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Key considerations - EY - Global

Inside the Locked Box

Key considerations

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The classical versus Locked Box approach

The method for reflecting accrued value must be done robustly. If it isn't, either party may risk leaving value on the table.

1. Protecting the value of the business

Under a Locked Box process, the value of the business is fixed long before the completion date. However, in the meantime the vendor may extract value from the business. For instance, dividend payments, undervalued asset disposals and management fees. The sale and purchase agreement should contain provisions to cover the risk of value leakage.

2. Reflecting accrued value

Determining a reasonable figure for the value that has accrued in the business is a matter of calculation, commercial judgment and negotiation. For the buyer, the accrued value represents the increase in equity value of the business. For the seller, it is either the lost increase in equity value or the interest (or return on investment) they foregoed by receiving the purchase price some time after the date the economic risk was transferred. Both parties need to consider the other party's perspective for maximum success.

There are different ways of expressing accrued value, of varied sophistication. Different ways of calculating the value accrual should be tried before negotiating the equity price.

3. Setting a Locked Box date

Date selection is usually a trade-off between a desire for comprehensive and reliable financial data and the length of time between the Locked Box date and completion. A long gap between the Locked Box date and the completion date will increase risk for the buyer, and possibly also the seller.?

To deal with this, the seller can prepare special purpose accounts if the business has changed significantly since its most recent statutory accounts or if the time lag is particularly long. Management accounts could be used with management providing a warranty regarding the financial statements used to determine the Locked Box balance sheet for the transaction.

4. Knowing what's in the box

Buyers will not always have all the information needed to enter a Locked Box transaction in confidence. Ideally, they would have access to a detailed, up-to-date profit and loss account, balance sheet and cash flow forecast through to completion. However, data of this quality is not always available.

Ultimately, it's a business decision

Technicalities aside, commercial considerations are often paramount.

Locked Box transactions are especially popular with private equity firms and financial investors (as sellers) because they see it as simplifying the process, freeing up capital and allowing them to move onto the next deal.

Equally, strategic corporate buyers and sellers will want to minimize:

  • The amount of management time spent on completion accounts
  • Post-transaction true-up negotiations
  • Protracted negotiations as a result of complex sale and purchase agreements, which may lead to the deal collapsing
  • The risk of nasty surprises after completion

A Locked Box is one way to reduce some of the risks associated with a transaction and increase the likelihood that it will deliver the anticipated value.

Your Locked Box checklist

1. Know the potential, alternative Locked Box dates that could be used
2. Review the balance sheet at the Locked Box date to determine net debt and "normal" levels of working capital (including adjustment to purchase price, if necessary)
3. Prepare and review the monthly financial information between the Locked Box date and closing (likely consisting of actual reporting and forecast)
4. Compare (where possible) the outcome of checkpoint 3 to your budget/forecast and prior year in order to understand business performance, analyze unusual developments and separately identify movement in net debt items
5. Identify any actual leakage since the Locked Box date andany specific leakage risks
6. Review the SPA to ensure appropriate clauses relating to the use of a Locked Box mechanism, including clauses to address any actual or possible leakage
7. Calculate the value accrual (absolute and as a daily/monthly percentage based on purchase price)
8. Perform a tactical assessment of the value to attribute to post Locked Box date cash flows, and consider how to present this

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