In the past 15 years, those working as transaction specialists have seen a few economic cycles and many changes in the mergers and acquisitions (M&A) space. In connection, many trends that originated in Europe have recently gained favor in the United States.
With so much money pouring into private equity funds, the landscape of buying and selling a company has drastically changed over time. More and more, buyers and sellers are now engaging professional advisors to assist in every stage of the sales process. Many sellers are going to market with investment bankers and engaging reputable CPA and advisory firms to produce branded sell-side due diligence reports to help educate and convey value to buyers. There also has been an increase in the number of businesses being sold through competitive auctions. Another trend that’s recently gained momentum is the use of a “locked box” mechanism, which fixes the purchase price of the business based on a predefined balance sheet date. This date is known as the locked box date and generally precedes the sale of the business by 60 to 90 days.
Traditional True-Up Working Capital Mechanism
For those familiar with buying and selling a business, one of the most contentious issues that plagues a transaction is the amount of working capital to leave the buyer at the time of close. Typically, consensus around this number isn’t easily reached.
Eventually, both parties agree on the amount of working capital the seller must provide at the time of closing, which is drafted into the purchase/sales agreement between the parties. Typically, this target amount is determined based on the company’s recent working capital trends, adjusted for any anomalies that have affected the business (normalized working capital).
Based on the terms of the purchase agreement, the buyer typically has 60 to 120 days after the closing date of the transaction to provide its view of the company’s working capital at date of close. The seller is typically given another 30 to 60 days (approximately) to confirm or dispute the amount. Differences between the targeted working capital amount per the purchase/sales agreement and the closing balance sheet calculated by the buyer are typically trued up and settled dollar for dollar as an adjustment to the purchase price of the company. To the extent the working capital amount at close is greater than the targeted working capital, there’s a positive adjustment to the final purchase price—and vice versa if there’s a deficiency.
Locked Box Mechanism
Under the locked box mechanism, the purchase price of the company is fixed at signing based on a balance sheet that precedes the actual sale of the company, i.e., locked box date. The chosen balance sheet date is usually the end of a fiscal period for which the financial statements have been audited or targeted by both parties relative to the transaction. The purchase agreement is drafted so as to “fully lock” the balance sheet from any leakage or deterioration of purchase price prior to the close of the transaction. Unpermitted leakage includes items such as dividends or distributions paid to shareholders or owners of the company, management fees or transfers of assets prior to close. Notwithstanding, under certain circumstances, the buyer and seller may agree upon certain transactions such as the payment of dividends, capital expenditures or transfer of assets.
Under the locked box mechanism, the seller typically provides various representations and warranties, agrees to various covenants and can indemnify the buyer that they won’t knowingly permit or incur unpermitted transactions from the date of signing to the date of closing. Typically, the seller will indemnify the buyer by providing “first dollar” coverage for any unpermitted transactions that occur.
Another caveat that’s often negotiated between the buyer and seller under this mechanism is the lost opportunity costs to the seller. At times, the buyer is required to pay the seller interest expense on the purchase price from the date of signing to the close date of the transaction due to the lost opportunity costs to the seller.
Advantages & Disadvantages of the Locked Box Mechanism
Although the locked box mechanism generally is considered seller-friendly, it’s commonly used between buyers and sellers in Europe and other parts of the world. Posted below is a brief summary of the advantages and disadvantages to the seller and buyer of using the locked box mechanism versus the traditional working capital mechanism.
- Certainty of price – Provides a benefit to both parties relative to price certainty at date of signing.
- Simplicity – Reduces the risk of any post-closing working capital disputes. Many times, shareholders selling the company will continue as employees post-close. The locked box method alleviates potential disruptions to the business post-close from any financial disputes between the buyer and seller. Also, since there are no post-close true-ups, the buyer and seller can remain focused on running the business and not be concerned with contemplating or settling any post-closing working capital true-ups.
- Speed and savings – Alleviates any drawn-out debate over the method to calculate or settle the working capital mechanism pre- and post-close.
- Comparability – Under an auction-related process, the seller is better able to compare offers, as there’s certainty over the purchase price being offered.
- Exclusivity – The buyer is committed to the purchase price before receiving exclusivity to perform any diligence.
- Exploitation – There’s an inability to exploit the purchase price by the seller or buyer because there’s no working capital true-up involved.
- Control and leakage – Under the locked box mechanism, the seller typically holds an advantage because it prepares the locked balance sheet and the buyer has limited access to the information used to construct such a balance sheet or propose or identify potential items considered leakage.
- Change in the business – Because the balance sheet is locked and the seller doesn’t benefit from any increase in the business after signing, the seller may lack incentive to increase the value of the business during the period between signing and close of the transaction.
Each party should determine which mechanism is best suited for its needs and consider what could be negotiated between the two parties. As noted above, the locked box mechanism is prevalent in Europe and other parts of the world. It can provide both parties with certainty around the purchase price negotiated for the transaction and alleviate any potential working capital disputes that could arise post-close. Although the locked box mechanism isn’t appropriate for all transactions, it can save both parties time and resources and can ensure the transaction gets done.
For more information, contact Wayne or your trusted BKD advisor.