This article is part of our M&A Tips series, focusing on various matters in the evolving world of M&A. Stay tuned for regular updates and commentary on topical issues across the sector.
The Australian M&A market has experienced significant activity during the first half of 2022 notwithstanding the effects of the global pandemic. In this article we discuss the two main purchase price adjustment mechanisms being completion accounts and locked box accounts.
- The completion accounts mechanism is often regarded as the “buyer-friendly” option as it grants an opportunity for the buyer to review the accounts and grant a degree of certainty on the actual financial position of the company. At completion, there is an estimated purchase price that is “trued-up” by reference to a set of accounts prepared post-completion but reflects the value of the target business as of the completion date.
- The completion accounts are prepared by one party within an agreed timeframe, using agreed principles with the other party having a chance to review and agree the final valuation of the target business as at completion. Depending on what the final adjustment figure is, one party may have to make a further payment to the other to pay the difference between the actuals and the estimates. In the case of any disagreements surrounding the adjustment figure, the sale and purchase agreement will usually contain detailed dispute resolution mechanisms.
Why lock the box?
- With a locked box transaction, the purchase price of the target is fixed at an agreed pre-completion date by reference to the most recent, usually audited, balance sheet with conventionally no post-completion adjustment (Locked Box Date).
Certainty of price
- The locked box mechanism delivers a fixed price, unlike the completion accounts method in which the actual purchase price is determined post-completion. This makes locked box accounts attractive to sellers as it provides certainty of price pre-completion and a clean exit from the business (the buyer however will have to seek suitable assurance in the due diligence it conducts for it to be comfortable with the purchase price for a locked box mechanism). The fixed price also grants a competitive advantage for bidders in an auction process as sellers can easily compare multiple bids.
- In contrast to the heavily negotiated and time-consuming process of drafting completion accounts provisions and the detailed dispute resolution mechanism required, the main negotiation for the locked box mechanism centres on what constitutes “leakage” and “permitted leakage”. “Permitted leakage” are items that have been agreed as appropriate expenditure by the seller for the period between the Locked Box Date and completion. These can be items such as staff wages in the ordinary course and permitted intra-group payments.
How can buyers protect themselves with a locked box mechanism?
- As buyers are also reliant on contractual provisions for protection during the period from the Locked Box Date up to completion, extensive warranties should be included in the sale and purchase agreement in relation to current trading of the target business.
- The definitions of “leakage” and “permitted leakage” are therefore crucial as these shape the buyer’s protection in maintaining the value of the target business and preventing sellers stripping any value. Buyers will usually want a wide definition of “leakage” and a narrow and detailed definition of “permitted leakage”. However, there will always remain a risk of the value of the target business deteriorating between the locked box date and completion.
- A seller will normally be expected to indemnify the buyer on a dollar-for-dollar basis for any payments and transfer that fall outside the definition of “Permitted Leakage”. Through warranties and indemnities, buyers are given assurances that the seller has been running the business effectively and in a way that substantiates the valuation as at the locked box date.
Financial due diligence
- As there is no ability for negotiation or adjustment post-completion with locked box accounts, the buyer should ensure thorough financial due diligence is undertaken. If the target being acquired does not have any recent audited or reliable accounts (due to the target being a relatively young start-up or having a complex group structure) or the target is such that the working capital is subject to instability, the locked box mechanism may not be appropriate.
- In such a situation, the parties can consider using completion account purchase price adjustments instead as this grants buyers a level of protection from value erosion in the lead up to completion. With this higher level of certainty on “getting what you paid for” comes an increase with transaction costs in the negotiation of the detailed provisions and a heightened risk of disputes.
As set out above, the appropriateness of each mechanism ultimately depends on the suitability of the asset being acquired and parties’ respective bargaining powers. There are several risks in “locking the box” on the price pre-completion with no adjustment mechanism and there are also difficulties relating to the use of a completion account mechanism. It is important that all parties consider the circumstances of the transaction in deciding which purchase price mechanism is most suitable and seek legal and financial advice on the matter.