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The ‘locked box’ mechanism – brings more certainty to M&A transactions

13 May 2009 PricewaterhouseCoopers

The traditional sale process used in mergers and acquisitions is cumbersome and complex as several adjustments are usually required to the selling price, meaning uncertainty for both buyer and seller, and unnecessary time being spent on the deal process by both parties.

“In contrast, the ‘locked-box’ technique is now increasingly being used as a mechanism to ensure the more effective completion of M&A deals, and in fact we see approximately half of deals in the UK now structured on this approach” says Tertius van Dijk, PricewaterhouseCoopers SA Transaction Services director.

Van Dijk says traditional M&A processes usually see an initial price decided at the early stage of the deal, subject to a due diligence which normally gives rise to some purchase price adjustments, followed by yet further adjustments in agreeing the working capital level on deal completion,.

“The traditional process gives rise to several adjustments and even disputes as there is often a lack of agreement as to how much cash can be withdrawn from the business by the seller before the economic interest of the concern is finally transferred across to the buyer. The completion period, being that after initial price agreement until the business is finally transferred, is a problematic period that can give rise to exploitation by both parties.”

Van Dijk says a frequent problem in M&A activity is that the parties may agree that the seller can withdraw funds until date of transfer to the buyer, based on what is considered to be ‘normalised’ working capital levels. “However, this is often not accurately defined and the seller sometimes withdraws excessive cash through running down working capital in the months post the initial price agreement up to final date of transfer. Not only may this require yet another purchase price adjustment to be negotiated, but the buyer may be faced with having to make a large and unexpected cash injection into the newly acquired business.”

“In contrast” highlights Van Dijk, “the ‘locked box’ mechanism contributes significantly to simplifying and expediting the deal completion process.”

Van Dijk explains that following an initial high-level due diligence review, a recent historic balance sheet is used as the ‘locked box’ and the purchase price is fixed at these levels. “The ‘economic interest’ of the business being sold is now effectively transferred earlier on in the sale process to the buyer, reducing the risk to the buyer of excessive withdrawals by the seller. Because economic interest now effectively passes at the ‘locked box’ date, (rather than at the deal completion date, which could be months later), the seller is no longer able to arbitrarily extract cash generated through profits earned after locked box date.”

The locked-box mechanism requires clear disclosure of permitted leakage (normally from working capital) by the seller in the sale and purchase agreement. This provides confidence to buyers that no unexpected working capital leakage will occur between the locked box date and deal closing date, and that sellers cannot uncontrollably extract cash and resources from the business during this time. The opportunities for exploitation in the completion period are therefore significantly reduced.

In exchange for the transfer of economic interest at an earlier date, the seller may be compensated through an interest charge on the purchase price or through a proxy for profits earned up to the final closing date of the transaction.

Van Dijk says another benefit is that time spent on debating completion accounts is eliminated. “This means there is more time for the buyer’s management to focus on post-deal operational integration of the target, business performance and capturing the value of the deal.”

For sellers, the locked box mechanism provides greater certainty of price as well as increased control over the sale process - attributes which are key to realising maximum value in the current buyers’ market.

Van Dijk anticipates increased use of the locked box mechanism, “In the current environment, certainty of sale proceeds is key and using the locked box mechanism provides both seller and buyer with this certainty at the earliest possible date.”

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