The locked box in U.S. private M&A is a relatively foreign concept – relegated to special situations and often looked upon with suspicion by wary buyers. Is this reputation justified? Should U.S. practitioners embrace the locked box as a value and efficiency creating mechanism?
A Primer on Closing Accounts vs. Locked Boxes
Prevailing practice in the U.S. private M&A market is a “closing accounts” purchase price construct. Under this construct, the equity consideration due to sellers in a transaction is derived by defining an enterprise value in dollars in the acquisition agreement and then adjusting this amount based upon the cash, indebtedness, net working capital (relative to an agreed target working capital figure or range) and seller transaction expenses as of the closing date. The calculations of these amounts are determined in accordance with definitions and accounting principles negotiated in the acquisition agreement. These figures are “trued up” post-closing through a settlement process, which, for sponsor sellers, is supported by an escrow account. This construct results in the seller benefiting from the earnings, and bearing the burden of losses, of the business through the closing date.
By contrast, in a locked box transaction, the equity value due to sellers is defined in the acquisition agreement in dollars and the only potential adjustment to that amount is for any “leakage” that occurred between a recent balance sheet date (aka the locked box date) and the closing date. Leakage consists of unpermitted payments to or benefiting seller and its affiliated entities and is typically expected to be zero—that is, it is meant to be a protective mechanism but not value-shifting. The dollar equity value is derived from buyer’s diligence of the earnings of the business and its balance sheet as of the locked box date. Some locked box structures may include a ticking fee concept, which provides seller incremental compensation the longer it takes to close the transaction. Any leakage is estimated at closing and additional leakage claims may be made for a limited period after closing in a manner similar to the closing accounts construct (including with a supporting escrow in sponsor sales). The locked box construct therefore provides that the upside and risks associated with the target’s performance between the locked box date and the closing date inure to the benefit of (or detriment to) the buyer. As a result, seller may seek to negotiate for a higher purchase price to compensate it for running the business between the locked box date and closing.
Although frequently utilized in European transactions, locked box transactions are rare in U.S. transactions. We have seen more discussion this past year of locked box constructs given the difficulties associated with constructing good working capital targets in light of temporary balance sheet disruptions during 2020 due to COVID. However those discussions rarely translated into usage of the locked box construct.
Locked box transactions are often touted as a way to avoid protracted negotiations over the working capital target and closing net working capital inputs. Whether this is true depends on the approach the parties take in arriving at an agreed equity value. There are two basic approaches:
- a. Buyer conducts due diligence on the target’s net working capital position as of the locked box date (e.g., relative to a trailing 12-month average), but in fixing the enterprise-to-equity value bridge (and resulting purchase price), the parties do not assume a specific normalized level of working capital (i.e., a peg/target) against which a calculation of the NWC position as of the locked box date is compared. Rather, only extraordinary working capital issues would be included in the bridge (as cash- or debt-like items). That is, the deal is priced similar to how a public company deal is priced based upon a fixed equity or per-share value.
- b. Alternatively, the enterprise-to-equity value bridge includes the full suite of closing account adjustments, determined as of the historical locked box date. Under this construct, the parties are accelerating the equity value calculation to the pre-signing period (and are keeping it out of the acquisition agreement), but must still engage in a negotiation concerning the basis of the calculation of the target net working capital.
Both approaches avoid the risk of a post-closing dispute relating to the calculations of the closing account purchase price adjustments, while the former approach has the added benefit of meaningfully reducing the time and effort spent negotiating purchase price adjustment terms and the resulting value changes relative to the agreed upon enterprise value.
In the case of either approach described above, the buyer and seller will need to agree upon amounts of excess cash (and the classification of any cash as restricted cash) and indebtedness (including debt-like items such as earn-outs and capital leases) on the locked box date balance sheet, as well as anticipated sell-side transaction expenses. On occasion, incurrences of debt outside the ordinary course or in excess of a certain threshold, or transaction expenses above a specified amount, are defined as leakage.
When Do Locked Box Transactions Make Sense?
The following factors might increase the appeal of utilizing a locked box structure:
- Seasonal business where testing closing date net working capital against a target might lead to a significant equity value swing, which is inconsistent with a going-concern transfer.
- Extraordinary activity in the historical period that makes agreeing on a normalized target net working capital figure more challenging (e.g., due to COVID impacts).
- Businesses with unusually large intra-week or intra-month swings that make agreeing on a target challenging where there is a possibility of closing at any day during a week or month.
- Transactions utilizing a portable debt structure in which the business deal is negotiated on the basis of an equity value / per-share value rather than an enterprise value.
Conversely, the following factors make the usage of a locked box construct more challenging:
- Absence of a recent balance sheet prepared in a manner that gives buyer comfort as to the accuracy and completeness of the balance sheet to be used as the locked box date balance sheet.
- A target company business with affiliate transactions that would make it challenging to cleanly define or police leakage from the target company to the seller or its affiliates (e.g., a corporate carve-out or family run business with numerous day-to-day transactions with family members or affiliated companies).
- Long sign-to-close period with uncertain projections that makes pricing in seller’s compensation for operating the business during the interim period challenging.
- Where the seller is a sponsor, buyer’s discomfort on relying on a small escrow as the sole recourse for any leakage discovered post-closing (i.e., where a buyer views leakage risks differently from typical closing estimate risks). A fund guaranty or similar support beyond an escrow for leakage claims could be offered by the private equity seller, but most U.S. sponsors are unwilling to offer a fund guaranty in connection with an exit transaction as a matter of policy.
Advantages and Disadvantages of the Locked Box Construct
There are a number of advantages and disadvantages to the locked box construct, both value and process-related. The chart below compares potential value-related pros and cons of the locked box construct from the perspective of each of the buyer and seller.
|Avoids “price chipping” by buyer through NWC peg/target negotiation after competitive tension has been reduced
Shifts risks of GAAP-based liabilities that arise between signing and closing to buyer
Avoids unexpected purchase price reductions through the closing estimate adjustment process or post-closing true-up
Ability to lock in seller compensation for expected profitability between sign and close based on mechanism or value agreed at signing
Reduces likelihood of costs associated with post-closing purchase price disputes
|Removes potential for purchase price increase through natural differences between closing working capital and the target (e.g., as a result of a growing business)
Avoids potential for unexpected purchase price increases through the closing estimate adjustment process
Potential to underpay seller for actual profitability between sign and close based on mechanism agreed at signing
Reduces likelihood of costs associated with post-closing purchase price disputes
|Loss of potential for purchase price increase through natural differences between closing working capital and the target (e.g., as a result of a growing business)
Risk of being undercompensated for actual profitability between sign and close based on mechanism agreed at signing
Loss of potential for unexpected (i.e., windfall) purchase price increases through the closing estimate adjustment process
|Requirement to commit to equity value purchase price (including any debt-like reductions and NWC adjustment components) at an earlier phase with potentially more competitive tension and/or less access to the management team
Risk of overcompensating seller for actual business performance between sign and close based on mechanism agreed at signing
Removes potential ability to allocate certain liabilities to seller that may be discovered after signing / after closing
Assume risks of GAAP-based liabilities that arise between signing and closing
Whereas economic advantages of the locked box construct to one party generally correspond to disadvantages to the other party, the process-related benefits of the locked box construct accrue to both parties. These include:
- Avoiding protracted negotiation over balance sheet definitions, accounting principles, sample balance sheet and certain other closing account terms.
- In public-company style locked box deals, avoiding the need for protracted negotiation relating to a target net working determination.
- Reducing likelihood of costs and distraction associated with closing estimates and post-closing true-up process.
- Reducing likelihood of distractions and adversarial discussions associated with post-closing purchase price disputes.
- For sellers, there is the potential to simplify the comparison of multiple bids (rather than needing to understand enterprise-to-equity value bridges based upon contract markups).
- For buyers, a willingness to accept or propose a locked box construct can be a distinguishing factor in a competitive process where other bidders are unwilling to do so.
These process-related benefits must be weighed against the following disadvantages of utilizing a locked box structure:
- Accelerates the need for sufficient balance sheet diligence (and potentially full historical NWC analysis) in advance of reaching an agreement on price (or forces bidders to make offers on price that may be difficult to modify in advance of completing due diligence).
- Potential need to negotiate a mechanism for compensating seller for the profitability or operation of the company between signing and closing.
- Lack of familiarity with the construct may create a learning curve for parties and their counsel, and may potentially lead to buyer suspicion in negotiations.
- For sellers, there is additional pressure on the locked box date balance sheet presentation and accuracy early in the process and there is the potential that seeking bids on a locked box basis may complicate comparison of multiple bids if some, but not all, bidders submit proposals accepting the locked box construct.
On balance, locked boxes are often thought of as seller-friendly given the greater value certainty they deliver (although sellers risk losing the benefit of the anticipated growth of the business through closing unless they capture it in the headline price or otherwise). While there is some truth to that idea, the full picture is more complex and use of a locked box construct may be beneficial to both buyer and seller, given the right set of facts and circumstances. U.S. M&A practitioners should add the locked box mechanism to their tool-kit and seriously consider its utilization where warranted based on the nature of the deal.