Locked-Box Mechanism

A locked-box mechanism is a method of setting the purchase price in the sale of a company. The buyer and seller agree a fixed price based on a balance sheet of the target drawn up at a date before the sale agreement is signed, known as the locked-box date. From that date the economic risk and reward of the business pass to the buyer, although legal ownership transfers only at completion. There is no adjustment to the price after completion.

It is one of two standard pricing structures in private mergers and acquisitions. The other uses completion accounts, in which a provisional price is paid and later adjusted to the actual cash, debt and working capital found at completion. The locked box became common in European sales by private equity owners from the 2000s and is now widely used there, particularly in auctions; it is less common in the United States.

The parties start from an enterprise value for the business, free of cash and debt. To reach the price for the shares, they deduct debt and add cash shown in the locked-box accounts, and adjust for any difference between actual and normal working capital at that date. These are the same adjustments as in a net debt adjustment and working capital adjustment under completion accounts, but they are made once, before signing, using historical figures, and the result is written into the agreement as a fixed sum.

The locked-box accounts are usually the latest audited year-end accounts or recent management accounts. Since the buyer has no later chance to correct the price, it examines them closely in due diligence and usually obtains warranties about them.

Because the buyer is treated as owning the business economically from the locked-box date, the seller must not take value out of it between that date and completion. Any such transfer is called leakage. The agreement contains a covenant that there has been and will be none, backed by an undertaking to repay any leakage to the buyer on a pound-for-pound basis. Leakage typically includes the following.

• Distributions. Dividends, returns of capital and share buybacks paid to the seller.
• Payments to the seller's group. Management fees, monitoring fees and payments under contracts that are not on arm's length terms.
• Assumption or waiver of liabilities. The target taking on the seller's obligations or releasing debts the seller owes it.
• Transaction costs. Advisers' fees and sale bonuses paid by the target for the seller's benefit.
• Tax arising on any of these.

Items that the parties agree may be paid are listed as permitted leakage and are reflected in the price. Typical examples are salaries of seller-appointed directors, payments in the ordinary course of trading and specific amounts disclosed in advance. Claims for leakage are normally subject to a short time limit, often six to twelve months after completion, and are not covered by the caps that apply to warranty claims.

The seller continues to fund and run the business between the locked-box date and completion, while the profits earned accrue to the buyer. Sellers therefore often negotiate an additional amount to compensate them. It may be calculated as interest on the price at an agreed rate, or as a daily sum reflecting the cash the business is expected to generate, and is sometimes called a ticker or value accrual. The buyer will accept it only to the extent that it believes the business is in fact generating that profit.

The main attraction is certainty. Both sides know the price at signing, the seller can distribute proceeds to its investors promptly without holding back for adjustments, and there is no completion accounts process, which saves cost and removes a common source of post-completion disputes. Bids in an auction are easier to compare, since each is a fixed number on the same basis. The structure is also simpler to combine with insurance for warranty claims.

The buyer bears the risk that the business deteriorates between the locked-box date and completion, and it cannot recover through the price if working capital at completion turns out to be low. It relies on the quality of the locked-box accounts and on the seller's conduct of the business in the interim, which the agreement restricts through covenants. The longer the gap between the locked-box date and completion, the greater these risks.

A locked box is poorly suited to cases where reliable stand-alone accounts do not exist, as when a division is being carved out of a larger group and shares cash, systems and costs with it; where the business is highly seasonal or volatile; or where completion is distant because of regulatory approvals. In those cases completion accounts or a hybrid, such as a locked box with a limited adjustment for specific items, are used. A general purchase price adjustment and deferred elements such as earn-out consideration or an escrow holdback may sit alongside either structure. The mechanism is common in a management buyout and other sponsor-led deals, where the seller's wish for a clean exit is strong and the management team staying with the business gives the buyer comfort about the accounts.