The “Locked Box” Mechanism – a current trend in M&A activity
The levels of merger and acquisition activity may not point to any particular pattern but one trend is apparent from the deals that are being done – the increasing use of a “locked box” mechanism.
Locked box arrangements are not new and have, for many years, been an alternative to the use of completion accounts. However, in recent years, across a range of sectors, a locked box is becoming the preferred approach.
The use of completion accounts allows a buyer to acquire a business and make any appropriate price adjustment post acquisition. A locked box involves much less scope for price adjustments post acquisition and so it is often the preferred mechanism for sellers.
Both mechanisms rely on the concept of “normalised working capital” and a “cash free/debt free” enterprise value but a locked box applies these concepts to a set of historical accounts, thus giving a much great degree of certainty.
Clearly circumstances will have changed since the date of preparation of historic accounts but once normalised working capital and cash free/debt free calculations are applied, the scope for further changes is relatively limited.
Those further changes are called “leakages” – where some of the value in the company has leaked from the locked box.
However, leakages aren’t as problematic as they may sound. The basic principle at work is that the value in the company, at the date of the locked box reference accounts, should not have been leaked to the selling shareholders in the intervening period.
The most obvious example is probably dividends but even the more indirect leakages are relatively easy to identify and agree (large salary increases for shareholder directors for example). Some payments, such as profession fees incurred in preparation for a business sale, may fall into a relatively grey area but it is usually possible to agree sensible “permitted leakages” which take into account the underlying reason for any payment.
From a seller's perspective a locked box also allows them to retain more control over the influential financial information and also allows a more certain like-for-like comparison of any bids in an auction situation.
Why then would a seller ever use anything other than a lock box mechanism? There are some disadvantages but if these are limited to the following, then an old Boy Scout (or Girl Guide) could “be prepared” and try and mitigate any downside:
Timing – the certainty that the seller obtains may cause the buyer to undertake more extensive diligence, which could lead to a longer time until completion;
Historic trading – the reliance on historic accounts means there is limited scope for any corporate restructuring shortly before sale, as the buyer may not have the empirical evidence it needs to form an assured view on the trading performance of the newly restructured group; and
Reliance on previous accounts – the seller may be required to prepare accounts at a time or to a standard that would not otherwise be necessary, which may incur additional delay and expense. Whether this expense might be agreed as a “permitted leakage” will be a matter for negotiation.
The fact that, in recent years, M&A deals are taking longer to complete may be a result of some of these factors or it may be driven by a cautious approach from buyers, which allows more time to accommodate some of these issues.
For further information please contact Kenny Mumford on 0131 226 8205