The locked box mechanism – simplifying the deal completion

process
In the current challenging economic environment, completion processes in respect of merger and acquisition transactions
are becoming increasingly protracted, as buyers look to price-chip through debating completion accounts and requesting
adjustments to working capital levels.

Tertius van Dijk, PricewaterhouseCoopers SA Transaction Services director, says that the firm is increasingly seeing the
use of the ‘locked box’ mechanism (used extensively in the UK and Europe), by sellers as a way to simplify and expedite
the deal completion process, “The locked box mechanism provides sellers with certainty of price as well as increased
control over the sale process - attributes which are key to realising maximum value in the current buyers market”.

“Following a due diligence review, a recent historic balance sheet is used as the “locked box” and the purchase price is
fixed, thus significantly reducing the cost and time spent on completion processes by both sellers and buyers” explains van
Dijk. He notes that the benefits of this approach also extend to the buyer as time spent on debating completion accounts is
eliminated. “This frees up time for the acquiror’s management to focus on post-deal operational integration of the target,
business performance and capturing the value of the deal.”

Van Dijk notes that through the locked box mechanism, economic interest effectively passes to the buyer at the locked box
date (before completion date), as the seller is no longer able to extract cash generated through profits earned after locked
box date, and any working capital movement is mirrored in net debt. As a result, the seller may seek compensation from
the buyer through an interest charge on the purchase price as well as a proxy for profits earned up to the closing date.

“The use of the locked box mechanism does present concerns to buyers”, says Ryan Rodkin, PwC Transaction Services
Manager. “Buyers need confidence that no leakage will occur between the locked box date and deal closing date, and that
sellers cannot extract cash from the business during this time. This requires clear disclosure of permitted leakage
(normally working capital) by the seller in the sale and purchase agreement”.

Rodkin continues that buyers may also seek to adjust the purchase price downwards for value leakages, as well as any
notional profit or interest charges. “Buyers will continue to seek opportunities to reduce the purchase price, but under the
locked box mechanism there is no completion mechanism to exploit”.

Van Dijk concluded by saying that, given the benefits to the seller, he anticipates increased use of the locked box
mechanism, as well as vendor due diligence, as sellers seek to regain control of the transaction process. “In the current
environment, certainty of proceeds is key and using the locked box mechanism provides the seller with this certainty at the
earliest possible date.”

The ‘locked box’ mechanism – brings more

certainty to M&A transactions
13 May 2009
PricewaterhouseCoopers : info@fanews.co.za 

The traditional sale process used in mergers and acquisitions is cumbersome and complex as several adjustments
are usually required to the selling price, meaning uncertainty for both buyer and seller, and unnecessary time being
spent on the deal process by both parties.

“In contrast, the ‘locked-box’ technique is now increasingly being used as a mechanism to ensure the more effective
completion of M&A deals, and in fact we see approximately half of deals in the UK now structured on this approach”
says Tertius van Dijk, PricewaterhouseCoopers SA Transaction Services director.
Van Dijk says traditional M&A processes usually see an initial price decided at the early stage of the deal, subject to a
due diligence which normally gives rise to some purchase price adjustments, followed by yet further adjustments in
agreeing the working capital level on deal completion,.

“The traditional process gives rise to several adjustments and even disputes as there is often a lack of agreement as
to how much cash can be withdrawn from the business by the seller before the economic interest of the concern is
finally transferred across to the buyer. The completion period, being that after initial price agreement until the
business is finally transferred, is a problematic period that can give rise to exploitation by both parties.”

Van Dijk says a frequent problem in M&A activity is that the parties may agree that the seller can withdraw funds until
date of transfer to the buyer, based on what is considered to be ‘normalised’ working capital levels. “However, this is
often not accurately defined and the seller sometimes withdraws excessive cash through running down working
capital in the months post the initial price agreement up to final date of transfer. Not only may this require yet another
purchase price adjustment to be negotiated, but the buyer may be faced with having to make a large and unexpected
cash injection into the newly acquired business.”

“In contrast” highlights Van Dijk, “the ‘locked box’ mechanism contributes significantly to simplifying and expediting
the deal completion process.”

Van Dijk explains that following an initial high-level due diligence review, a recent historic balance sheet is used as
the ‘locked box’ and the purchase price is fixed at these levels. “The ‘economic interest’ of the business being sold is
now effectively transferred earlier on in the sale process to the buyer, reducing the risk to the buyer of excessive
withdrawals by the seller. Because economic interest now effectively passes at the ‘locked box’ date, (rather than at
the deal completion date, which could be months later), the seller is no longer able to arbitrarily extract cash
generated through profits earned after locked box date.”

The locked-box mechanism requires clear disclosure of permitted leakage (normally from working capital) by the
seller in the sale and purchase agreement. This provides confidence to buyers that no unexpected working capital
leakage will occur between the locked box date and deal closing date, and that sellers cannot uncontrollably extract
cash and resources from the business during this time. The opportunities for exploitation in the completion period are
therefore significantly reduced.

In exchange for the transfer of economic interest at an earlier date, the seller may be compensated through an
interest charge on the purchase price or through a proxy for profits earned up to the final closing date of the
transaction.

Van Dijk says another benefit is that time spent on debating completion accounts is eliminated. “This means there is
more time for the buyer’s management to focus on post-deal operational integration of the target, business
performance and capturing the value of the deal.”

For sellers, the locked box mechanism provides greater certainty of price as well as increased control over the sale
process - attributes which are key to realising maximum value in the current buyers’ market.

Van Dijk anticipates increased use of the locked box mechanism, “In the current environment, certainty of sale
proceeds is key and using the locked box mechanism provides both seller and buyer with this certainty at the earliest
possible date.”
"Locked box" is an alternative to a completion accounts mechanism (familiar to advisors working
under UK law) used in legal agreements when a target business is sold.

A traditional completion accounts mechanism:

- Is designed to be fluid: post deal a firm of auditors measures net assets for the target business. If
actual net assets, as measured by the auditors, are less than previously-agreed target net assets, the
seller will have to compensate the buyer;
- Takes time and is prone to argument and dispute. Potentially every item measured by the auditors,
and every accounting treatment applied, could be questioned by either side. Because the audit and
any argument happen after the sale, buyer and seller are left with price uncertainty.

Given the potential problems outlined above, a locked box mechanism replaces the fluid completion
accounts mechanism with a "sticky" alternative. Only if, say, actual net assets prove to be 10% less
than expected does the seller compensate the buyer. This is designed to deliver price certainty to both
sides.

A locked box mechanism is not without its problems though. Net assets still need to be measured after
the deal, there is plenty of scope for argument over actual net assets and a claim could still easily
result. However, because of the "stickiness" of the mechanism, you would expect a reduced chance of
claim.

Sceptics have commented: "accountants like completion accounts mechanisms because they create
more work for them (completion accounts policies, post-completion audit) but lawyers like locked box
because it's more work for them (drafting the mechanism)".

The reality is both mechanisms have their faults. A few more details are provided below:
- Locked box has been imported into the UK from the US as an attempt to get around the arguments
that inevitably arise out of a traditional completion accounts adjustment;
- Locked box replaces a fluid "£ for £" adjustment mechanism where one side is bound to have to
compensate the other for one where one side might have to compensate the other;
- Under locked box the seller guarantees a completion balance sheet which is typically an historic
balance sheet (e.g. the last audited balance sheet or a very good management accounts balance
sheet) plus the adjustment to net assets arising from profitably up until completion, less permitted
adjustments e.g. an agreed pre-sale dividend;
- There is no completion accounts process. It is replaced with the risk of claim against the seller if the
guaranteed balance sheet (less, say, 10%) is not delivered.

Where lawyers and accountants are involved arguments are still likely to result!