M&A purchase price adjustment mechanisms - completion accounts vs locked box

When selling a business, one of the most critical, and overlooked, considerations is which purchase price adjustment mechanism to use in your sale contract.

What is a purchase price adjustment mechanism and why is it important?

In mergers and acquisitions (M&A), a purchase price adjustment mechanism refers to the process used to determine the final price to be paid for a target company by a buyer. It establishes how the initial price offered can be adjusted to reflect the value of the business at the time of deal completion.

Selecting the right purchase price adjustment mechanism is important to address risks associated with value fluctuations between signing and closing the deal.

What are the types of purchase price adjustment mechanisms?

There are many types of pricing mechanisms, however, the two most widely used mechanisms in M&A are completion accounts and locked box.

Explore the pros and cons of each mechanism below in further detail.

Completion accounts

Completion accounts are financial statements that provide a snapshot of a business's financial position at the time of deal completion.

Completion accounts have been the most commonly used purchase price adjustment mechanism for "middle market" businesses in Australia - that is, those businesses ranging from $5 million to around $300 million in value - in recent years.

This mechanism incorporates a post-completion adjustment to the price agreed when signing the sale contract, and is typically based on one, or more, of net assets, net debt (i.e. enterprise value on a cash-free debt-free basis) or working capital of the business, as at the completion date.

This is achieved by drawing up a set of completion accounts, or financial statements, after the deal has completed, and comparing the completion net assets, completion net debt and/or completion working capital figures within those accounts against pre-determined target figures set out in the sale contract.

This approach requires a period of cooperation between the seller and the buyer post-completion. Post-completion, one party will draw up the completion accounts (usually the buyer who now owns the business) and the other party will have the opportunity to review, accept or dispute these calculations. Once agreed, the purchase price that was paid on completion will be adjusted accordingly.

Example:
Using a working capital adjustment, if the target working capital figure in the sale contract is $1 million, but the completion accounts show a completion working capital figure of $900,000, then the seller will be required to "refund" the $100,000 difference (working capital deficit) to the buyer.

Advantages and disadvantages of completion accounts

The completion accounts method offers a range of advantages and disadvantages.

Advantages

• More accurate assessment of value: it provides a more accurate representation of the target business's value at the time of completion.
• Allows for adjustments: it allows for adjustments for any changes in the target business's financial position between signing and completion.

Disadvantages

• Can result in disputes: it can lead to post-completion disputes about the preparation and interpretation of the completion accounts.
• Time and resources: it requires additional time and resources to prepare, negotiate and finalise the completion accounts.

Locked box mechanism

A locked box mechanism is a fixed-price model based on a historical set of financial statements. The mechanism derives its name from the 'locked box' of accounts.

A locked box provides the buyer with protection against any unauthorised activities that could strip value from the business between the locked box date and completion (often referred to as "leakage").

Prior to signing the sale contract, the parties agree on a fixed purchase price based on an agreed set of financial accounts of the target company. While there is no post-completion adjustment to the agreed purchase price, provisions in the sale contract will protect the buyer against "leakage" between the locked box date and completion that is not otherwise permitted.

Understanding leakage

The definition of "leakage" is a key aspect of the locked box mechanism, as it identifies the payments or other transfers of value that will constitute unauthorised reductions in the value of the target company. Where there is "leakage" that is not permitted, the seller will generally be required to indemnify the buyer for this amount on a dollar-for-dollar basis.

Explore key locked box terminology in further detail below.

• Leakage: Any transfer of value from the target company to the seller(s) or its (their) related entities between the locked box date and completion. For example, dividends or other distributions, returns of capital, transaction expenses, payments to directors, or non-ordinary course related party payments.
• Permitted leakage: Any payments that the buyer has specifically agreed that the target company can make to the seller(s) or its (their) related entities between the locked box date and completion. These may include certain payments that are necessary to allow the target company to operate in its ordinary course, or specific payments that have been agreed and otherwise factored into the purchase price. For example, staff remuneration, permitted trading arrangements, or permitted dividends.
• Locked box accounts: The accounts on which the price will be agreed and "locked" prior to signing the sale contract. Given the importance of these accounts, they are often year-end financial statements, which may be audited, or a set of special purpose accounts that have been specifically prepared for the transaction.
• Locked box date: The date to which the locked box accounts have been prepared.
• Locked box period: The period between the locked box date and completion.

Advantages and disadvantages of locked boxes

The locked box method offers a range of advantages and disadvantages.

Advantages

• Reduced cost and complexity: it avoids the time and expense involved in preparing, negotiating and finalising completion accounts, which often adds complexity and cost to a transaction (as the parties will require time and professional support to prepare/review the completion accounts and implement any purchase price adjustments).
• Avoids disputes: it avoids any disputes that may arise after completion as a result of having to agree upon the completion accounts that determine what the ultimate price will be.
• Price certainty: it provides greater price certainty, as the purchase price is fixed from the locked box date and will not be adjusted post-completion. The buyer and seller can be certain at completion how much they are paying or receiving for the business. This is particularly important for financial sponsors like private equity who often require price certainty to source their funding.
• Clean-exit: provided there is no leakage, the seller receives a fixed purchase price on completion and does not need to retain a portion of the purchase price to potentially pay any post-completion purchase price adjustment against the seller, providing for a clean exit.

Disadvantages

• Accuracy of price: completion accounts are prepared after completion to determine the actual value of the business on the date of completion. Completion accounts are therefore attractive to buyers as they are only "paying for what they get" and they can worry less about the accuracy of historical financial statements provided by the seller or the risk of events adversely affecting the business prior to completion.
• Buyer control prior to completion: given the price is "locked" on a set of accounts prior to signing the sale contract, the buyer will typically require leakage provisions, indemnities and covenants from the seller during the locked box period, which can inhibit the seller's ability to fully operate the business prior to completion.
• More due diligence: the buyer may require more intensive due diligence given that it needs to agree upon a fixed price prior to signing the sale contract and will not have the ability to adjust the price after completion.
• Increase in value of business: If the value of the business increases between the locked box date and completion, this will not be recognised in the seller's favour in the final purchase price. Also, locked box mechanisms are less appropriate where the working capital or performance of the business is subject to volatility, since this cannot be entirely addressed in the sale contract.

Shifting economic and market conditions in Australia have resulted in more mid-market deals using locked box mechanisms to deliver greater price certainty and simplicity.

Locked boxes are typically viewed as "seller-friendly" mechanisms, due to the advantages of price certainty, a clean-cut exit, and the avoidance of any post-completion purchase price adjustment disputes. They are particularly popular when the sale is conducted by way of an auction process and when private equity is involved in the bidder pool. However, private equity is also increasingly using locked box mechanisms on negotiated (non-auction) deals, due to their familiarity with such mechanisms and the certainty of funding that such mechanisms provide.

From an international perspective, locked boxes are often the preferred option in other jurisdictions like the UK, and are increasingly adopted on multi-jurisdictional transactions, including ones with US counterparties, which is a new development.

Choosing the right purchase price adjustment mechanism to use when selling your business is complex and can feel overwhelming. If you are considering selling your business, you can access expert guidance and support at each step of the way from Lander & Rogers' mergers and acquisitions legal professionals.

Our M&A legal team has a deep understanding of Australia's middle market, and experience helping founders navigate the complexities of selling a business.