Background
In M&A transactions, a prospective Buyer will enter into a non-binding agreement (typically called ‘Heads of Terms’ or ‘HoT’) with the prospective Sellers. The HoTs set out, amongst other things, the valuation of the Target. This usually starts with a concept called ‘Enterprise Value’.
Enterprise Value (‘EV’) may be referenced explicitly, or the HoTs may allude to the price being on a cash-free, debt-free basis, and assumes a normalised level of working capital. In essence, the EV is the starting point used to calculate the eventual purchase price of the Target. It is then adjusted to reflect the capital structure of the Target i.e. the mix of cash and debt used to fund operations.
What Sellers are usually more interested in is the ‘Equity Value’. This is the overall cash consideration paid to the selling shareholders after adjustment for the Company’s capital structure. See our blog on the difference between Enterprise Value and Equity Value here.
Completion mechanisms
The completion mechanism determines the method for adjusting the Enterprise Value of the Target to arrive at the Equity Value for an M&A transaction.
Selecting the most appropriate completion mechanism is a key decision in an M&A transaction. The chosen mechanism can have a significant impact on the proceeds that the Sellers receive or the Buyer pays to acquire the Company.
The most appropriate mechanism for your transaction will depend on several factors, including the characteristics of the company being bought or sold.
In the UK there are two commonly used completion mechanisms:
‘Completion Accounts’
Under this mechanism, the sellers prepare a projected roll-forward balance sheet of the Target to estimate the Equity Value at the date of Completion. Depending on the degree of certainty in this adjustment, the Buyer and Sellers will negotiate the initial element of the purchase price paid to the selling shareholders at Completion. This is separate from any withholding of funds in relation to ‘deferred consideration’ or retention amounts to cover warranty or indemnity risks.
Shortly after Completion, a set of Completion Accounts are produced. These are used to determine the actual purchase price of the Target at Completion. The Completion Accounts are then reviewed by both sides and, provided the parties agree, the final purchase price is determined.
A true-up payment representing the difference between the estimated Equity Value and the final Equity Value is then made. This true-up payment can, in theory, be either a positive or negative adjustment, but it’s usually structured to be a further payment to the Sellers – meaning the initial estimate is carefully set at a lower value than might otherwise be the case.
‘Locked Box’
The key difference with the Locked Box mechanism is that there is a fixed and agreed price within the share purchase agreement. So, there is no post-Completion adjustment to the price in normal circumstances.
The purchase price (i.e. Equity Value) is agreed based on a fixed balance sheet date (the ‘Locked Box Date’) – with that balance sheet having undergone Due Diligence by the Buyer. This is typically two to three months prior to Completion.
Given there is a time lag between the Locked Box Date and Completion (the ‘Locked Box Period’), the Buyer will seek to protect against any leakage of value (e.g. dividends paid to Sellers before Completion) within the Locked Box Period. To do this, a Buyer will seek an indemnity from the Sellers to cover any leakage or extraction of value during the Locked Box Period.
On the other hand, as the Sellers continue to run the business during the Locked Box Period, they may seek some form of compensation – such as interest on the purchase price, or an allocation of profits during the Locked Box Period. This can be known as a ‘value accrual adjustment’.
Which completion mechanism should I use?
Deciding which completion mechanism is most appropriate for your transaction will mainly depend on:
- which best suits you as a Buyer or a Seller
- the unique characteristics of the Target
- the overall value of the deal
- your appetite for uncertainty in the eventual purchase price.
There are advantages and disadvantages to each mechanism, but some points to consider are:
- Accuracy of purchase price
- A key benefit of the Completion Accounts mechanism is that the overall purchase price is fairly calculated based on the assets and liabilities acquired at Completion. This is especially relevant where the Buyer has concerns around the accuracy of the historical financial statements and/or a higher degree of uncertainty as to trading performance in any Locked Box Period.
- Price certainty at Completion
- The Locked Box approach provides price certainty for both the Buyer and the Seller at Completion (i.e. there is normally no need for a post-Completion true-up).
- Price certainty at Completion can be advantageous to Sellers, particularly where there are financial investors involved as Sellers.
- Complexity of execution
- Completion Accounts are drawn-up after Completion. This requires resource and review time (both on the Seller and Buyer side). The Share Purchase Agreement (“SPA”) also needs to accurately provide the basis on which the Completion Accounts are prepared.
- The Locked Box method has an agreed price at Completion, but it does require the Buyer to satisfy themself that no leakage has occurred.
- Economic value risk
- The Locked Box mechanism transfers the risks of changes in value of the Target to the Buyer at the Locked Box Date i.e. two to three months prior to Completion.The Completion Accounts mechanism transfers the risks of changes in value of the Target to the Buyer at Completion.
- As such, when using the Locked Box mechanism, appropriate leakage provisions need to be incorporated. These will include mutual agreement on permitted and non-permitted leakage during the Locked Box Period. An example of the latter would be the payment of dividends to the Sellers.
- Risk of disputes
- Under the Completion Accounts method, there is an increased risk of dispute between the Buyer and Sellers if they are unable to agree the Completion Accounts. Appropriate dispute resolution mechanisms will be incorporated into the SPA to deal with this.
- Given the price is agreed at Completion under the Locked Box, this is not an issue.
- Growth trajectory / seasonality of the Target
- The overall Equity Value of the business may vary considerably between the Locked Box Date and Completion. As a result, opting for a Locked Box mechanism vs. Completion Accounts may result in a material difference in the overall cash-consideration to Sellers.
- Potential loss of value
- As set out above, under the Locked Box mechanism, any value that the business accrues between the Locked Box Date and Completion is for the benefit of the Buyer. For profitable or high-growth businesses, this means potentially leaving value on the table in return for price certainty.
- The negotiation and agreement of a value accrual can go some way to mitigating against this.
- Depth of due diligence
- When using a Locked Box mechanism, the Buyer will usually conduct more detailed financial due diligence on the Locked Box accounts, as there is no mechanism to adjust the price after Completion.
Choosing the most appropriate completion mechanism
Ultimately, the most appropriate completion mechanism will depend on the specific circumstances of the transaction. It’s also worth noting that there are hybrid mechanisms that combine features of both approaches.
Engaging a Corporate Finance advisor early in a potential transaction allows you to quantify the likely impact of either mechanism on the proceeds payable, and to understand the optimal position in the circumstances.
Want to learn more, or understand the impact of Completion Accounts vs. Locked Box on your specific transaction? Let’s talk.
