In order to determine the acquisition price payable (equity value) for a target business in an M&A transaction, two main pricing mechanisms have evolved and are now the widely accepted norms: “closing accounts” and “locked box” mechanisms.
Before we discuss these pricing mechanisms and their relative advantages, we must recap two events closely related to the actual closing, namely the effective date and the signing date.
What is the effective and the signing date in an M&A deal?
In this context, the effective date is defined as the date on which the economic interest is transferred from the seller of a corporate to the buyer, the signing date, as you know, is the date on which the SPA is signed by the two parties. The main difference between the closing accounts and the locked box mechanism is the timing on which the economic interest in the target company is transferred from the seller to the buyer. In a transaction in which closing accounts are used, the economic interest is transferred only on the closing date, i.e., the date on which the actual change of control (CoC) takes place, whereas under a locked box mechanism the economic interest is transferred to the buyer even before the signing date, referred to as the “locked box date”.
Now that we have established the basics and the chronological sequence of events for both mechanisms, we should take a closer look at the actual implementation and the tasks involved for each alternative.
Closing Accounts: Traditional Approach to Establish Purchase Price
The traditional way of establishing a cash and debt-free purchase price is via closing accounts, whereby the SPA outlines the exact calculation of the price payable at closing, the principles, and definitions for preparing an interim balance sheet, the so-called “closing accounts”, and a provisional price based on previous accounts and/or the target’s projections at closing. Post-closing, you calculate the enterprise value based on the definitions previously set out in the SPA. Thereafter, you deduct actual net financial debt at closing (cashless financial debt as per the closing accounts) and add the difference between the current and reference working capital to arrive at the final cash and debt-free purchase price.
The preparation of the closing accounts, their review, and discussions around the interpretation of the principles set out in the SPA often lead to lengthy processes which you can sometimes shorten by using the locked box mechanism. In a locked box transaction, the purchase process is essentially “streamlined” by refraining from adjusting the purchase price depending on the target’s performance prior to the closing.
Locked Box Deal: Fixed Price Structure for Seller Certainty
A locked box deal is a fixed price deal, in which the final payable purchase price is already defined in the SPA at signing. In this case, the equity value is negotiated based on a recent, historical balance sheet, prepared before the signing of the SPA – the so-called “locked box balance sheet”. As the cash, debt and working capital positions are already known, the purchase price is displayed as a final amount in the SPA which cannot be adjusted after closing. This means, as previously indicated, as a buyer the economic interest of the target passes to the seller on the date of the locked box balance sheet, although the actual CoC takes place only after closing. Hence, the seller needs to protect itself from leakage of value from the target business between the locked box date and closing through representation and warranties defined in the SPA. All permitted leakages, like salaries, expenses or agreed dividend pay-outs to the seller need to be listed in the SPA as well.
Choosing the Right Mechanism: Deal Specifics and Advising Perspective
When you want to determine which of the two mechanisms is beneficial for your transaction, the outcome is highly dependent on your deal specifics and the side you are advising (seller or buyer).
A locked box pricing mechanism is generally seen as more beneficial for the seller; however, it gives both parties greater price certainty already at signing, it generally enhances the simplicity of the SPA and reduces transaction costs as no closing accounts need to be prepared. It additionally avoids time and resources being spent post-transaction on the completion mechanisms.
However, in some cases, locked box structures are difficult to apply, for example when carving out a target business, if there are only partial or incomplete balance sheets are available, or if the gap between the locked box date and the closing date is relatively large (exceeding six to nine months), thus increasing the risk for potential leakage and declining business performance. The risk of leakage and the information asymmetry during the final price debate at signing from a buyer’s perspective are the main hurdles to overcome in a locked box transaction.
To put it in a nutshell, the principles to calculate the equity value are the same for closing accounts and locked box, but the timing and level of certainty are different.
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