As a price structuring mechanism the “Locked-Box” has now been with us for a number of years having originated as a creation of the private equity industry in a significantly more buoyant M&A marketplace.
The primary attraction of the structure to a Seller is certainty – other comparable price adjustment structures typically depend upon the production some months after completion of a closing balance of the target with a price adjustment linked to net assets or working capital. The Seller has to wait at best several months before being certain about the price it will receive and from the Buyer’s perspective the process can make significant calls upon management time at a sensitive period for the target business.
The Locked-Box arrangement is intended to remove that uncertainty for the Seller by fixing the price in advance with no post closing adjustments. In this way economic ownership of – and risk in - the target passes to the Buyer from that point.
This article examines the traps of a locked-box structure for the unwary Buyer as well as the implications for the Seller and considers whether the chillier economic climes will precipitate its demise .
What is a Locked-Box?
The “Box” is essentially the target’s balance sheet at the chosen date (which pre-dates closing) and is “Locked” in the sense that parties intend that (with limited exceptions) no economic value leaves the target between that date and completion (the locked-box period).
When is it appropriate?
The structure is only appropriate where the transaction involves the sale of a stand-alone entity (i.e. not a trading division).
Issues for the Buyer
● First and foremost the Buyer must address the risks posed by the fact that it is assuming economic ownership of the target from a date preceding completion. Clearly the shorter the locked-box period the better as the Buyer is vulnerable to any deterioration in trading during that time; it is important that the balance sheet is not too historic and that the business is properly run in that period.
● In order to ensure that the box is locked tightly the Buyer will wish to avoid any “leakage” during the locked-box period i.e. that the Seller does not extract cash or other value from the business unless factored into the price. This is a key area of protection for the Buyer and needs to be as comprehensive and detailed as possible.
● How reliable is the locked-box balance sheet? The Buyer will need to be able to undertake effective due diligence on the locked-box balance sheet and obtain warranties from the Seller to underpin it.
● Key to the Buyer’s pricing strategy (particularly in auctions where the Buyer finds itself committing to a price before exclusivity and an opportunity to get management on-side) will be its ability to satisfy itself on the correct level of net debt and whether the amount of working capital is representative of a normal level.
● If the Seller is seeking to retain the profits generated during the locked-box period then the Buyer must be able to satisfy itself that the daily profit rate or interest charge is reasonable (e.g. is it supported by latest trading?).
Issues for the Seller
● As outlined above a properly advised Buyer will wish to ensure that no value leaves the target during the locked-box period. The corollary is that the Seller will need to identify exceptions to this principle (“Permitted Leakage”) which will include payments made in the ordinary course of business (e.g. wages, hire finance charges etc.).
● The Seller may wish to retain the profits generated by the target in the locked-box period (not least to reflect the fact that it is financing the business during that time) and will typically seek to achieve that via an adjustment to the purchase price e.g. an interest rate or a daily profit rate.
● The Seller will need to consider carefully any warranties sought in respect of the locked-box balance sheet and “leakage”. Far better from the Seller’s perspective to allow the Buyer a reasonable opportunity to get comfortable with that balance sheet and the key working capital and net debt components.
● The Buyer must ensure that it acquires what it expects; whilst the locked-box mechanism is clearly weighted in favour of the Seller the Buyer can, with appropriate detailed provisions, ensure that it is adequately protected.
● A more fundamental question perhaps is the future of the locked-box as a price structuring device. That times have changed is axiomatic but the likelihood is that with a number of private equity houses looking to exit investments made in the last 3-5 years the locked-box has entered hibernation rather than extinction.
(This is one in a series of articles by the PSW corporate team on trends and issues in M&A deal structuring)