While closing accounts have traditionally been the default mechanism of choice of the parties in M&A transactions, the use of locked box structures has become more common in recent years. The real key difference between the two mechanisms is the different moment in which the economic risk and benefit in the target company passes from the seller to the buyer: at completion, with closing accounts; at the so-called “locked box date” (agreed between the parties before signing) with locked box.
1. Evaluating the target business: key financial metrics
The term Enterprise Value describes the value of a given business – determined according to whatever method the parties decide to adopt: multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), discounted cash flow etc. Assuming that the Net Financial Position is zero (total cash position minus total financial debt = zero).
Equity Value is the Enterprise Value of a given business plus total cash position minus total financial debt. The offers for target businesses are often made on a cash-free/debt-free basis, i.e., on the basis of the Equity Value.
The challenge arises as the accounts of the target company available at closing usually date back few months from closing date. Additionally, the total cash and total financial debt of an operating business vary every day, making it practically impossible for the parties to know the Net Financial Position on the very date of closing. Hence, there is a need to provide in the Share Purchase Agreement (SPA) a mechanism and a process for the exact calculation of the purchase price at closing.
The discussions between the parties usually focus on the correct determination of the enterprise value of the business, which is typically a multiple of the EBITDA, on the assumption that EBITDA:
- is representative of the sustainable level of cash profit generated by the business;
- represents the trading performance before interest, depreciation and amortization;
- does not take into account the financing structure or the net asset strength of the business.
Following the above evaluations, the last step is drafting the Share Purchase Agreement (SPA) which reflects the relevant price adjustment mechanism which has been agreed between the parties.
2. The traditional approach: closing accounts mechanism
In case of an SPA (Share Purchase Agreement) with closing accounts mechanism, the SPA, will provide a provisional price, based either on the accounts at some date before closing or on some projections of the target’s accounts at closing. Such provisional price is then adjusted on the basis of the Net Financial Position at closing.
The SPA usually will include an obligation to manage the company “consistently with past practice” in order to avoid that the seller, in the period between signing and closing, intentionally “inflates” the cash position of the target company (for example, delaying payment of suppliers or accelerating collection of receivables). In addition, given that NFP may be affected by changes in working capital (payables and receivables, fluctuations of inventory etc) intentionally made to change the Equity Value, the SPA may provide for a mechanism for the adjustment of the working capital at closing as compared to working capital based on which the provisional purchase price is calculated (accounts at a date prior to closing or projection of accounts at closing). at the time of the signature of the SPA is not known.
Alternatively, the SPA may provide that the exact calculation of the purchase price at closing (that is: based on NFP and WC at closing) is made after closing. This means that the buyer will pay the enterprise value at closing and this will be adjusted following the preparation and agreement of the closing accounts. In this scenario, the SPA will usually provide the rules for the preparation of the accounts, in order to protect the in interest of both the buyer and the seller.
3. The innovative solution: locked box structure
Under a locked box structure, the price is calculated based on accounts of the target prepared before the signing of the SPA. Therefore, at signing, the parties will already be aware of the amounts of cash, debt and working capital and there will be no price adjustment after the closing, save for those claims (i.e., leakages) agreed between the parties and listed in the SPA. At closing, the buyer assumes the risk of paying more than the actual Equity Value of the target at closing (because NFP increased between accounts at signing and closing); conversely, the seller assumes the risk of selling at a price that is lower than the actual EV at closing (because cash increased between accounts at signing and closing).
Unlike the closing accounts mechanism, a locked box SPA provides for a fixed price which can be adjusted only in the case the seller allows certain values to leak out of the target between the locked box date and completion of the transaction. This essentially means that the buyer:
- must price the target business based on a recent (but not updated) set of accounts prepared by the seller;
- will have no ability to adjust the equity price after closing;
- will have only remedies related to leakage and other contractual protections (such as representation and warranties or, in case the parties agree so, a material adverse effect provision).
In addition, the buyer may require that the seller guarantees that NFP at closing be not higher than a certain amount, and ask for indemnification if NFP turns out be higher.
4. Comparative analysis: pro-buyers vs pro-seller perspective
Is closing accounts really pro-buyer and locked box areally pro-seller? Closing accounts have been traditionally regarded as more buyer-friendly, while the locked box apperead to be more favorable to sellers. Although each mechanism has advantages and disadvantages for both sides, and the effective benefit for one party over the other must be assessed on a case-by-case basis, it is possible to identify specific advantages and disadvantages for both sellers or buyers in each structure.
In case of closing accounts, the seller may benefit from a more expeditious could have advantages in speed of negotiation and execution and negotiation, as the buyer may need a lower level of comfort with the accounts balance sheet before completion. Furthermore, the seller could also have major economic benefits in the business, that would not be limited by the leakages and, therefore, they could receive profits up to closing.
With reference to the buyer, one important pro is linked to the fact that it only pays for what it gets, and it can, when in full control of business, double-check the closing accounts.
Potential adverse consequences could affect both seller and buyer in similar ways; as a matter of fact, due to its uncertainty, post-closing adjustment could potentially give rise to disputes between the parties, which might cause additional costs and time delays for both. In addition, the closing accounts structure could grant to the seller (which takes economic risk of business until closing) less control over the adjustment process.
On the other hand, locked box can give both the seller and buyer more certainty about the price and simplicity of process, as well as lower costs.
With reference to the potential adverse consequences, firstly the buyer would take into account extra due diligence efforts, as well as constant monitoring between locked box date and closing, for taking control over the possible risk of leakages which might affect the business.
Furthermore, the parties need to debate in advance certain items, and the buyer could be in a weaker negotiating position, having potentially less detailed knowledge during this phase. Conversely, the seller could be affected by not getting full benefit from the business operations during the interim period, as these are not even compensated for by the post locked box interest rate (if agreed), which is usually too low compared to the missed earnings of the target.