Over the past few years, the locked box pricing mechanism has been popular in European M&A deals, and is now making its way over to the US and Canada. Locked boxes have been revolutionary in private equity deals in particular, allowing management to focus on running the newly acquired business and begin adding value to the investment, rather than taking up time calculating purchase price adjustments during the crucial first 100 days of management post-acquisition.
With Canada's impressive cannabis and technology sectors continuing to look attractive to domestic and international investors, perhaps the locked box mechanism will become more commonplace as private equity firms look to invest in these industries. In addition, as blockchain technology and smart contracts become commonplace in M&A transactions and business operations, generally, the locked box mechanism could become more prevalent.
This article sets out what a locked box is, the advantages and disadvantages to using one, how to effectively draft one into a purchase agreement, and how blockchain technology and smart contracts will affect its use. Please refer to our video “Decode the blockchain technology” should you need a full explanation of what blockchain technology is.
What is a locked box?
Traditionally, the purchase price of a target business would be adjusted post-closing using financial statements of the target drawn up shortly after completion to verify certain value assumptions (e.g., cash, debt, net assets, working capital, etc.). While this traditional method allows for flexibility and accuracy in adjusting the final purchase price, the preparation of post-closing calculations can be costly, time consuming (thus delaying payment of some of the purchase price) and create disputes between the parties.
In contrast, a locked box mechanism provides for the equity price to be calculated using a recent historical balance sheet of the target prior to the signing of a purchase agreement. Once the Effective Date (as defined below) has been set and the locked box price calculated, there are no post-completion adjustments other than for pre-identified claims for value leakage. To the extent that any benefit or liability accrues after the Effective Date, these are assumed by the buyer.
Economic risk passes to the buyer at the agreed Effective Date prior to signing. It is important for buyers to (a) consider what risks may arise in relation to trading in the business after the Effective Date (with particular thought and consideration afforded in times of economic uncertainty), and (b) identify what accounts are to be used for pricing the locked box mechanism (usually either audited accounts or recently-available management accounts).
What are the advantages and disadvantages of the locked box?
The locked box mechanism is great for certain deals but not others. An analysis of the advantages and disadvantages of the locked box should be undertaken with legal counsel (and other advisors) during the initial deal planning stage in order to assess whether the locked box is appropriate for the deal at hand.
- Creates price certainty for both buyer and seller;
- Less management time/resources are used post-transaction in preparing completion accounts, allowing for management of the buyer to concentrate on running the newly acquired business;
- Useful in an auction process where bidders are required to submit bids on what they would be willing to pay for the target;
- Simplifies the process for both buyer and seller; and
- Avoids the cost of preparing completion accounts.
- Post-closing adjustments allow for more scrutiny on every line item of a balance sheet, and provide greater flexibility to any changes in the target's assets;
- The use of a locked box mechanism may slow down the initial negotiation of the deal because a buyer may need greater comfort on the balance sheet used for creating the locked box (as opposed to being able to speed up negotiations and amend the purchase price post-closing);
- Increased diligence is often necessary, with an increased reliance on representations and warranties;
- There is a risk of the business deteriorating between the locked box date and the closing date; and
- The seller has control over all of the relevant information required to calculate the locked box price, meaning that the buyer must elicit as much information as possible in order to effectively negotiate.
If there is a lengthy time period between signing and closing (or if there is the potential for a lengthy period between signing and closing, such as waiting for regulatory approval) then buyers may be less likely to favour a locked box mechanism as the risk of value leakage from the locked box increases over time.
Arguably, the use of a locked box mechanism places the economic risk of changes to the acquired business on the buyer (as opposed to the traditional net value or completion accounts approach). However if structured correctly, the locked box mechanism can be advantageous to the buyer and can help encourage a time and cost-efficient closing.
When drafting the locked box clause within a purchase agreement there are a few important aspects to consider:
- The effective date of the locked box;
- The definitions of both leakage and permitted leakage;
- Appropriate undertakings by the seller protected by any necessary indemnities for breaching such undertakings; and
- Representations and warranties of the seller.
In order to begin setting the locked box price, the buyer will want to see a balance sheet prepared as at an agreed date (the "Effective Date"), and then have such figures verified. The Effective Date should be a suitable balance sheet date which is appropriately related to the basis of the buyer's valuation (for instance, if the nature of the target's business is seasonal then this should be taken into account when setting the Effective Date).
As a starting point, it is important to ensure that the accounts used to create the locked box are no more than six months old. The bigger the gap between the date of the accounts and the desired locked box date then: (a) the bigger the risk that the performance of a target's business may have changed; (b) value may be leaked from the locked box; and (c) a greater amount of financial due diligence will be required in order for the buyer to feel comfortable with the deal.
Once the buyer is satisfied with the Effective Date, the parties must define the period in which the locked box mechanism is to apply (i.e., the gap between the Effective Date and closing, the "Locked Box Period").
When drafting the purchase agreement, care should be taken to cross-check any reference to the Effective Date to ensure that it does not conflict with any other accounting reference dates in the agreement (for instance any reference to the "Accounts Date" or "Financial Statements").
Leakage and Permitted Leakage
Once the Effective Date has been worked out, a robust definition of "Leakage" and "Permitted Leakage" should be drafted to cover (a) all possible ways that a seller could extract value after the Effective Date, including the issuance of dividends, transactionrelated costs, discharging of assets at an undervalue, etc., and (b) all permitted exceptions.
To support the definitions of "Leakage" and "Permitted Leakage" the buyer will want to ensure that there is recourse for any leakage through the inclusion of an appropriate indemnity clause that covers the buyer for any losses incurred. Such a clause is often limited to the exact amount leaked, and sellers will want to ensure there is no recourse for any additional costs.
Some agreements can include provisions that allow the parties to test for any leakage since a specified date and then ensure that such leakage is reflected in the final adjusted purchase price.
Undertakings and indemnities
A locked box provision will include a "no-leakage" covenant and supporting indemnity, whereby in the event that any value is "leaked" from the locked box, then the seller will reimburse the buyer dollar for dollar. From the buyer's perspective, it is important to ensure that any indemnities are not subject to any of the limitations on the seller's liability that may typically be included in an acquisition agreement.
To further reduce the risk of leakage a buyer should ensure that interim covenants are drafted to cover the Locked Box Period. In particular, subject to permitted exceptions, such covenants should place restrictions on the conduct of the business during the locked box Period, and also on the types and amounts of transactions that the target business can undertake (for instance, some undertakings may restrict all payments made to third parties in the ordinary course of business unless expressly permitted in the purchase agreement). The aim of the restrictive covenants is to ensure that the contents of the locked box do not fundamentally change, and therefore thought should be given to ensure that the covenants are stringent enough to minimize the risk of leakage, but flexible enough to allow the target to continue to operate its normal business activities.
Representations and warranties
In addition to minimizing leakage from the target from the Effective Date, a buyer will aim to ensure that the target is in the same condition (or ideally, better condition) as it was at the Effective Date when the locked box price was calculated.
A buyer may expect the usual representations and warranties in relation to operating the target in the ordinary course of business between signing and closing, but locked box specific representations and warranties should be included in the purchase agreement to prevent any leakage. This may include representations and warranties governing the balance sheet (and accompanying facts) used at the Effective Date to ensure that all information is accurate and that there are no omissions, and that certain payments have not and will not be made (e.g., no distributions, dividends or repayment of loans to the seller), among others.
Buyers will want to make the representations and warranties as broad as possible in order to allow for maximum recourse in the event of leakage. As an added layer of protection, buyers should aim to restrict any qualifying language from the seller's management in relation to the representations and warranties (e.g., that a statement is correct "to the best of their knowledge" or true in "all material respects"), particularly in relation to the balance sheet.
Accurately defining the seller and all potential related parties within the locked box provisions is essential in order to reduce the opportunity for the seller to indirectly extract value from the target.
In order to address any concerns the buyer may have about the locked box accounts tabled by the seller, it may be prudent to complete an audit or an agreed lesser form of independent review to help speed up negotiations. Audited accounts offer more certainty for buyers and are therefore preferred in locked box transactions, but buyers may accept unaudited accounts if an independent accounting firm completes seller financial due diligence on which buyers may rely.
The impact of blockchain technology and smart contracts
A thorough explanation of "what is blockchain?" is beyond the scope of this article, but in a nutshell blockchain technology (or distributed ledger technology) offers the promise of a tamper-proof, verifiable, digital record of information and transactions that has the potential to completely change the way M&A deals are done. As the technology continues to develop and become more mainstream, at some point in the near future significant business may be conducted on the blockchain through the use of smart contracts, which are automated and self-executing when certain conditions within the contract are met.
Trust is the foundation to any transaction, and typically, after extensive due diligence on the target with a number of financial, tax and legal advisors, a purchase agreement undergoes multiple rounds of negotiation to ensure that the covenants, representations, warranties and indemnities (as well as any holdback or earnout payments) mitigate any risks or perceived lack of trust between the parties. Once blockchain and smart contracts are commonplace, however, parties should have a tamper-proof, verifiable, digital record of information and transactions that will allow diligence to be completed quicker and cheaper, and for parties to have certainty over key information with which they can negotiate the deal.
Some of the expected key benefits of blockchain and smart contracts in relation to locked box mechanisms are that:
- There will be greater certainty on the financial statements of the target because there will be a verifiable and tamper proof, digital record of all assets and liabilities. This will allow the buyer and seller to have more of an equal position in relation to the visibility and accuracy of the financial information of the target, and will consequently speed up the initial negotiations surrounding the locked box price and the Effective Date;
- Diligence should be significantly quicker and cheaper. The buyer will quickly be able to verify important information in relation to the target, including that the target (a) owns or leases all assets listed, (b) achieved the claimed number of sales in the latest financial year, and (c) is party to the disclosed credit facility, among other things; and
- A smart contract can be used for the purchase agreement to incorporate the definitions of both leakage and permitted leakage and automate what transactions and payments can and cannot be undertaken during the Locked Box Period (such as the payment of dividends or ordering additional inventory, for example), reducing the risk of leakage or deterioration of the target's business during such period.
As discussed above, the locked box pricing mechanism is used by private equity firms in European M&A deals because it provides certainty of price and allows management to get on with running the newly-acquired business. The widespread adoption of blockchain and smart contracts should only add to the benefits of the locked box by increasing the speed and certainty of deals, whilst simultaneously reducing the risk of leakage and business deterioration during the Locked Box Period. Therefore, although the locked box mechanism is not common in the Canadian market currently, we could be seeing it become commonplace for Canadian M&A deals in the near future.
Until then, however, if European private equity firms seek to enter Canada's attractive cannabis and technology sectors, among others, then we may see more occurrences of a locked box mechanism being used in purchase agreements. In this instance, it is imperative that both buyers and sellers have legal counsel (as well as accounting and financial advisors) that understand how to maximize the benefits of the locked box to realize value for both sides of the deal.