PRINT THIS PAGE The key to the locked box14/11/2007. Source: Lovells. Richard Ufland 
Over the past 12 months there has been a marked increase in sellers requiring a 'locked box' deal in European M&A transactions, particularly on auctions by or to private equity houses. Richard Ufland, a partner in business law firm Lovells’ private equity group, explains how the mechanism works and considers the issues. What is a locked box?
The “locked box” is a mechanism under which the parties agree a
price payable for the target company based on a balance sheet drawn up, and settled between the parties, as at an agreed date in advance of signing. The value of the target is in this way determined prior to the sale, which has the merit from the seller’s point of view of avoiding the uncertainties which completion accounts create.
Why use a locked box?
Private equity transactions are usually structured on a cash free/debt free basis, with the buyer being assured that a normalised level of working capital is left in the business.
Traditionally completion accounts have been used as a means of verifying the figures for cash, debt and working capital, though sometimes sellers have been able to prevail on buyers to accept their estimates. In addition completion accounts can be used to test and adjust the purchase price by reference to other matters, such as net assets, earnings or profits, as well.
From a seller’s point of view, however, completion accounts carry a number of disadvantages. It will inevitably take some time before the final price is established and potentially involve the seller in significant time and expense in agreeing the completion accounts and resolving any dispute arising from them.
In contrast, the locked box mechanism will provide the seller with certainty of sale proceeds at completion. From a selling private equity house’s perspective this is attractive because it means that it can remit all of the sale proceeds to its investors following completion.
For both parties there is the additional benefit that a locked box mechanism avoids the time and costs associated with preparing and agreeing completion accounts after closing.
From a buyer’s perspective, however, the locked box mechanism does not provide as much protection as a completion accounts mechanism because there is no opportunity to adjust the purchase price after completion. A buyer will therefore only agree to a locked box mechanism if it is in a position to carry out proper due diligence on the target, including on the base balance sheet, so as to feel comfortable with proceeding on this basis. The locked box approach will of course, as with the seller, provide the buyer with certainty as to the amount of the purchase price. This will have some benefit for private equity buyers, as it will avoid the complications of their having to raise additional moneys after closing which can arise where there is the potential for upward purchase price adjustments under a completion accounts procedure, but this advantage will hardly outweigh the risks for the purchaser if it cannot be fully satisfied as to the quality of the base balance sheet.
The key to how it works
The price for the target company is set by reference to the agreed base balance sheet, which may be the last audited balance sheet, the balance sheet in the most recent management accounts or a pro forma balance sheet prepared specifically for the purpose.
The essence of the locked box mechanism is that the buyer will
effectively bear all risks in the business and reap all rewards in respect of the period from the date of the base balance sheet to the date of completion, but the buyer will want to ensure that the seller cannot manipulate working capital in that period. This will typically be achieved by the seller covenanting that no 'leakage' will occur between the date of the base balance sheet and completion, with 'leakage' typically defined to include:
- dividends
- other distributions or returns of capital paid to the seller’s group and any other sums paid to the seller’s group which are not paid
on arm’s length terms and in the ordinary course of business
- fees and expenses incurred by the sellers in connection with the transaction to the extent reimbursed or paid for by the target
- repayments of shareholder debt, other than as has previously been agreed.
As stated above, the general principle is that the company should be free to carry on its business in the ordinary course and therefore often the agreement will make it clear that the following items are not caught by the leakage restrictions:
- the repayment by the target company of any financing and operational indebtedness, as set out in the sale agreement
- payments by the target company in the ordinary course of business, such as for goods, services, wages and tax.
Typically, a form of interest mechanism will also be agreed that will apply to the agreed purchase price from the balance sheet date to the completion date. Its purpose is to compensate the seller for not having the use of the purchase moneys during that period. Alternatively, the parties may agree that a 'daily earnings amount' should be added to the agreed purchase price in order to reflect the earnings of the target company between the balance sheet date and the completion date.
Additional buyer protections
In addition to the leakage restrictions, it is not uncommon for additional buyer protections to be agreed. The most common of these are set out below:
- an undertaking from the seller that any non-permitted leakage will be payable to the buyer on an indemnity (that is, a pound-for-pound) basis. Sometimes private equity funds themselves, as the indirect owners of the target, are willing to provide a direct undertaking to the purchaser
- caps on all, or some, of the categories of permitted leakage
- increased covenant protection (such as a higher level of negative
controls and lower monetary thresholds) in the period between signing and completion to protect the target company’s asset value. Private equity sellers will generally not be willing to give an absolute undertaking to the purchaser in respect of the conduct of business between signing and completion and will merely agree to exercise their voting rights and the powers of control that are available to them in this regard
- warranty of the accuracy of the base balance sheet or key line items (such as the amount of debt) shown in that balance sheet (although this will not be given by private equity sellers)
- vendor due diligence reports being addressed to the buyer or the
firms which have produced these expressly permitting the buyer to
rely on them (but the buyer will normally have to accept material
limitations as to the scope of the reports and the liability of the providers).
Practical issues to watch out for
As the usability of the locked box mechanism depends on the buyer’s ability to conduct detailed due diligence of the base balance sheet and the underlying financial information, it is important that the transaction process allows sufficient time before signing for the buyer’s advisers to conduct this due diligence. Very occasionally, the sale agreement might provide a procedure for the buyer to verify the balance sheet (and the related purchase price) between signing and completion, but this is generally not acceptable to a seller as it effectively gives a one-way option to the buyer and therefore undermines the principal benefit which a seller is hoping to achieve from the locked box approach.
Where to now?
The locked box mechanism has arisen out of the increasing competition amongst buyers to acquire attractive investment opportunities. It is currently a sellers’ market and sellers are accordingly able to dictate aggressive terms for sale. The locked box approach originated with private equity sellers, given their strong desire for certainty as to price, but with demand for well regarded companies outstripping supply the approach has been taken up by corporates too so that, even when a corporate group is auctioning one of its businesses for which it knows that there will be strong market interest, it will often now seek a locked box deal.
Buyers recognise the potential risks that this mechanism entails for them and this approach will only last for so long as the current M&A bull market lasts – in addition it does not tend to feature in the stressed and distressed markets, as the buyer rather than the seller tends to have the bargaining strength on those deals.
Ricahrd Ufland
Lovells is one of the largest international business legal practices, with over three thousand people operating from 26 offices in Europe, Asia and the United States. For more information about the firm go to www.lovells.com
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