Locked box or completion accounts. Which to use?
Corporate & commercial solicitors do not always deal with negotiating the headline terms of a business sale and purchase. These matters are often carried out by the parties directly or by a broker, before solicitors are instructed. However, the way a transaction is structured, and the key terms of that transaction will hold great importance when coming to completion. Furthermore, buyers and sellers are not always clear on the implications of such terms from the outset, only becoming aware of the full effects of such terms once they are readying for completion. One area of particular importance is the method of obtaining a final valuation at the time of sale. This can be overlooked in the early stages of a deal when the parties are more focused on agreeing a headline price and getting due diligence underway.
Unlike a property transaction, where the purchase price is invariably agreed from the outset as the final purchase price (subject to any glaring defects in title or otherwise), the value of a business is far more liable to fluctuation in its underlying assets and liabilities or enterprise value, and a balance sheet can only provide a snapshot of the value from the time it is produced. A diligent buyer or seller will want to ensure that they do not end up overpaying or being underpaid for the business but will also want to balance this with any administrative measures required to provide a final valuation as at Completion.
Therefore, various methods have developed which assist a buyer or seller in agreeing a final valuation. Notably, these are a Completion Accounts mechanism or a Locked Box mechanism.
Completion Accounts
As noted above, a balance sheet only provides a snapshot of the net assets to determine a company’s value at the time it is produced. Therefore, Completion Accounts are an obvious way to obtain a final valuation, by instructing accountants to produce a set of accounts shortly following completion of the sale, to reflect the net asset value at the time of Completion. This period is often around one month so that the accountant can pull together all assets and liabilities as at Completion. A £1.00 for £1.0 adjustment is then made for any sums which exceed or are under the agreed Target Net Asset base which the parties have agreed. Another method is zero cash/ zero debt completion accounts adjustment, which (as the name suggests) simply measures the levels of free cash against the current liabilities of the Company, which may be more appropriate where the Company has little or no tangible assets.
Whilst this seems straightforward in principle, it can often be frustrated by issues around agreeing the different accounting policies on which the parties are relying in the production of such accounts. These issues are generally agreed upon in the Share Purchase Agreement but can still be cause for some dispute post completion if they are not nailed down sufficiently. In addition, the Buyer will often want an agreed level of working capital to be left in, which can complicate matters further. However, once the Completion Accounts are finalised, it is simply a case of paying an adjustment either way.
Locked Box
Because the Seller will usually want a ‘clean break’ from Completion and will not want to wait for several weeks for a final valuation to be determined, the Locked Box mechanism has become very popular in recent years due to the upfront certainty which it gives to a Seller and Buyer. In essence, the purchase price is set at a fixed value ahead of the completion date (the Locked Box Date), by reference to an existing set out accounts. At this point, the levels of cash, debt and working capital are all set in stone. Warranties will almost always be provided for against these accounts, so that the Buyer has a claim against the Seller for any inaccuracies or omissions in them. “Leakage” provisions are the main contractual protections for a Buyer. The definition of “Leakage” will vary from transaction to transaction, but it is usually defined as any extraction of value for the Seller’s (or a person connected to them) benefit which falls outside of the ordinary course of business of the target company. Warranties will be provided by the Seller confirming that no Leakage has occurred, and the Buyer will have a remedy for breach of warranty if any leakage has not been accounted for in the run up to completion. An indemnity may also be provided for further protection. Certain items will be classed as “Permitted Leakage” such as salaries or dividends for extraction of surplus cash.
With the above in mind, the Buyer effectively takes on the risk and benefit in the business from the Locked Box Date (rather than the date of completion), as it has no entitlement to an adjustment of the price on completion (save for any breach of warranty or indemnity claim). Therefore, to protect the Buyer’s interest during the intermittent period, the Buyer will require contractual protections in the Share Purchase Agreement to prevent the Seller from unjustly extracting any value from the business during that time.
Because the Buyer will take the benefit of the Business from the locked box date, the Seller won’t receive any portion of the profits generated after the locked box date. On larger transactions where negotiations can last for several months, a “profit ticker” may be negotiated for a Seller so that they can retain the benefit of some profits that have been made up to completion if they exceed a certain level. A Buyer may be inclined to agree this as it keeps the Seller incentivised in the ongoing management of the business during the intermittent period.
Conclusion
Whether to use the locked box method, or completion accounts, in determining a final valuation is an important issue and a buyer or seller of a Company should address this and seek advice when agreeing heads of terms and before agreeing to either structure. Sometimes the parties will willingly agree to a certain method at the outset of the transaction and later realise that it is not suitable or desirable for them. Advice from a valuation expert or often the Company’s accountants will be necessary to understand which method is appropriate by considering the financial implications in each case.
The level of due diligence (particularly financial due diligence) and the shape and size of the Share Purchase Agreement will all hinge on what transaction structure has been selected and so choosing the right method at the beginning of a sale can save on professional costs and prevent unwanted delays to completion, or even (in rare cases) an abortive transaction.
