In mergers and acquisitions (M&A), determining the purchase price on completion can be a complex process. Buyers and sellers must decide how to reflect the financial performance and position of the business between the last set of complete financial records (often prepared 14-30 days in arrears) and completion. Two popular mechanisms used to finalise the purchase price are Completion Accounts and the Locked Box mechanism. Understanding their nuances, advantages, and implications can help both parties negotiate a more successful deal.
1. Understanding the Mechanisms
Completion Accounts
This mechanism involves completing the deal based on an estimate of the Completion Accounts (usually the last set of complete and warranted management accounts) then adjusting the purchase price post-completion based on a final set of accounts drawn up to the date of Completion. An adjustment, to whichever party is out of pocket, is made upon the Completion accounts being closed.
Who Prepares the Completion Accounts?
- At Signing: The seller typically prepares the estimated Completion Accounts. These accounts are scrutinised during due diligence and agreed upon by all parties at signing.
- Post-Completion: The buyer usually prepares the Completion Accounts based on the company's financial position at the Completion date. However, the process is guided by rules defined in the Sale & Purchase Agreement (SPA), which address key aspects:
- Policies and Principles: The SPA specifies the accounting policies, principles and formats to be adopted in the preparation of the Completion Accounts. These can often be detailed schedules running to many pages.
- Timing: Deadlines for preparing, reviewing, and finalising the Completion Accounts are outlined to avoid breach of contract and minimise uncertainty.
- Dispute Resolution: If disagreements arise, the SPA often includes provisions for escalation to qualified and independent third-party advisors (e.g., accountants) who would act as mediator in applying the policies to the source working papers and data as provided by the contracted parties.
Importance of SPA Details
The more comprehensive the SPA is in specifying policies, timing, and dispute resolution mechanisms, the fewer opportunities there will be for disagreements during the preparation and review of Completion Accounts. Whilst these are often appended to the rear of an already large document (not uncommon to see over 100 pages in total) they must be reviewed in detail by experts to avoid a seller committing to something which may in time cost significant funds.
Example
A company is sold for an agreed purchase price of £100 million, assuming the following financial assumptions at signing:
| Metric | Assumption at Signing | Actual at Completion | Adjustment |
|---|---|---|---|
| Net Debt | £10 million | £12 million | -£2 million |
| Working Capital | £5 million | £4 million | -£1 million |
See our article (link) relating to what is Net Debt and Working Capital
Final Purchase Price Calculation:
- Agreed Price: £100 million
- Adjustments: -£2 million (Net Debt) - £1 million (Working Capital)
- Final Price: £97 million
This adjustment ensures the buyer pays for the company as it stands on the Completion date, reflecting any financial changes which have occurred in the period.
Locked Box Mechanism
In the Locked Box method, the purchase price is fixed at signing, based on historical financials as of the "Locked Box Date" - often a set of Management Accounts no older than 60-days from Completion. From this date, sellers guarantee no "leakage" of value, except for specifically permitted items (e.g., regular business expenses). Note that the longer the period between Locked Box Date and Completion, the greater the volume of trade which needs to be insulated from leakage and the more work required to evidence control of that.
Example
The financials as of the Locked Box Date (31 December 2023) are as follows:
| Metric | Locked Box Date Value |
|---|---|
| Equity Value | £100 million |
| Net Debt | £10 million |
| Working Capital | £5 million |
Between the Locked Box Date and the completion date (10 February 2024), the following transactions occurred:
| Transaction | Amount | Permitted? | Adjustment to Price |
|---|---|---|---|
| Regular employee wages | £1 million | Permitted | No adjustment |
| Payment of authorised dividend | £0.5 million | Permitted | No adjustment |
| Shareholder loan repayment | £1 million | Not Permitted | Deduct £1 million |
| Unauthorised dividend payment | £2 million | Not Permitted | Deduct £2 million |
Final Purchase Price Calculation:
- Agreed Price: £100 million
- Adjustments for Non-Permitted Leakage: £1 million (Loan Repayment) + £2 million (Unauthorized Dividend)
- Final Price: £97 million
Key Takeaways
- Permitted Leakage: Includes agreed-upon, routine expenses like wages and authorised dividends. These do not affect the purchase price.
- Non-Permitted Leakage: Any unauthorised transactions, such as unapproved dividends or shareholder-related payments (but will be any transaction which is not Permitted, so can incorporate a lot of permutations), reduce the final price to compensate the buyer.
2. Pros and Cons
| Aspect | Completion Accounts | Locked Box |
|---|---|---|
| Flexibility | Reflects actual financial changes post-signing, offering flexibility. | Fixed price simplifies the process but requires high confidence upfront. |
| Certainty | Price is uncertain until accounts are finalised. | Price is fixed, providing certainty at signing. |
| Complexity | Requires detailed preparation and negotiation post-completion. | Less complex, but demands rigorous due diligence beforehand. |
| Risk Allocation | Typically viewed as Buyer-friendly as Seller carries whole risk and less certainty until Completion. | Typically viewed as Seller-friendly as Buyer carries risk of a fixed price with limited recourse post. |
| Timing | Longer process due to post-completion adjustments. | Faster completion as no post-closing adjustments are needed. |
| Cost Implications | Additional costs for preparing accounts and resolving disputes. | Lower costs but may lead to higher pricing if risks are priced in upfront. |
3. When to Use Each Mechanism
Completion Accounts
- Suitable for businesses with significant operational volatility or uncertain financials.
- Ideal when buyers want the most accurate financial data.
Locked Box
- Best for stable businesses with predictable cash flows and low volatility.
- Common in competitive transactions or deals requiring a quick close.
4. Conclusion
Both Completion Accounts and Locked Box mechanisms have their merits. Completion Accounts offer flexibility and fairness, while the Locked Box simplifies transactions and provides certainty. By ensuring that the SPA includes detailed provisions regarding policies, timing, and dispute resolution for Completion Accounts—or robust leakage protections for Locked Box deals—both buyers and sellers can mitigate risks and reduce the likelihood of future disputes.