Introduction

• An Important step in any M&A transaction is evaluating the target company and arriving at a Final Purchase price using valuation methods like Discounted cash flow or Earnings multiple and Net Assets approach.The most common way how the deal is structured by the buyer to arrive at a Final Purchase Price is that that transaction will be evaluated on Cash Free Debt free basis along with a normalized working capital that would be negotiated between the buyer and seller.
• The valuation methods most commonly used is the earnings multiple approach but as more acquisitions are happening where the target companies still not have break even or still burning cash, the revenue multiple approach is used.
• If the target has net debt or debt like items in the balance sheet then the final enterprise value and equity value would vary taking into account the net debt.This is generally referred to as bridge between Enterprise to Equity value.
• To arrive at the target Working capital or Working capital peg takes a lot of time and involves extensive negotiations between the buyer and seller.Right from what is needed to be included in the Working capital and as well as excluding values like bad debt or deferred revenue in arriving at the Target Working Capital.
• All these parameters including valuation approach used along with Target Working Capital details used to determine the final purchase price along with Representation and Warranties as well as Covenants related to the operations of the Target business between signing and closing needs to be drafted in the SPA - Sale and Purchase Agreement and then is signed between the buyer and seller.
• There is generally a delay in time between the signing and closing, due to the regulatory approvals that is needed to be obtained by the buyer and seller.Once all approvals are obtained along with other conditions to closing like any Customer approvals required on ownership changes and other legal disputes if any that is required to be settled by the seller prior to closing, the seller accounts are closed and its balance sheet is audited by the buyer using a third party consultant.The third party consultant evaluates the seller Financial statements at closing to identify key values like EBITDA, any net debt found in the seller balance sheet along with the actual working capital that is calculated based on parameters set by the buyer and seller while signing the deal.If any changes are observed between the target values and actual values then there will be adjustments in Purchase price accordingly. For instance, In a deal with Purchase Price of $150M, the Target Working Capital is $30M and if the actual Working capital calculated at closing is $20M then this deficit will be followed by adjustment in the Final Purchase price from $150M to $140M.
• Hence the Purchase price that is generally announced in the media at the time of signing could be different from Purchase price that the target would receive post closing.

What is Locked Box Mechanism?

• If there is a high adjustment in the Final Purchase Price between the signing and closing, then the seller stands to lose in the consideration that he shall receive at the end.This leads to uncertainty in the price especially for sellers like Financial sponsors or Private Equity firms who are obligated to share the final proceeds with the shareholders.Hence this uncertainty can lead to a huge loss in Shareholder returns.
• In order to prevent this uncertainty, locked box mechanism is preferred by the seller.In this process, the final purchase price is predetermined and locked at a date prior to signing which is called as a Locked Date.In this date, the final accounts of the seller are audited and basis this, the target Working capital and final purchase price is arrived at.This purchase price determined will not be subjected to any adjustments at the closing of the deal.
• This approach works for the seller as there is a certainty in the Final Purchase price but the buyer is exposed to a huge risk as the target business can deteriorate between the locked box date and closing.In order to protect the buyer from this situation, any value that is leaked between the signing and closing shall be indemnified by the seller to buyer at dollar to dollar basis.

Value leakage between the locked box date and closing date

• The seller has an opportunity to manipulate and extract value from the target business during the time between locked date and closing date by paying dividends and bonus to shareholders or may neglect to business operations as seller is no longer the owner and not motivated.In some cases, the seller might get involved in business deals with related parties where the pricing is generally not at arm's length price but a preferred price. This happens in the case of carve outs where the parent can leverage the services of carved out entity at a preferred price rather than arms length.This can impact the profitability of the business.Hence covenants terms needs to be negotiated between the buyer and seller to prevent the seller from taking any actions that can result in value leakage.In some deals, the seller needs to be take buyer consent to decide on key areas of business.
• The locked date and locked accounts are generally decided by the seller.In most of the cases, Locked date is generally the year end financial date as this can enable the seller to get its financials audited.In cases where the deals happen at mid year, then buyer would be interested to have the latest audited financials data and would not rely on audited data that is months old.In this case, the management accounts to date audited and certified by a third party consultant.As the buyer has the complete exposure and risk on target business from locked date, it needs to ensure that the locked accounts are audited.Then a detailed Finance due diligence would be conducted by a third party consultant on behalf of the buyer to identify any risks.These are then drafted in SPA agreement with representations and warranties along with indemnification provisions to the buyer for any future claims.Generally the covenants between the locked date and closing date are negotiated in detail to include indemnification provisions as the buyer cannot do any adjustments on Final Purchase value at completion.A part of the purchase price is holdback by the buyer or maintained in escrow to account for value leakage in the target business between locked date and closing.These claims are indemnified dollar to dollar basis and does not include any thresholds or caps for claims.
• The seller charges the buyer for the activity it does for running the business on buyer behalf between the locked date and closing date.These payments can either be given as form of interest payments on the purchase price where the interest rate is generally the opportunity costs of seller for running the business.In some cases, the seller charges an interest percentage on the excess profits that is brought by the seller between the locked date and closing date that increase the equity value.This excess profits needs to be above the projected profits that the buyer has estimated while valuing the target business and arriving at the purchase price.This is to ensure that the buyer is not double charged by the seller.

Key Features of Locked Box Mechanism

• This approach saves time and cost for buyer and seller.The additional cost of involving an auditor for completion accounts is not required.
• The time spent for negotiating on the covenants on the purchase price adjustments between signing and closed is saved.This negotiations takes a lot of time and cause delay in closing the deal.
• The Locked box mechanism works better when the time taken between signing and closing is less.If there is a huge delay between signing and closing, then there can be material changes in the net debt level and even in some cases value of assets in addition to the Working capital changes.This puts the buyer at a high risk.In such cases additional covenants and indemnification needs to be included in the final SPA document.
• The locked date should also take into account the seasonality of the target business.If the target business declines between the locked date and closing date, then the buyer needs to put it in additional funds after taking over the business. These needs to be accounted in the covenants

Conclusion

• Locked box mechanism is generally preferred by the sellers as this gives a certainty on the Final Purchase price.
• This approach also helps the sellers in auction scenarios where the seller can compare the Final Purchase prices of multiple buyers at an apple to apple basis.
• This approach favors buyers as it takes less time and costs.
• Any indemnification claim on the value leakage by buyer has a time limitation which is less that normal claims.The time frame to raise claims is within 1 year from closing.
• As the buyer takes a huge exposure by owning the target business from Locked date against closing date, it needs to do a detailed Financial due diligence with the latest audited financials of the seller at locked date to minimize any risks that it incurs post closing.