to these matters but essentially requires that any adjustment to the price by virtue of these matters is agreed by the parties at signing.
Normalised working capital.
Where an adjustment to the price by reference to working capital is required, the parties will need to agree the level of the normalised or target working capital of the target business against which to compare the actual working capital of the target business. Whilst the amount of the actual working capital will be as determined by the completion accounts mechanism, an understanding of the working capital cycle of the target business in the context of the likely date for completion will be needed in order to agree the level of the normalised or target working capital.
A locked box transaction may also require this comparison between normalised or target working capital and actual working capital. However, the comparison falls to be carried out by reference to the normalised or target working capital and the actual working capital as shown by the locked box accounts and any required adjustment to the price is made at signing.
Locked box, leakage and permitted leakage
The parties have agreed that the price is to be fixed and calculated by reference to the locked box accounts. However, signing and completion of the acquisition does not occur until sometime after the date of the locked box accounts and the buyer will be keen to ensure that no value has been leaked from the target business to the seller(s) since that date. In consequence, a key element of any locked box mechanism is an undertaking from the seller(s) which purports to compensate the buyer in relation to any leakage of value to the seller(s) since the date of the locked box accounts through to completion. In this context, leakage could include distributions or dividends, any return of capital, a repayment of intra group or shareholder debt, service agreement payments.
Permitted leakage is, as the name suggests, a permitted exception to the effective prohibition on leakage. It will always be a bespoke concept as it effectively allows value to flow from the locked box of the target business to the seller(s). In consequence, the buyer will want permitted leakage to be as tightly drawn as possible and will be keen to ensure that all permitted leakage items are sufficiently identified or referenced. The seller(s), on the other hand, will be keen to ensure that all regular or anticipated payments to the seller(s) from the target business are not interrupted and do not have the effect, by virtue of the locked box undertaking, of reducing the price. Depending on the nature of the seller(s) and of the transaction, permitted leakage may, amongst other matters, include ordinary course salaries to the seller(s), periodic interest payments on shareholder debt, fixed dividend payments, monitoring fees and / or the settlement of intra group trading.
The buyer will require that the leakage undertaking is given by the seller(s) on an indemnity basis (i.e. pound for pound). Where there are multiple sellers a decision will need to be made as to whether the sellers are to be jointly and severally liable for leakage or whether a particular seller is to be liable only for leakage which it (or perhaps also its connected persons) receives. Care will also be required to ensure that this undertaking is not inappropriately limited by reference to some or all of the seller limitations on liability in the agreement.
Further protection for the buyer
In relation to a locked box mechanism and in addition to the leakage undertaking, a well advised buyer will require some protection concerning the quality of the locked box accounts, by reference to which the price has been calculated and agreed.
A buyer will often want the locked box accounts to be audited as this will provide the buyer with some comfort that a third party, the auditor, has reviewed and given an opinion as to the quality of those accounts. It will also usually not want the locked box accounts to be too old so giving a very out of date view of the target business and also requiring an extensive locked box period. The buyer will often require some warranty protection from the seller(s) in respect of the locked box accounts (whether they are audited accounts or not) and in this context the buyer will need to consider whether certain aspects of its warranty comfort should be given on an indemnity basis (i.e. pound for pound) and free of some or all of the seller limitations on liability in the agreement. For instance, if a cash free, debt free transaction is required then if the cash and / or debt stated in the locked box accounts as at the locked box date are inaccurate then arguably there should be a pound for pound adjustment in respect of such inaccuracy.
Pros and Cons
There are several advantages and disadvantages to be considered when deciding between the two mechanisms, neither of which provides a perfect solution.
Certainty of price. A locked box mechanism provides both of the parties with certainty of price at the point of signing and therefore extinguishes one of the potential needs for a retention or escrow following completion. A completion accounts mechanism does not provide the same certainty of price in that an adjustment to the price is possible following completion by reference to the completion accounts. However, this lack of certainty is often mitigated in practice by the inclusion of a “cap” (a maximum permitted increase of the price) and a “collar” (a maximum permitted reduction of the price) which apply to any resulting price adjustment.
Certainty of funding. The buyer will want to ensure that it has certainty of being able to fund its payment obligations as they fall due. With a completion accounts mechanism the price may be increased and the buyer called upon to make an additional payment to the seller(s) which it has to be able to fund. Again, a buyer may require a cap on any price adjustment to ensure that at signing it has certainty as to the maximum extent of its funding requirements.
A locked box mechanism delivers certainty of funding where there is a simultaneous signing and completion. However, where there is a gap between signing and completion a locked box does not necessarily provide this certainty of funding. If there is any debt in the target business this will have been measured by reference to the locked box accounts for the purposes of calculating the price. However, the debt may have increased in the period between the date of the locked box accounts and completion (e.g. because of the ordinary accrual of interest) and this debt will ordinarily need to be settled in full on completion in addition to payment of the price on completion, which price will not (unlike in a completion accounts mechanism) be reduced by reference to this increased debt. In consequence a buyer will require a clear understanding of the likely movement in the debt in the period up to completion and may require restrictions upon the seller(s) ability to take on new debt in the period between signing and completion.
Reward. A completion accounts mechanism ordinarily results in the reward in relation to the target business passing to the buyer on completion at the same time as the seller(s) receives the headline price.
In contrast a locked box mechanism, due to the leakage undertaking, ordinarily results in the reward in relation to the target business passing to the buyer with effect from the date of the locked box accounts which may be significantly before the seller(s) receive the price. In consequence, the seller(s) may require some form of compensation from the buyer for this effective delay, which may take the form of interest on the price calculated from the date of the locked box accounts. If such interest is requested the buyer will need to form a view as to whether the reward in the business accrued in this period and locked in the box is commensurate with the extent of the interest requested.
Risk. Risk is allocated between the seller(s) and the buyer by a combination of the effective date of the reference accounts, the scope of the warranties in the agreement and the time at which they are given by the seller(s) and any other specific rights or obligations in the agreement (e.g. an ability to terminate due to a material adverse change in the period between signing and completion). With a locked box mechanism a buyer will be additionally concerned to ensure that he is duly compensated for any decrease in the value of the target business due to leakage (i.e. that the box is appropriately locked) and that the locked box accounts themselves, by reference to which he has agreed the price, are of a requisite quality.
Uncertainty and scope for dispute. There is certainly less scope for uncertainty and dispute between the parties following completion if a locked box mechanism is adopted. However, this has to be counter balanced by the need for the parties, and in particular the buyer, to have reached a sufficient level of understanding, by its due diligence, in relation to all of the relevant matters affecting valuation before signing. Indeed, it is often the need for the buyer to reach this level of understanding, when the seller(s) may have a comparatively higher level of knowledge and understanding, prior to signing which fuels a buyer’s desire for a completion accounts mechanism as opposed to a locked box mechanism.
Seller(s) often appear to favour a locked box mechanism over a completion accounts mechanism whilst buyers often appear to view a locked box mechanism with some degree of trepidation and favour a completion accounts mechanism. In reality both approaches involve a similar assessment of factors which affect the valuation of the target business and require the parties to reach an agreement as to how these factors are to impact the price. The essential difference between the two approaches is one of timing, with a locked box mechanism requiring the parties to commit to a certain price at signing and a completion accounts mechanism committing the parties to a mechanism for determining the certain price at some time following completion. The choice of mechanism in a particular transaction will be dependent upon a multitude of factors including the contracting strength of the seller(s) and the buyer, the time by which certainty of price is required, the nature of the target business itself and also the proposed sale process.
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