In many M&A deals, including for tech companies, the buyer and seller(s) include a mechanism in the sale and purchase agreement (SPA) to potentially adjust the final purchase price for the business being sold. Particularly, if there is period of time between signing of the SPA and completion, a buyer will want to ensure that the business continues to operate in the ordinary course of business and if there is any reduction in value, the price be adjusted downwards to reflect this. Similarly, if a buyer has not done significant financial due diligence, purchase price adjustments in the SPA enable a buyer to mitigate its risk.
The two common mechanisms used to adjust the purchase price between signing of the SPA and completion are completion accounts and a locked box adjustment. We look at each in turn.
A completion accounts mechanism is typically preferred by buyers. The SPA sets out an initial purchase price. However, the final price is determined a short period after completion based on the actual balance sheet of the target business prepared as at the completion date. Typically, the period to agree the completion accounts might be 2 or 3 months after completion. Consequently, a buyer gets comfort that if the value of the target business is less than they had anticipated through their financial due diligence, or as a result of actions of seller(s) after signing, the purchase price will be adjusted downwards.
Completion accounts often show the net assets of the target business as at completion, including a balance sheet, and a profit and loss account showing the financial performance for the period from the latest set of financial accounts up to completion.
A well drafted completion accounts mechanism will set out the rules for preparing, challenging and agreeing the completion accounts. Sometimes the buyer will prepare the completion accounts for review by the seller(s), or it may be the other way round – it depends on who practically is best placed to prepare them. Another key point to agree is the applicable accounting policy that should apply to the preparation and review of the accounts. As a starting point, you would expect this to be consistent with the way the accounts had been prepared by the target business prior to completion.
Sometimes there may be an adjustment to the purchase price by reference to an agreed level of target working capital required in the business as at completion, depending on how this compares to the real position as at completion.
Overall, buyers prefer completion accounts as it enables a dollar-for-dollar adjustment post completion, therefore mitigating the risk that the balance sheet of the target business materially changes between signing and closing, or is not fully aligned with what was presented to them during due diligence. The downside is the period of time needed to prepare, discuss and agree the completion accounts and how this distracts management.
Sellers often prefer a locked box mechanism to finalise the purchase price. The process provides greater certainty as to the value of the business being sold at completion.
The mechanism is called a locked box as the key feature is that no value is permitted to leave the business between the locked box date (agreed in the SPA) until completion. The balance sheet is therefore “locked”. If there is any such leakage, the seller(s) will be required to repay the relevant reduction in value to the buyer, effectively reducing the purchase price.
Parties to an SPA generally agree that certain permitted leakage is allowed. This covers items both parties are aware of prior to completion, which is in effect already factored into the sale price. Permitted leakage often relates to matters which occur outside the seller(s)’ control, but can also cover agreed transactions between the target business and the sellers such as dividends, salary or other fees payable in the relevant period.
The date the locked box is fixed is a key aspect. A buyer will want its financial due diligence to be adequate up to that date. Having a long period between the locked box date and completion is likely to result in a greater chance of leakage. Bear in mind however that sufficient time is required to enable the seller to prepare the balance sheet for review by the buyer before completion. Sometimes the locked box date is the target business’ last financial year end, which has the benefit of allowing audited accounts to be used as opposed to a new balance sheet created just for this purpose.
As the purchase price for the target business is effectively fixed on the basis of the locked box accounts as at the applicable date, the buyer will expect the seller to stand behind the accuracy of those accounts. Sometimes more extensive warranties are required by a buyer covering the period from the locked box date to completion. Sellers should resist these warranties given the whole purpose of this mechanism is to fix the purchase price (and inclusion of these warranties starts to make it look more like a completion accounts adjustment).
A final key feature of a locked box mechanism is how to deal with accrued value movement in the balance sheet due to the business continuing to operate between the locked box date and the completion date. Sellers may expect to be compensated for this via an upward adjustment to the purchase price (assumes the business is profitable). This adjustment is called the “value accrual”. For tech company sales, this concept is less likely to be relevant.
The key difference between a locked box transaction, as opposed to using completion accounts, is that the balance sheet on which the purchase price is determined is fixed before signing. This is a useful tool for sellers as it has a higher degree of certainty of the purchase price. It also makes for a cleaner deal with no discussion post deal on pricing (assuming no non-permitted leakage has occurred in which event the buyer will have a claim under the SPA). This takes up less management time post-closing than where completion accounts have to be prepared and agreed.
Buyers may be reluctant to go down the locked box route where they have carried out limited financial due diligence and will prefer the comfort of completion accounts. Particularly, if the financial performance or working capital of the target business is subject to volatility. If a locked box mechanism is adopted, buyers will want to include a list of restricted activities between signing and closing to mitigate their risk given they are taking on the economic risk of trading from the locked box date.