M&A Purchase Price Calculations the

Locked Box Mechanism

Date : 13 November 2012
Author/s : Jeff Mansfield, Kieren Parker

Context Under a locked box mechanism, the purchase price is

A locked box is an alternative approach to preparing fixed by reference to accounts dated prior to signing the
completion accounts, in the context of calculating the SPA, commonly called the effective date or the locked
purchase price for private M&A transactions. Locked box box date. Economic exposure to the target transfers from
mechanisms rose in popularity in the UK in the mid- the seller to the buyer at the effective date, rather than at
2000s, particularly for private equity exits. Although we the completion date. There is no completion adjustment
suspect the underlying mechanism has been in quiet use to the purchase price in the SPA.
for some years in Australia, the locked box phrase has
recently gained in recognition here. Locked box
mechanisms will likely become more common as M&A
activity picks up in favour of sellers, so it is thus timely to
look at their advantages and the factors to consider when
employing them.

What is a Locked Box?

To illustrate, consider the following common structure for
a private M&A transaction:
the target is acquired on a debt free/cash free basis,
where the equity value equals enterprise value less net
debt;
the target is acquired with what the buyer considers to
be a normal level of working capital;
the enterprise value of the target is determined as a
multiple of what the buyer believes to be the targets
sustainable earnings, often a normalised EBITDA
multiple; and
there is a settlement period or gap period between
the signing date and the completion date, to allow for
conditions to be satisfied prior to consummating the
transaction, or for other reasons.
Under a traditional completion accounts approach, the
purchase price is commonly expressed as a formula in the
sale and purchase agreement (SPA) and paid as an
estimate at completion. The purchase price is then
adjusted after completion based on the difference in the
working capital1 of the business between the figure used
in determining the estimated purchase price (or some
other reference figure) and the actual figure calculated
from a set of special purpose completion accounts
prepared as at the completion date.
The locked box refers to the purchase price being locked
in a box at the effective date, with no value leaking from
the box through to the completion date.
We note at the outset that locked box mechanisms are not
the revolution that some practitioners suggest, nor in our
view are the benefits as pronounced. A locked box
mechanism differs from a completion accounts
mechanism more in terms of timing than the way in
which the target is valued. Although a locked box
mechanism may avoid some of the issues which affect a
completion accounts mechanism, it will give rise to its
own issues. These issues are explored below.
Nonetheless a locked box is a useful alternative to
traditional completion accounts approach, particularly for
sellers.
The Benefits of a Locked Box
The main benefits of a locked box mechanism are:

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 the purchase price is fixed at signing giving the
parties certainty;
no provisions are required in the SPA to deal with
completion accounts, which can be lengthy and
heavily negotiated saving the parties time and costs,
and preserving goodwill in the negotiations; and
the parties are not required to prepare completion
accounts and deal with subsequent disputes again
saving time and costs, and allowing management to
focus on the target business.
In addition, a locked box approach may make it easier for
a seller to compare bids in an auction, as the tenderers
will be asked to submit a fixed price based on a set of
effective date accounts supplied by the seller in the due
diligence pack.
The Sellers Agency
The Sellers Agency Explained
Under a locked box approach, the buyer prices the target
as at the effective date. Thereafter the buyer accepts the
risk and reward of owning the target in economic terms.
The seller will continue to own the target until completion
in legal terms. In essence (if not legally) the seller is
operating the business as the buyers agent during the gap
period. We refer to this as the Sellers agency.
The Sellers Position
Will the seller behave differently during the gap period
compared with a completion accounts approach?
There is little motivation for the seller to maximise the
targets performance during this period, as the profits will
accrue to the buyer (the exception being if the seller has
the opportunity to receive an earn-out). However, the
seller will be far from disinterested, as conditions to
completion may not be satisfied, or completion may not
otherwise occur, meaning the seller will retain the
business.
One advantage of a locked box mechanism for buyers is
that a seller is not motivated to manipulate the target
business during the gap period to exploit any loopholes in
the completion accounts adjustment, for example by
delaying capex to boost cash. This problem does not arise
under a locked box mechanism as balance sheet items at
completion are irrelevant to the purchase price.
However a locked box mechanism may give rise to
another issue. The seller may be motivated to exploit any
potential leakage, or improper transfer of value from the
target to the seller, in the period from the effective date to
the completion date. This could be as obvious as a
dividend or as subtle as incurring transaction costs, which
the parties have agreed are for the sellers account, in the
target. Leakage is discussed below.
The Buyers Position
Will the buyer behave differently during the gap period
compared with a completion accounts approach? Buyers
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normally hold concerns about the way in which the target
business is run during the gap period. The Sellers agency
will likely heighten these concerns. Buyer protections or
gap controls which address these concerns are discussed
below.
Further, if the targets performance deteriorates in the gap
period, the buyer may experience a stronger feeling of
buyers remorse than if such poor performance was for
the sellers account. If so, the buyer may be more likely to
try to walk away or renegotiate.
When is a Locked Box Mechanism
Appropriate?
First and foremost, the buyer needs reliable effective date
accounts to commit to a locked box mechanism. The
buyer will not have the chance to test the targets balance
sheet through completion accounts. Consequently the
buyer will seek accounts that are not out of date at
signing, and will want them audited. The seller should
also expect the buyer to:
undertake thorough financial due diligence on the
effective date accounts;
require strong warranties relating to the effective date
accounts;
require strong warranties relating to the targets
operations and performance since the effective date.
Under a completion accounts approach, the buyer will
usually be in control of preparing the completion
accounts. Unless the SPA contains specific rules about
these things, the buyer is in a stronger position to put
forward its view of the appropriate value for certain items,
like distressed inventory or doubtful debtors. With a
locked box, the seller is in control of preparing the
effective date accounts. Even after thorough financial due
diligence the buyer may still be taking a risk on the value
of the assets shown in the effective date accounts. This
may be an advantage to the seller. Then again, the buyer
can simply price in this risk through a lower purchase
price.
If special purpose effective date accounts are required,
this may cancel out the benefit, under a locked box
mechanism, of not having to prepare completion
accounts. Management time will be spent preparing,
explaining and negotiating the treatment of effective date
accounts, rather than completion accounts. Moreover, the
warranties relating to the effective date accounts may give
rise to subsequent disputes that merely take the place of
disputes over the completion accounts.
A locked box mechanism will not be appropriate if:
the buyer does not trust the seller or the incumbent
management team to run the business during the gap
period, or otherwise wants full control over the target
this is an obvious consequence of the Sellers agency
issue, although it may only be relevant for turnaround
or management buy-in deals. Otherwise, the
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 management and the way they have run the target will being in excess of fair value or a value shift to the seller
commonly be one reason that the buyer is investing; may be permitted by the buyer, provided it is visible and
certain at signing, and there is a corresponding reduction
the buyer believes that value has leaked from the
in the purchase price.
target between the effective date and signing, or the
buyer is otherwise uncomfortable with the targets If the target owes shareholder or intra-group loans, expect
activities or performance during this period the buyer to control any increase in these loans during the
although the buyer can seek warranty protection on gap period, not only for possible leakage but also to
these matters, it will be easier to insist on completion understand the proposed use of the funds.
accounts rather than to pursue the seller for warranty
Possible sources of Possible sources of
claims post transaction;
leakage include: permitted leakage
the transaction involves a long or uncertain gap period include:
dividends, returns of
this will likely make the buyer anxious about the capital, management dividends paid to the
length of time during which the Sellers agency fees, bonuses etc paid to seller and identified in
persists. the seller the SPA (with an
Some commentators have stated that a locked box will be appropriate purchase
seller group corporate
price reduction)
inappropriate if the target is part of a larger corporate charges although such
group. This may be the case if the buyer fears that the charges may represent remuneration in the
seller will exploit any opaque arrangements between the the targets share of ordinary course
target and the seller group between the effective date and legitimate overhead
costs, such as rent and
permitted trading
the completion date. Otherwise, the buyer will need to be arrangements between
insurance
comfortable with the strategy to disconnect the target the target and members
from the shared services provided by the seller group, and waivers of rights or of the sellers group
the consequences to the targets cost base, at the time of claims against members
signing the transaction. This is true whether the parties of the seller group or
agree to a locked box or completion accounts. The more third parties
important question to determine if a locked box is changes to any
appropriate is whether the effective date accounts give a permitted trading
reliable picture of the target as a stand-alone entity. arrangements between
the target and members
Some commentators have also stated that a locked box of the seller group, or
will not be appropriate if the target has volatile working any new arrangements
capital or earnings. In our view this does not necessarily
transaction costs
follow. Firstly, the volatility of the working capital will
incurred by the target
need to be reconciled with what is considered normal by
the buyer. Again, this is the case whether working capital
The buyer will normally insist that the SPA contain
is calculated by reference to effective date accounts or
extensive covenants and indemnities to protect against
completion accounts. Secondly, the volatility of the
prohibited leakage. The buyer will also demand that the
earnings is reflected in the price, usually a reduced profit
monetary limits for warranty claims do not apply to
multiple. Aside from the Sellers agency issue, there is no
claims for breach of such covenants and indemnities. In
magic in the gap period the buyer will own those volatile
return the seller should demand a shorter time limit for
earnings long after the gap period has passed.
bringing such claims (such as six months) than the time
limit applying to warranty claims (normally at least one
audit cycle).
Considerations When Using a Locked Box
Mechanism Gap Controls
Gap controls, or covenants on the seller to ensure that
Leakage
during the gap period the target conducts its business in
As mentioned above, leakage refers to the seller extracting the ordinary course, and does not undertake certain
value from the target in the period from the effective date actions without the buyers consent, are almost always
to the completion date. The parties will need to identify required by buyers under completion accounts deals.
possible sources of prohibited leakage, and the sellers There is a tension between the seller wanting to get on
obligations in this respect are usually backed by an with business during the gap period, particularly if there
indemnity. is a real chance that the deal will fall over, and the buyer
However, not every transaction between the target and a wanting a say on material decisions affecting the business.
member of the sellers group will be improper, and the These considerations will be heightened under a locked
parties will also need to identify permitted leakage. There box deal, owing to the Sellers agency issue.
is ordinarily no reason why arms length transactions We note that lengthy negotiations on gap controls will
between the target and the sellers group which are priced erode to some extent the benefit under a locked box
fairly should not be allowed to continue, at least until
completion. Even leakage that is viewed by the buyer as
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mechanism of avoiding lengthy negotiations on Pros Cons
completion accounts provisions.
Buyer avoids potential potential for the
for the seller to seller to exploit
Information Flows exploit leakage
The buyer will request regular information flows during completion
normally controls
the gap period to monitor the target, although again this accounts
the completion
is also common under completion accounts deals. For adjustments
accounts and the
during the gap
example the buyer will seek to track movements in net flow of
period
debt, particularly if the targets performance from the information
effective date to the completion date may affect any more extensive
proposed acquisition financing structure. financial due
diligence
Proxy Profit Payment
The seller should seek to be compensated for the fact that
the buyer receives the profits of the target from the
effective date, but pays the purchase price at the Conclusion
completion date. This compensation payment could be Locked box mechanisms are a useful alternative to a
viewed as a proxy for the forecast profits to be earned by completion accounts approach, particularly for sellers. In
the target during this period (albeit with forecast profits the right circumstances, a locked box mechanism can save
locked in, risk free to the seller), or a proxy for interest on the parties time and costs, give the seller more certainty
the purchase price had it been paid at the effective date. and allow the buyer to get on with business post
Either way this is a matter for negotiation. completion. Notwithstanding, locked box mechanisms
give rise to their own problems which mean the benefits
can be overstated. For these reasons, they are likely to be
Summary of Pros and Cons for Locked Box most useful to sellers seeking a quick sale, or exiting
Mechanisms target companies that are sought after and will generate
competitive tension through an auction process.
Pros Cons
Expect to hear more about locked box mechanisms as this
Both price certainty at Sellers agency
overseas trend migrates to Australia and M&A activity
parties signing issue
increases.
parties avoid shifts the focus of
negotiating negotiations from
completion completion
Jeff Mansfield, Partner
accounts accounts to gap
Telephone +61 2 8915 1016
provisions in the controls
SPA Email jeff.mansfield@addisonslawyers.com.au
potential disputes
parties avoid on effective date
preparing and accounts Kieren Parker, Senior Associate
disputing warranties Telephone +61 2 8915 1013
completion Email kieren.parker@addisonslawyers.com.au
accounts post
transaction
ADDISONS. No part of this document may in any form or by any means be
Seller control of the special purpose reproduced, stored in a retrieval system or transmitted without prior written
effective date effective date consent. This document is for general information only and cannot be relied upon
as legal advice.
accounts and flow accounts may be
of information required
avoids potential
for the buyer to
exploit 1
Sometimes the adjustment encompasses a movement in the value of all net assets, not
completion just working capital. The extent of the adjustment will depend on the type of business
accounts carried on by the target. There may also be an adjustment for any difference in capital
expenditure against budget, again depending on the targets business.
adjustments after
completion

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