Completion accounts
In a scenario where completion accounts are used, the parties agree on a preliminary purchase price by agreeing on an estimate of what the equity value will be as of the date of completion. The process for establishing the final purchase price typically begins immediately after completion has taken place and the preliminary purchase price has been paid. At this time, one of the parties (normally the buyer since they are now in control of the target company) is obliged to draw up completion accounts.
The other party (normally the seller) is typically given the opportunity to review and either accept or dispute the calculations. If necessary, a special dispute resolution mechanism can be used to determine the final content of the completion accounts. Once the final purchase price has been established, any difference between the preliminary purchase price paid at completion and the final purchase price is settled between the parties through a purchase price adjustment.
Locked box
With a locked box mechanism, the parties both agree on the final purchase price using the company’s most recent audited financial statements and there is no post-completion adjustment. Because of this, the buyer will seek to safeguard the value of the target company in the period between the locked box date and the date of completion by including an obligation in the share purchase agreement (SPA) for the seller to indemnify the buyer for any undue leakage or extraction of value from the business that takes place during the locked box period. On the flip side, because the seller continues to support the business during the locked box period, the seller may seek some form of compensation, such as an interest on the purchase price, for an increase in value that happens during the locked box period.
Which option works for you?
The locked box and completion account purchase price mechanisms are very different, and identifying the right one for your transaction requires you to understand the drawbacks and advantages of each. The five considerations include:
1) Complexity of execution
The completion accounts mechanism adds complexity to a transaction and is more cost-intensive. The final purchase price will only be determined post-completion – often several months later - and the compilation of the completion accounts requires resources in the target companies. Management has to deal with this in addition to the day-to-day business and the SPA needs to provide for the adjustment and dispute resolution mechanism. Overall, the locked box mechanism offers a more straightforward approach by reaching a purchase price agreement upfront.
2) Value leakage
In a locked box scenario, buyers face the risk of a disconnect between the purchase price and the value of the company at completion. It is critical to achieve satisfactory (particularly financial) due diligence results prior to signing. Buyers also need to negotiate appropriate protection for value leakage prior to completion to ensure that the box is effectively locked. Because of this risk, locked box mechanisms are less appropriate where the working capital or performance of the target company is subject to volatility since this cannot entirely be hedged for in the SPA.
3) Accuracy of purchase price
The main merit of the completion accounts mechanism is the fact that the consideration is precisely calculated as of the date of completion. To some extent, the mechanism can be said to manifest the idea that “you should only pay for what you get.” In light of this, it is easy to see why the completion accounts mechanism can be especially attractive to buyers who might have worries regarding the accuracy of historical financial statements presented by the seller and the risk of adverse events in the company in the period leading up to completion.
4) Purchase price certainty at completion
Although a locked box mechanism cannot offer the same level of precision of the purchase price (in the sense described above) as completion accounts, it provides the parties with certainty as to it provides the parties with certainty already at completion as to what the final purchase price will be. No post-completion adjustments are necessary, which is particularly important for financial investors. In an auction scenario, the ability to offer a locked box mechanism and, thus, a fixed purchase price payable on completion generally provides a competitive advantage for a bidder over completion accounts. Further, it creates an incentive for both parties to agree to the balance sheet on which the purchase price is based on.
5) Risk of disputes
The (potential) adjustment of the purchase price bears a much higher risk of disputes for the parties post-completion. On the contrary, agreeing on a definite purchase price already at signing, as is done when using a locked box mechanism, means it is less likely for the parties to be involved in such disputes. This is particularly in the interest of the seller.
Making a selection
The selection of a purchase price mechanism depends on the circumstances of the specific transaction and is often predetermined by the seller (e.g., in the process letter). If this is not the case, it is crucial for the parties to discuss and find an agreement on the transaction structure as early as possible to ensure an efficient process. However, it is important to remember that a single approach may not be appropriate for all deals and the attributes of each deal should be considered in reaching a decision. Key questions to contemplate include:
- Are you the seller or buyer and is private equity involved?
- Is there volatility in working capital or target performance?
- Is work required for ongoing management of the business until completion?
- What is the potential to fund a true-up?
- What is the potential for a dispute?
- Is there a need for swift closure at completion?
Conclusion
With the ongoing strong sellers’ market and growing involvement of private equity firms in transactions, locked box transactions have increased and are likely to remain more prevalent. Nonetheless, weighing the specifics of each deal is an important step that will help decrease your risk and improve your likelihood of success.
- Determine whether a purchase price mechanism has already been identified for the transaction.
- If a purchase price mechanism has not been selected, carefully assess the specifics of the transaction as well as your position and bargaining power in the process.
- As a purchaser in a competitive auction process, for instance, you may want to offer the leanest and least burdensome mechanism for the seller to “survive” the filtering process, whereas, in a one-on-one situation with no competition, you may want to optimize the process for you and get the most out of it.
- No matter which completion mechanism you agree to with the other party and whether you are the purchaser or the seller, it is crucial to pay close attention to the mechanics and corresponding safeguards provided for in the SPA, and to make sure have an experienced legal counsel by your side.
