Recent years have seen the rise of an alternative approach to conventional purchase price adjustment mechanisms in private M&A transactions: the so-called “lockedbox” structure. The structure first gained prominence in the United Kingdom during the sellers’ market of the early 2000s. It made inroads into North America during the 2005-2007 cycle and has regained popularity over the last few years, particularly in the context of “hot” auctions.
Assuming the recent frothy sellers’ market continues into 2015, we expect to see more use of the locked box in the near future.
Conventional Closing Balance Sheet Method
Private M&A in North America frequently follows a common template: the target is acquired on a debt-free, cash-free basis, assuming sufficient or “normalized” levels of working capital. Under that structure, the final purchase price is not known at closing. Instead, the parties estimate debt, cash, working capital—and sometimes other adjustment items—and then “true-up” these estimates shortly after closing. That adjustment procedure requires the preparation of a closing balance sheet, often drags on for four months or longer, and is arguably one of the primary sources of disputes among parties to private M&A transactions. Only once that procedure has been completed is the final price set. That price uncertainty, in turn, often requires sellers to post short-term escrows to back up potential repayment obligations.
“Locking the Box”—An Alternative Approach
Under the locked-box structure, the purchase price is fixed at signing. It is calculated as of a so-called effective date, typically the date of a recent audited or unaudited balance sheet (the “reference balance sheet”). From that date forward, the “box is locked,” meaning that the risks and rewards of the target business transfer to the buyer as of the effective date, with negotiated protections addressing value leakage from the target to the seller between the effective date and closing. Critically, there is no purchase price adjustment mechanic. Because the target is effectively sold as of the effective date, sellers frequently request the addition of an interest ticker on the purchase price that runs from the effective date through closing.
The advantages of the locked-box structure are obvious: price certainty at signing, no need to negotiate price adjustment provisions (including setting working capital targets), and the elimination of often time-consuming price-related disputes between the parties after closing. Sellers see additional benefits in the locked-box structure because they control the preparation of the reference balance sheet rather than having to review and work from a closing balance sheet typically prepared by the buyer. In an auction environment, a locked-box offer can also be easier for the seller to value and compare against competing offers. The locked-box approach can equally benefit buyers by reducing any incentive for sellers to manipulate traditional purchase price adjustments to their advantage, for example, by deferring capital expenditures to artificially inflate cash at closing.
Beyond the advantages, however, the locked-box approach presents several issues that a buyer should consider carefully. First, the buyer needs to make an upfront investment of time and money to thoroughly diligence the reference balance sheet, because unlike transactions using the conventional mechanism, there will not be an opportunity to dispute balance sheet positions once the value has been locked. This is particularly true where the reference balance sheet is not audited. It may be difficult to reconcile that upfront due diligence commitment with other transaction dynamics, for example, in situations where speed of execution is key.
A second issue for buyers is that locked-box deals sometimes do not provide for a full bring-down of the seller’s representations and warranties to closing−other than with respect to certain fundamental representations and warranties regarding the validity of the transaction. This is another upshot of the basic premise that the buyer, from an economic standpoint, owns the business as of the effective date on a locked-box deal. As a result, the buyer’s walk-away rights at closing may be more limited than in the conventional structure. Similarly, locked-box transactions may not permit a buyer to seek indemnification post-closing for breaches of the representations and warranties that occur between signing and closing.
A third key issue for buyers in locked-box transactions which requires particular attention is related-party “leakage”—that is, any transfer of value from the target to the seller and its affiliates between the effective date and closing. Leakage potentially undermines the buyer’s fixed purchase price obligation and can be thought of in three categories:
Permitted leakage that should not give rise to a purchase price reduction and may include, for example, amounts payable by the target to affiliates of the seller for services rendered on arm’s-length terms;
Negotiated leakage that is permitted under the terms of the purchase agreement but gives rise to a purchase price reduction—examples include the payment of target transaction expenses, management fees to private equity sponsors or stay bonuses; and
Prohibited leakage that comprises all payments to or on behalf of the seller and its affiliates which do not fall into the first two categories. The purchase agreement will typically include provisions that restrict this category of leakage and give the buyer recourse against the seller on heavily negotiated terms if restrictions are violated.
While the locked-box structure presents advantages over the conventional mechanism, these advantages come largely at the buyer’s expense. However, in the context of competitive auctions, prospective buyers who are able to get comfortable with the drawbacks of the locked-box structure may find that they can differentiate themselves from their rivals.
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