Price adjustment vs locked box
Published on 24th Oct 2017
Alternatives for the determination of the purchase price in share sale and purchase deals.
The mechanisms for the determination of the purchase price are a key issue to be addressed in the negotiation of share sale and purchase agreements (SPA). The mechanism traditionally used is a post-closing purchase price adjustment, where, after completion, the company’s financial statements at closing date (completion accounts) are drawn up by one of the parties (usually the purchaser with its auditors) and the parameters that have served the parties to value the company (typically, working capital, net debt and cash) are calculated in accordance with the methods and principles of calculation agreed by the parties in the SPA. The parties will have to agree on how to determine these parameters (ultimately, through an independent expert designated by the parties in the SPA) to subsequently carry out, if appropriate, the corresponding post-closing price adjustment.
Currently, we are seeing an increasing number of deals that, instead of using price adjustment mechanisms, are completed under a locked box pricing mechanism. In these cases, the parties agree on a fixed price (not subject to post-closing adjustments) based on the financial statements of the target at a certain date prior to closing (the locked box accounts and the locked box date). Therefore, following signing, there is no need to prepare completion accounts, neither calculate nor verify the parameters for the valuation of the target, or to make any adjustment of the purchase price paid by the purchaser (except for those that, if applicable, may correspond as a consequence of misrepresentations in the locked box accounts guaranteed by the seller to the purchaser under the SPA’s representations and warranties regime). For the protection of the purchaser, the SPA restricts any form of value extraction from the target business to the seller or its related parties (such as the payment of dividends and management fees) from the locked box date until the closing date (leakage),-except for those outflows expressly carved out in the SPA (permitted leakage). In case of any leakage, the seller shall reimburse the corresponding amount to the purchaser.
The main difference between the two mechanisms is the date of transfer of the economic risk of the target business performance. When price adjustment mechanisms are used, the economic risk is transferred to the purchaser on the closing date. However, when using a locked box mechanism, the risk is transferred to the purchaser at the locked box date, and thus, prior to the signing of the SPA. Therefore, any asset or liability arising between the locked box date and the closing date will be borne by the purchaser.
Some advantages in the use of the locked box mechanism are the price certainty, the lack of need for the debate that involves agreeing on the methods and principles of calculation of the parameters that have served to value the company and also the costs and time saved which are implicit in the preparation, review and debate of the completion accounts.
If the parties choose to use the locked box mechanism, they should be aware of the following considerations: the seller will have control over the process of preparation of the locked box accounts, which serve to fix the purchase price; the purchaser must ensure that a thorough due diligence is carried out on the locked box accounts; and the purchaser must consider whether it requires additional guarantees from the seller, such as additional covenants from the seller in relation to the conduct of the business from the locked box date to the closing date and/or a holdback of part of the purchase price as guarantee for the payment of possible leakages. In addition, the seller can compare the different offers received in a bidding process (where there is more than one purchaser interested in acquiring the target company) since the purchasers will have to compete with a fixed price.
Generally, the purchaser will aim to agree on a post-closing purchase price adjustment, since this mechanism ensures him that the purchase price takes into account the performance of the target company until the closing date of the transaction. However, the seller will possibly prefer the locked box pricing mechanism, since it enables him to know the final purchase price from the signing date of the SPA.