What is a ‘locked-box’ valuation?

Corporate Finance, Investment

Budget briefcase

Identifying, evaluating and completing business mergers and acquisitions (M&A) can be a complex and time-consuming process, with managers and executives involved in such deals often working in quite a volatile business environment.

Traditionally, one of the trickiest parts of the process has been the final stage of completion. After all due diligence has been carried out, the buyer and vendor agree a purchase price for the company, which includes the business valuation, minus any debt, based on the balance sheet at completion, and with an adjustment for working capital.

Negotiating the target working capital is often fraught with disagreements; there are complexities with ‘normalising’ working capital, determining an appropriate target and determining which items should be included in, or excluded from, the calculation.

One of the main difficulties of this process is that between agreeing the sale of the business and completing the deal, the value of the business is likely to change – usually down to variations between the actual and forecast net debt and working capital.

Where the working capital is greater than forecast, there is a positive adjustment to the final purchase price, and vice versa if there is a deficiency. But again, the ‘true-up’ process post-completion to agree changes to the purchase price is often disputed, consuming a great deal of management time, and adding further complexity. All of which can delay the points at which the final price for the target business is agreed and paid, with value potentially lost along the way.

Growing in popularity in mergers & acquisitions

One alternative that’s proving increasingly popular across the M&A sector is the use of ‘locked-box’ pricing agreements, in which the value of the target company is determined before signing the deal, and is not then subject to any post-completion adjustment.

Put simply, a locked-box transaction is a fixed-price deal, where the buyer determines the value of the company as of a date that precedes closing, known as the ‘reference date’. That date is usually the end of a fiscal period for which financial statements have been prepared. Any benefits or liabilities that accrue from the business performance after the reference date are for the buyer to take on.

The vendor guarantees the quality and accuracy of the reference date financial statements, and also agrees to a ‘no leakage’ covenant or indemnity, which would see the buyer ‘reimbursed’ for any value ‘leaked’ from the box after the reference date – such as dividend payments or below market dispositions.

What format do ‘locked-box’ accounts take?

The locked-box accounts may be audited or unaudited, but certain issues will have greater impact on a buyer’s ability to rely on them. The first is the time gap between the accounts being completed, and the agreement being signed. The longer the gap (and anything over six months is likely to deter a buyer), the more likely it is that the business performance may have changed significantly since the box was ‘locked’.

An audit, or some lesser form of independent review, may also be important to address any concerns about locked-box accounts being prepared by the seller, although the use of independent accounting firms to prepare vendor financial due diligence reports on these accounts will often allay buyers’ fears.  

Related reading: Acquisition targets: how to find financial information on a business

What is the final price?

In a locked-box deal, although the buyer essentially acquires the business from the reference date, the vendor doesn’t receive payment until completion; as a result, vendors often require compensation in terms of interest on the equity value of the business, from the reference date to completion.

So the final purchase price effectively equals the purchase price determined at the reference date, less the monetary value of any subsequent leakage (as scheduled), plus vendor compensation (in the form of interest) from the reference date to the closing date.

While there is still likely to be a share purchase agreement (SPA) drawn up as part of a locked-box transaction, it is usually much simpler than the type of SPA required in a traditional completion accounts process, and will consist mainly of covenants and warranties surrounding the activity of the target business, to ensure that the contents of the locked box do not change during the process.

Locked-box valuations and pricing mechanisms have the potential to significantly reduce the complexities and delays sometimes associated with the completion process in traditional M&A activity. But the process may not be the most appropriate method for all sales or acquisitions, and it’s important to take professional advice early to see if it’s the best option for you.

This post was written by Chand Chudasama, one of Price Bailey’s Strategic Corporate Finance Directors. If you would like to know more then please contact Chand using the form below.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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