The locked box concept involves the vendor providing, and generally warranting, a balance sheet for the business being sold at a point in time (the ‘Effective Date’) before signing of the SPA, but generally as close as practicable to the potential completion date.
This Effective Date balance sheet is used to fix the equity price in respect of the cash, debt and working capital actually present at the Effective Date.
The resulting equity price is written into the agreement as an amount and paid by the purchaser at completion. This price is not adjusted further following completion, and the sale and purchase agreement will not require the preparation of any completion accounts.
As a result, the purchaser effectively takes on the financial risks and rewards of ownership of the business from the Effective Date. The vendor then ‘holds separate’ the business to be sold in terms of accounting for and capturing the value from its continuing business activities.
The overall approach leaves the buyer relying on contractual protection for the period from the Effective Date to Completion to ensure value is not stripped out of the business by the seller, for example through dividends, management fees etc. The seller typically indemnifies the buyer for specifically defined “leakage” transactions to provide a degree of comfort over this.
The vendor also typically agrees, via the sale and purchase agreement, to some restriction of its conduct of the business between Effective Date and completion in respect of activities that could significantly impact the value from the business, for example requiring consent of the vendor prior to payment of dividends, agreement of large or long-term contracts, purchasing large fixed assets etc.
Where the ‘stub period’ between the Effective Date and legal completion is long, the vendor will of course be keen to ensure they receive value for the element of profits between the Effective Date and completion. However, it is not desirable to introduce a price adjustment mechanism in respect of this stub profit period – to do so would effectively move back to preparation of a completion balance sheet.
Instead, it is common to include either a fixed daily amount of additional consideration to be payable for the period from Effective Date/signing to completion, or to agree that interest on the consideration for the business (net of Effective Date debt) will be payable for that period in addition to the consideration.
The rationale for this is that the purchaser otherwise has the benefit of the profit without, during this stub period, having the cost of servicing the acquisition cost.
In addition, the purchaser then settles the inter-company balances outstanding with the vendor at completion (just as they inherit the obligation to settle all other liabilities of the business at completion).