Locked box and completion accounts

The last couple of years have been particularly vibrant for a relatively young and still expanding Baltic M&A market. After escaping the gridlocks of a global pandemic, 2021 marked itself as a record year in terms of deal volume (244 investments), while 2022 peaked with an all-time high total investment of €212 M in the region1. The 1st half of 2023 started sluggish, with deal activity slightly declining, in line with the deteriorating macroeconomic factors2. Nevertheless, we expect M&A activity for the second half of 2023 to pick up the pace, where business founders and operators will need to make a series of vital decisions to capture the highest possible deal value.

The acquisition process of a target company (Target) may be long and tedious. Even after selecting the winning bid, the process is still not finished. It is common for counterparties to negotiate the inclusion of specific price adjustment clauses after testing for profitability, net asset value, as well as net debt and normalized working capital (NWC) levels.

These adjustments are required to account for and reflect the Target’s financial position at deal Closing as well as safeguard the Buyer from any value loss before closing the transaction. To finalize the process a completion mechanism is employed to arrive at the final acquisition price. There are two widely accepted approaches in M&A transactions – locked box and completion accounts. Both approaches provide their advantages to a transaction as well as present different risks that should be thoroughly assessed. The purchase price may be subject to change depending on whether the deal is structured using the locked box or completion accounts.

In layman’s terms, the locked box mechanism is a “fixed price deal” without any post-closing adjustment allowed. The transaction structure includes a pre‑agreed date in time (locked box date), which fixates on the financial statements to calculate both enterprise value (EV) and equity value, often it may be the end of a most recent financial year.

The Buyer estimates business value, net debt position, and the NWC adjustments based on the locked box date. The purchase agreement using this route should already detail the EV to equity bridge given that transaction parameters have already been settled. A good shorthand to remember is, if the transaction price is subject to changes after signing, it is not a locked box after all.

The gap between the locked box date and the Closing date is referred to as the locked box period. As there cannot be any price adjustment, the Buyer aims to preserve the value of the Target company. During this time the Seller is restricted in exercising cash payouts (value leakage) such as dividends, non-operational transactions, or management fees. Additionally, parties may agree to a permitted leakage, which is usually captured in the purchase agreement draft to carve out certain items from the balance sheet and factor it into the equity value formula.

On the contrary, the Seller may negotiate some form of compensation from the Buyer for running the business during the locked box period, which is called the value accrual, as technically the legal ownership of the company is only transferred after the Closing date. In practice, value accrual may take the form of additional cash flow generated by the company between the locked box and the closing date (given that the business is profitable) or be calculated as a fixed interest on the estimated equity value. It is crucial to lay out how value accrual will be calculated as well as which payments are considered permitted and which are treated as leakages.

It is important to note, that the locked box date should be selected with caution. It should provide enough time for the Seller to prepare the financial statements and for the Buyer to carry out appropriate due diligence, i.e. locked box date should not be too close to the closing date. However, a locked box date far in the past may increase the risk of value loss. Generally, 2-3 months are considered appropriate.

The main difference between locked box and completion accounts methods is that while utilizing completion accounts only the EV is precise, whereas the equity value is finalized at Closing. Implementation of the completion accounts usually entails the following steps:

1. The Seller prepares a preliminary closing balance sheet before to the closing date which is required to appropriate equity value and finalize the purchase price exercise.
2. The preliminary purchase price is then paid by the Buyer after signing the agreement.
3. The process of determining the final purchase price typically begins right after the completion and transfer of the preliminary purchase price. Legally the buyer now is in control of the target company, and is required to draw up the completion accounts. The acquisition agreement should detail a timeframe within which the new owner (the Buyer) has to provide a final closing balance sheet. The other party (the Seller) is normally allowed to review and either accept or dispute the closing financial accounts.
4. Based on the closing financial numbers the purchase price, net debt and NWC balance are estimated. Any difference between the preliminary purchase price and the final price is either paid by the Buyer or reimbursed by the Seller. The final transaction price is settled between the parties through a purchase price adjustment.

The definitions of cash, debt, and working capital items are of most importance while using completion accounts and need to be detailed as distinctly as possible to prevent unwanted discussion afterwards. To avoid the risk of time-consuming disputes over the transaction price at Closing, at signing parties typically agree upon the definitions, resolution process, and the involvement of an independent accountant (if needed).

As with many situations in finance, the most straightforward answer is - it depends. For a great deal of time, the go-to approach for M&A transactions globally has been the completion accounts, and it is still the preferred approach in certain regions of the world.

However, more recently in part due to the growing demand for high-paced and clear-cut M&A transactions, locked box has grown in popularity. The latter method provides more clarity and certainty for a Seller, where the most important components including the purchase price are determined before the moment of signing.

In contrast, completion accounts may yield a stronger incentive for a Buyer because transaction value will more accurately match the actual business value at the time of completion. While using this completion mechanism, the Seller is not warranted with a concrete purchase price. Instead, a meaningful amount of work, including external advisors, is required to prepare and review the closing financial accounts.

As evident from the points above, there is no one-fit-all solution when it comes to the right structure of an M&A transaction. The prospective buyers and sellers should agree on the transaction structure as soon as possible for an efficient and smooth process. The main difference between the two methods discussed is one of timing.

The locked box mechanism requires both parties to agree on the transaction price before signing, while with completion accounts the final price is only settled at Closing. Thus, the final decision should reflect the unique attributes of the transaction as well as the specific interests of the economic agents involved. Understanding the strengths and weaknesses of both mechanisms will aid you in lowering the risk of dispute and maximizing the likelihood of success.