The "locked box" method as an alternative to preparing closing statements
The locked box mechanism is an alternative method of determining the purchase price under a sale and purchase agreement instead of calculating the purchase price based on closing statements prepared as of the closing date. By using this approach, the volume of potential post-closing disputes over the content and results of such closing statements is significantly reduced. This means that companies can save energy, time and money. PSP therefore favours this alternative in the interest of its clients.
In the case of all corporate acquisitions, a company’s current net asset value and its asset composition at closing date are (in order to ascertain cash-free/debt-free values) key elements for determining the purchase price. By their very nature, asset deals offer almost no other option than to assess the relevant assets and debts at completion date. Yet, also in the case of share deals, it is basically assumed that the value and composition of the net assets held at closing date are indispensable for determining a "fair" or "true" purchase price. The question therefore repeatedly occurs of how to deal with the uncertainty arising in relation to the net asset value and any changes in this value materialising during the intervals between the following dates:
- Closing date of the last, essentially reliable set of accounts in terms of net assets (usually audited annual financial statements), for instance 31 December 2016
- Contract signing date, for instance 15 May 2017
- Closing date, for instance 30 June 2017
- Date of finalising the closing statements, for instance 15 August 2017.
A dilemma arises due to the fact that, although past financial statements may be analysed in the course of contractual negotiations (in the case of our example, during April/May 2017) and a due diligence carried out, only vague information is however received regarding the company’s current asset situation and this can, in the case of active business operations, change daily, especially with regard to the asset composition. Since one does not possess clairvoyant skills, it is impossible, at the time of signing, to ascertain the actual decisive state of the company’s future net asset situation that will emerge on closing date (the date on which shares are transferred). Even if one endeavours to arrange for signing and completion to take place on the same date, there would still be no information forthcoming on the composition of assets on such date since, from a purely practical point of view, preparing a set of company accounts as of any closing date takes a not inconsiderable length of time (in the case of our example, 1.5 months).
A radical way out of this dilemma would be to determine the purchase price solely on the basis of historical figures (in the case of the example given, based on the situation as of 31 December 2016), so that from this previous date onwards (which would inevitably precede signing), the seller would have been managing the company "for the account of the buyer". This solution is however particularly problematic in that, based on this logic, the buyer would have to bear the economic consequences of (possibly poor) management of the company on the part of the seller during the interim period, whereby the seller would normally be reluctant to accept any liability in this regard, since he would not be paid, even in the event of benefits accruing from his good management. The risk of action being taken with intent to harm the buyer must however by all means be excluded at all costs.
To solve this problem, contractual practice in Germany generally resorts to a complex mechanism which envisages the preparation of a completion balance at a future date (after completion). This mechanism usually includes the following elements.
- Estimated net values specified in the agreement for the purpose of fixing the provisional purchase price payable on completion date.
- Agreement of a post-contractual purchase price adjustment clause based on the difference still to be determined between final net values and estimated net values.
- Contractual definition of a conciliation process, including a detailed description of how final net values are to be ascertained (post-closing). Being of relevance for the purchase price, this conciliation process is, from experience, a source of considerable potential dispute. The contractual provisions are therefore usually fairly exhaustive and normally include the following steps:
- Party number one prepares the relevant accounts by a set date. In line with the agreement, the results are initially of a preliminary nature (preliminary net values).
- Party number two is allowed to inspect the set of accounts. Provided that no objections are raised within a certain period, the preliminary net values are deemed to be the final net values.
- If objections are raised (which is normally the case), the parties are required to reach agreement within further set periods.
- Should they fail to reach agreement within such periods, an arbitrator subsequently decides on the final net values, his discretionary powers usually being limited to the extent of the objections.
Weak points of determining the purchase price post-closing
Based on experience gained by PSP, the conciliation process seldom functions to the satisfaction of both parties in the case of the post-closing purchase price element (reaching agreement on closing statements), leading instead to tedious conflicts in almost all cases. Although such conflicts may serve the interests of certain consulting firms, they certainly do not serve the interests of the parties.
Up to the time of signing the sale and purchase agreement, the parties are driven by a "will to deal" and, as a result of their psychological involvement and the resources invested so far, the closer the signing date draws, the more intensive this mood becomes. Experience has shown that after signing and during the post-closing phase, the parties are hardly ever prepared to compromise. Apart from the sale and purchase agreement, the parties are not usually connected with each other in any way (a significant difference to, for instance, a long-term business relationship in the industrial sector which, due to the need to maintain relations, often creates an ability to compromise). From now on, it is simply a matter of egoistically optimising one’s own asset position in the absence of any "overriding reasons" (of an economic or strategic nature) which might advocate self-restraint. The parties concentrate on cherry-picking and formulating claims. In the case of disputes involving the last €500,000, the merit of their own input or that of consultants is also often valued quite highly.
It is therefore no small wonder that these conciliation processes often entail considerable time and expense for both parties and frequently end up in the hands of an arbitrator.
The locked box method avoids determining the purchase price post-closing
The locked box mechanism offers an alternative which significantly reduces the volume of potential post-closing disputes, due to the fact that the locked box approach involves no post-contractual purchase price adjustment clauses and no post-closing valuation activity.
In the case of the locked box mechanism, net assets are "alternatively" determined as of completion date, based on the following estimate.
- Net assets are determined on the basis of the last balance sheet (locked box balance sheet), …
- … these assets being locked by preventing or precisely defining the extent of any leakage of cash back to the existing shareholder, …
- … and the changes in assets resulting from ongoing operations up to closing date being estimated on the basis of budget data.
In practical terms, this mechanism allows a fixed purchase price to be agreed on the basis of both the last balance sheet (locked box balance sheet) and the budgeted or agreed movement data for the period between the locked box balance sheet date and the date of completion, i.e. the full purchase price can be fixed at the time of signing without any necessity to adjust the purchase price post-closing. All significant conciliation processes take place prior to signing, providing the parties with a much greater degree of certainty that, following completion, they will not be faced with disputes over major elements of the purchase price.
The individual elements required to determine the net asset value at closing date are as follows.
- The first stage of the locked box mechanism focuses on the last balance sheet (locked box balance sheet) prepared for the target company (in the case of our example, as at 31 December 2016). Prior to signing, the parties may negotiate for as long as they wish regarding the accuracy of the balance sheet (and any normalisation potential), its influence on the purchase price formula and ultimately therefore the (fixed) purchase price as such. The figures are known at the time of conducting contract negotiations and may be subject to a due diligence analysis. Possible differences of opinion regarding the correct application of valuation methods or content are settled prior to signing, thereby minimising any remaining uncertainty.
- During the period following the locked box balance sheet date, assets are "locked", i.e. the seller guarantees that until completion, no (or only precisely specified) assets will exit the company in the direction of the existing shareholder (seller). In the case of companies obliged to keep accounts in accordance with European (or other high-standard) regulations, this is relatively easy to specify by concluding a binding contractual agreement on the amount of any dividends or other returns of capital (or other remuneration payable to either the seller or individuals related to the seller) (still) permitted after the closing date of the locked box balance sheet. A basic requirement for this is however that the company may not be too closely interlinked with other group companies or other related individuals outside the "locked" circle.
- Furthermore, account must be taken of anticipated earnings between the locked box balance sheet date (in our example, 31 December 2016) and completion (in our example, 30 June 2017) and consequently of changes in assets accruing from the operating result. Any refinancing transactions or investments which may be either necessary or planned should also be included. It is normally fairly easy to reduce the uncertainty of this estimate by reviewing ongoing business operations and the forward order book up to the date of signing, namely, in the case of our example, until 15 May 2017. A review of this kind is normally included in due diligence analyses. Estimated earnings should include only calculable risks and opportunities for both the seller and the buyer. If material risks are still envisaged at this stage, the advantages of the locked box method will be reduced accordingly.
In terms of structuring the contract, this procedure means that the purchase price is fixed and transfer of economic ownership agreed as of the closing date of the last balance sheet. This initially results in the buyer being formally entitled to any profit subsequently generated. If it is foreseeable when completion will take place, any profit expected before such date may be added to the purchase price (after allowing for any returns of capital or dividends payable during the interim period) and will consequently accrue to the seller. This assessment takes place during a phase (pre-signing) in which both parties still have a "will to deal", i.e. are essentially prepared to reach agreement. If the closing date has not yet been set at the time of fixing the purchase price (e.g. in the form of an LOI) and profits generated prior to completion, or at least a part thereof, are to accrue to the seller, it is possible to agree a linear rate of interest on the purchase price from the last balance sheet date to closing date ("escalator clause").
Even in the case of this structure, the problem of course remains that the company’s actual earnings situation may not develop as planned. In particular – and this often constitutes an argument on the part of the buyer – the seller may cease its efforts to manage the company prior to completion, since payment is anyway to be based on a lump sum for amounts earned by the company up until completion date, whether or not this is actually achieved. Allowance can be made for this problem under the contract by granting the buyer extensive pre-completion inspection and possibly also consultation rights, by imposing certain rules of conduct on the seller for the period between the locked box balance sheet date and completion, as well as a possibility for the buyer to withdraw in the event that the company’s earnings performance is grossly contrary to expectations (so-called MAC case - material adverse change). A subsequent dispute over the actual amount of any interim change in the enterprise value is however effectively ruled out.
Special issues arising from use of the locked box method
Compared with the purchase price assessment method based on closing statements, greater relevance must be ascribed to certain aspects in the case of applying the locked box method. These mainly include:
- Guarantees regarding the accuracy of the locked box balance sheet (i.e. in our example, the balance sheet as at 31 December 2016)
- Precise definition of the amount of any dividends or returns of capital (or other remuneration payable to the seller) following the locked box balance sheet date
- Special provision for tax burdens, particularly in the case of partnerships (tax burdens settled during the year)
- Precise definition of capital contributions, if appropriate
- Estimated earnings between the locked box balance sheet date and completion; an escalation clause (see above) could be necessary, especially if the closing date is flexible
- Constraints on material changes in financing between the locked box balance sheet date and completion, as well as provision for any extraordinary investment projects
- Ensuring that other guarantee provisions are compatible with the locked box method
- Ensuring that the advantage of the locked box method is not "cancelled out" as a result of guarantee provisions which are too tight in terms of the net asset value / equity at completion date.
Additional special issues also arise if the locked box method is to be used in the context of asset deals, which does not however present a particular problem as far as the contractual structure is concerned. In this case, the value of the company’s aggregate assets are processed in accordance with the locked box method, instead of the assets as reflected in the purchase price payable for its shares. The object of purchase are all assets at a fixed price, whereby account is already taken of additions and disposals up to completion on the date of signing, based on a consistent assessment by the parties. Although the object of purchase (aggregate assets) may still change between signing (or the locked box balance sheet date) and completion, in that certain assets (notably current assets) may exit such aggregate "in the ordinary course of business" and other new assets be added, this will not however alter the purchase price payable.