In an M&A transaction, a completion mechanism is used to calculate the final price that a buyer needs to pay to acquire the shares of a target. In this article we set out the theory and pros/cons of the two most widely accepted mechanisms – completion accounts and locked box.
The same deal convention applies to both mechanisms whereby the price is agreed on a cash-free, debt-free basis with a ‘normal level’ of working capital which bridges between the Enterprise and Equity value (final consideration paid to shareholders) of the business.
The most traditional approach is the completion accounts mechanism (also heavily favoured on US transactions) but in recent years, the locked box method has grown in popularity as there has been an increased market demand for high-paced M&A transactions and clean-cut closing procedures particularly for Private Equity buyers.
During the SPA negotiation, the buyer and seller will agree on an initial purchase price by estimating the equity value at the date of completion.
The process for calculating the final purchase price begins post-completion when the buyer draws up the completion accounts (generally 60-90 days after closing). The seller then has the opportunity to review and either accept or dispute this calculation. Once agreed, the purchase price is adjusted up or down to align with the value reflected in the completion accounts.
Completion accounts are generally seen as a buyer friendly approach as the final purchase price should reflect the actual value at the time of completion and there is no value leakage.
For a seller, we set out the pros and cons below:
- Uses a precise method for final valuation using the benefit of hindsight to accurately calculate the completion balance sheet.
- Tends to reduce the time and effort during financial due diligence process as there is less pressure to agree price before close.
- The seller will receive all the benefit of profits up to completion rather than relying on an estimate.
- May be more time consuming as the buyer will require support when drafting the completion accounts.
- There is a higher risk of disputes given the subjectivity around accounting in the final accounts.
- Increases the complexity as accurate definitions are required in the SPA and there is less certainty on the value you will receive.
Under this mechanism, the final purchase price is agreed by the buyer and seller at the point of completion with no post-closing adjustment.
The buyer will ‘lock the box’ at a defined balance sheet date (ideally as close to the completion date as possible) and at this point the economic risks and rewards transfer to the acquirer. The sellers will continue to run the business between the locked box and completion date so are compensated for the profits generated in the period less any ‘leakage’.
Buyers who prefer clean closing procedures tend to favour this approach but typically it is seen as seller friendly as there is certainty over the price that they will receive. A buyer risks losing value if there is a disconnect between the purchase price and value of the target at completion. It is therefore essential to conduct detailed financial diligence on the locked box balance sheet and negotiate appropriate protection for value leakage prior to closing.
Below we expand on the pros and cons for sellers:
- There is price certainty for the seller.
- Avoids lengthy negotiations / disputes post-completion and sellers can concentrate on running their business.
- Reduces friction during negotiation and can reduce transaction costs.
- Financial due diligence will be more intensive as buyers don’t have the ability to adjust price post completion.
- May not get the full benefit if the value of the business has increased between the locked box and completion date.
- A buyer may require more onerous provisions around leakage.
The choice of price mechanism will largely depend on the profile of the buyer and robustness of the target’s accounting procedures. Ultimately, there shouldn’t be a difference between the value that a seller receives in either mechanism but as we have explained above there are various considerations that a seller should take on board before agreeing to a methodology.