Determining The Price Of A Target Business In M&A Transactions: Completion Accounts V Locked Box Mechanisms

The article looks at the key features of completion accounts and locked box pricing mechanisms, together with their advantages and disadvantages

One of the most negotiated areas in the private acquisition of a business is the method of pricing the target. The two most popularly used mechanisms for this are completion accounts and locked box. The completion accounts method gives the parties the opportunity to adjust the price based on the figures in accounts put together after completion, and the locked box method involves a fixed purchase price based on a balance sheet prepared before completion. Completion accounts are seen as more favorable to purchasers and have been traditionally used in private acquisitions of businesses. However, in many other jurisdictions around the world, locked box mechanisms have become popular in share transactions, especially where sellers have the greater bargaining power. It is worth noting that in India, completion accounts mechanisms cannot be put in place for multi-jurisdictional transactions because the regulatory rules do not allow the price to be adjusted post completion without being subject to restrictions. This article sets out the key features of both pricing mechanisms, together with their advantages and disadvantages.

Completion Accounts

In merger and acquisition transactions, historical accounts such as the latest audited accounts or more recent management accounts are used by the parties to come to a conclusion about the value of business. A prudent purchaser would be concerned about figures in accounts changing since the date of these historic accounts. To address this, the parties may agree to a completion accounts pricing mechanism whereby accounts are put together on an agreed date following completion and the purchase price is amended based on the difference between historical accounts and post-completion accounts. Such an adjustment can work both ways or only one way, depending on the bargaining strength of the parties. Completion accounts can range from a balance sheet and profit and loss account, only a balance sheet, or a statement setting out net assets, net cash/debt, or working capital.

The purchaser and the seller agree which party's accountants will be responsible for putting together completion accounts within a specified period following completion. The seller may argue that his/her accountants have already familiarized themselves with the business. On the other hand, the purchaser would have taken over the target by the time completion accounts are put together and may therefore state that it makes more sense for his/her accountant to prepare them. The parties will also agree to accounting policies that will be used in preparing the accounts and their order of priority. Such policies can range from specific policies set by the parties, the policies used by the target in its latest audited accounts, and standard accounting policies including International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Policies (GAAP). After completion accounts are prepared by the accountants of one party, the other party's accountants have the opportunity to review them within a specified period. If there is a disagreement over the figures, the parties are given time for dispute resolution, and if they do not succeed in resolving the dispute, then it is referred to an independent accounting expert.

The advantages of completion accounts for the seller are the time saved on the transaction process because the purchaser does not need so much assurance on a balance sheet prior to completion and the seller benefits financially from the business including its profitability right up to completion. The disadvantages for the seller include the possibility of a disagreement regarding the completion accounts; the seller bearing the financial risk of the business right up to completion; the lack of certainty between completion and the post completion adjustment; and the costs of preparing, reviewing, and agreeing to the completion accounts.

The advantages of completion accounts for the purchaser include the benefit of an adjustment if the value of the target is lower than what it has paid and the purchaser having access to accounting facilities of the target post completion in order to assess adjustment. The disadvantages for the purchaser include the possibility of a disagreement regarding completion accounts; the lack of certainty between completion and the post completion adjustment; and the costs of preparing, reviewing, and agreeing to the completion accounts.

Locked Box

Locked box mechanisms involve the parties determining a price for the target by reference to historic accounts, most often a balance sheet, and suit share transactions more than asset transactions. The seller gives warranties to the purchaser in relation to the accuracy and preparation of these accounts. The locked box accounts most commonly used are the target's latest annual audited accounts; however, if such accounts are not recent, the purchaser may request more recent management accounts to be used. Given that the historic locked box date is fixed, the purchaser benefits from the profitability of the business from such date, and therefore, the seller is paid interest on the purchase price between this date and completion.

The purchaser is also given protection in respect of leakage to prevent the seller taking out value from the target between the date of the historic locked box accounts and completion. Examples of such leakage include waivers of debt from the seller or payments and transfers to the seller of the following: dividends and distributions, transaction fees, bonuses, charges, and expenses. The seller would normally fully indemnify the purchaser in respect of any such leakage without there being a maximum cap on such an indemnity. However, claims by the purchaser are normally required to be made by the purchaser within 6 to 12 months post completion. Carve-outs to leakage called 'permitted leakage' are usually provided for to prevent disrupting the target's usual course of business, for example, to pay salaries in the ordinary course of business or to make intra-group payments on arm's-length terms, but permitted leakage is usually very specifically defined and subject to maximum limits.

The advantages of a locked box mechanism for the seller include the certainty as to the price early on, control in setting the price, the simplicity of the process, and the opportunity to compare bids on an auction sale. The disadvantages for the seller are that the purchaser may request more comprehensive warranty protection on the locked box and management accounts and that the seller will not get the entire benefit from the business during this period between the date of the locked box accounts and completion (however, the seller will benefit from interest payments from the purchaser on the purchase price between these two dates).

The advantages of a locked box mechanism for the purchaser include certainty as to the price early on and the simplicity of the process. The disadvantages for the purchaser are that the business may become unprofitable between the locked box date and completion, the locked box accounts are drawn up when it has less knowledge of the target, and because there is no price adjustment following completion, the only way by which the purchaser may adjust the price after completion is through a successful warranty or leakage claim.

Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.