Locked Box vs Completion Accounts
How do these two options work when you are selling a company? And which one might be right for you?
When an acquirer makes a formal offer to buy your business, the offer price is always linked in some way to your company’s financial position. Whether the valuation has been based on the Net Asset Value shown on your balance sheet, or a multiple of your EBITDA, your statutory or management accounts are the starting point for the value the buyer puts on your business.
But once you have accepted a formal offer, the due diligence and completion process often takes several months. During that time, your company will continue to trade and its financial position will change.
This creates some risks and uncertainties for both buyers and sellers. However, there are two different mechanisms that are commonly used to address the issue.
Completion Accounts
Completion accounts are a one-off set of financial statements prepared after a business sale has completed. Their purpose is to calculate the company’s actual equity value at completion, rather than relying entirely on estimates made when the deal was agreed.
The main advantage of this approach for the buyer is that the final price paid is tied to the company’s actual financial position at completion. This reduces the risk of paying for cash that is not present, debt that is greater than expected, or working capital that is below the agreed level. It can also protect the buyer where the business’s financial position changes materially before completion.
For the seller, completion accounts potentially allow the shareholders to benefit from improvements in the relevant financial metrics between the initial estimate and completion. The trade-off is uncertainty – the seller will not know the final proceeds until the accounts have been prepared, reviewed and, if necessary, settled through the SPA’s dispute procedure.
The process usually follows four steps.
1. An estimated price is agreed. Before completion, the parties agree an estimated purchase price based on their expected view of the company’s cash, debt and working-capital position at completion. The SPA should set out the accounting policies, definitions and calculation methods to be used.
2. The transaction completes. The buyer pays the consideration based on an estimate of the financial position at the point that ownership of the company transfers. Because final accounts cannot usually be prepared instantly, the initial payment is based on the agreed estimates.
3. The completion accounts are prepared. After completion, completion accounts are prepared showing the company’s actual financial position as at the completion date. They are often prepared by the buyer, which will normally control the business after completion, although the SPA can provide for a different process
4. The price is adjusted. The seller is given an opportunity to review and accept or challenge the accounts. Once the figures are agreed, the initial price paid is compared with the final price, with a compensating adjustment made where necessary.
The final price adjustment is often straightforward. The difficult part is agreeing what counts as cash, debt, debt-like items and working capital, and which accounting policies apply, which should all be set out in the SPA.
A well-drafted SPA should also specify who prepares the accounts, the timetable for doing so, the seller’s information and review rights, the procedure for resolving disputes and how the final payment will be made.
Locked Box
A locked box provides an alternative to completion accounts. The parties agree the equity price by reference to an agreed historical set of accounts as at a specified ‘locked-box’ date. This is often the date of the most recent audited, reviewed or reliable management accounts, rather than necessarily the date on which the offer is made.
The locked-box accounts are used to establish the agreed financial position of the company, typically including cash, debt or debt-like items and working capital. The resulting price is normally fixed in the SPA, with no ordinary post-completion price adjustment.
The business continues to trade between the locked-box date and completion. In principle, the buyer takes on the benefits and risks of ownership during that period. Growth or cash generation may benefit the buyer, but they may also bear the economic downside if business deteriorates (although a material decline in trading could of course put the whole deal at risk).
The buyer’s principal protection is a prohibition on value leakage. Leakage is a transfer of value from the target to the seller or the seller’s connected parties during the period from the locked-box date to completion. Examples may include dividends, distributions, transaction bonuses, related-party payments or the repayment of shareholder loans, unless they have been expressly agreed as permitted leakage.
The company should continue to operate in the ordinary course, including paying ordinary-course employee remuneration and business expenses. Payments to shareholders or their connected parties must be permitted under the SPA or they may constitute leakage, for which the buyer may be entitled to compensation, via a deduction from any unpaid consideration or a repayment by the seller.
A locked box can be attractive to sellers because it gives greater certainty over the price and avoids a post-completion accounting exercise. It can also make the transaction simpler and quicker to conclude.
A locked-box transaction may also include a value-accrual mechanism, sometimes called a ticker. This is an additional amount payable to the seller for the period between the locked-box date and completion. It recognises that the seller may continue to operate and grow the business during the period before completion, while the buyer receives the economic benefit of the business from the locked-box date.
A ticker may be calculated by reference to an agreed daily amount, an interest-like rate applied to the purchase price, or an agreed estimate of cash profits or value generated during the period. The precise method is a matter for negotiation and should be set out clearly in the SPA. It should not be assumed that a ticker is necessarily based on profit after tax or cash generated.
Buyers are not automatically willing to agree to a ticker. It may help align incentives and compensate the seller for the gap period, but it also increases the consideration payable and may be resisted by the buyer.
The choice between completion accounts and a locked box depends on factors including the buyer’s and seller’s preferences, the nature and volatility of the business, the quality and recency of the financial information, the expected period between signing and completion, and the parties’ bargaining positions.
If you are working with an M&A adviser, they should help you assess the implications of each mechanism and negotiate your preferred position with the buyer.
