What is a locked box mechanism?
A locked box mechanism is a purchase price mechanism commonly used in mergers and acquisitions, particularly in transactions involving the sale of shares in a company. It establishes the value of the target company by reference to historical financial information prepared as at a specified date, known as the locked box date. The purchase price is fixed by the parties before signing the transaction documents and, in principle, does not change on completion.
Under this mechanism, the economic risk and benefit of operating the target business pass to the buyer from the locked box date, even though legal ownership of the shares may be transferred later at closing. The buyer therefore acquires the benefit of profits generated after that date, but also bears the economic consequences of any deterioration in the company’s financial position, subject to the contractual protections negotiated by the parties.
The key feature of a locked box transaction is the protection against so-called leakage. Leakage generally means any unauthorised transfer of value from the target company to the seller or persons connected with the seller between the locked box date and closing. The share purchase agreement usually prohibits leakage, except for payments specifically identified and permitted as permitted leakage.
How does a locked box mechanism work?
The mechanism begins with the preparation and review of financial statements or management accounts for the locked box date. These accounts are used to determine the enterprise value, debt, cash position, working capital assumptions and, ultimately, the equity purchase price. Unlike a completion accounts mechanism, the parties do not prepare a new set of accounts after closing to calculate a price adjustment.
Instead, the seller typically provides warranties confirming that the locked box accounts fairly present the target company’s financial position and that no prohibited leakage has occurred up to signing. The agreement will also usually include protections against prohibited leakage between signing and closing. It may also contain a covenant requiring the seller to operate the business in the ordinary course between signing and closing. This is particularly important where regulatory approvals, financing conditions or merger control clearance delay completion.
Examples of prohibited leakage may include dividends, management fees, repayment of shareholder loans, transfers of assets for less than market value, unusual bonuses or payments to the seller’s affiliates. Permitted leakage may include specifically disclosed remuneration, agreed transaction costs or payments arising under pre-existing arrangements. The contractual definition should be precise, as it determines which payments may be recovered by the buyer.
When is a locked box mechanism worth using?
A locked box mechanism can be appropriate where the target company has reliable historical financial information, a relatively stable business model and a limited period between the locked box date and closing. It is often used in competitive sale processes because it gives the seller greater certainty as to the amount it will receive and reduces the scope for post-closing disputes concerning the calculation of the purchase price.
For buyers, the mechanism may simplify the completion process and provide a clear financial framework before signing. However, it also requires careful financial, tax and legal due diligence. A buyer must assess whether the locked box accounts are accurate, whether the business has changed materially since the reference date and whether the leakage protections provide an effective remedy.
A completion accounts mechanism may be preferable where the target’s financial position is volatile, working capital is seasonal, debt levels may change significantly or the period between signing and closing is expected to be long. In practice, the choice between a locked box and completion accounts model depends on the transaction structure, bargaining position of the parties, quality of financial reporting and the risks identified during due diligence.
Early legal and financial advice can help avoid an incorrect valuation, insufficient leakage protection, disputes over permitted payments or unexpected financial losses after closing. It is particularly important to align the locked box provisions with the warranties, indemnities, covenants and disclosure process contained in the share purchase agreement.
Law firm support in locked box transactions includes in particular:
- advising on the selection of an appropriate purchase price mechanism;
- reviewing locked box accounts and the findings of legal due diligence;
- drafting and negotiating leakage and permitted leakage provisions;
- preparing warranties, indemnities and seller’s pre-closing covenants;
- reviewing dividend, shareholder loan and related-party payment arrangements;
- supporting negotiations and closing of share purchase transactions.
Need legal support with a locked box mechanism? Contact us.