Managing Associate Hamburg
"The purchase price for the target company is therefore one of the most fundamental aspects of the transaction and initially determined based on the valuation of the target company that both parties have agreed upon."
Mergers & acquisitions (“M&A”) are largely driven by the financial motives of the parties involved. The purchase price for the target company is therefore one of the most fundamental aspects of the transaction and initially determined based on the valuation of the target company that both parties have agreed upon. There is no standard formula for calculating the purchase price. Purchase price calculations are as varied as the target companies themselves and the reasons for their acquisition. The choice of the moment in which the economic benefits and risks of the target business are transferred to the buyer determines the pricing method. In this second edition of our series of articles on the basic principles of M&A, we review two widely used mechanisms for defining the final purchase price – “closing accounts” and the “locked box” mechanism – and how they differ from each other. Please find the first article in this series here.
Closing Accounts
Traditionally, M&A transactions were led by so-called closing accounts mechanisms: on the closing date, the buyer pays a preliminary purchase price based on the estimated equity value of the target company as of the date of the closing of the transaction. To determine the equity value a preliminary cash-free/debt-free adjustment is made on the basis of assumptions which are then reviewed later as part of the closing accounts: after closing, the buyer usually prepares closing accounts for the target company (as the seller is then no longer in control of the business) and suggests the adjustment amount to the seller. The seller then has a specified period of time to review and either accept or challenge the calculations made by the buyer. The preliminary purchase price paid on the closing date is subsequently adjusted in accordance with the adjustment amount finally determined based on the closing accounts.
Locked Box
"Ultimately, the choice of the purchase price mechanism may be influenced by several factors, such as the commercial realities of the target company’s business or industry, identity of both the seller and buyer, overall transaction timeline and preferences of the parties involved."
Unlike the closing accounts method, the locked box mechanism provides for a fixed purchase price agreed by the parties on signing (outlined in the first article linked to above) and is generally not subject to post-closing adjustments. Instead, the equity value based on the target company’s financial statements at a defined balance sheet date is “locked” as the cash, debt and working capital of the target company are known amounts. On the closing date, there is no additional financial statement required. Nevertheless, the more time passes between the defined balance sheet date (the “Locked Box Date”) and the signing date, the more likely it is that the buyer will ask for more up-to-date financial statements of the target company prior to signing. In such case, the seller is usually expected to provide (usually less formal) management accounts enabling the buyer to verify whether “extraordinary” business transactions or events have occurred in the phase after the Locked Box Date, when the opportunities and risks of the target company’s business operations already ”belong“ to the buyer.
Additionally, the buyer will be interested to contractually ensure that no funds or other assets from the target company are extracted from the target company to a member of the seller’s group between the Locked Box Date and the closing date without the consent of the buyer (“Leakage”). If such outflow of value is expected, the seller will be asked to identify possible events and circumstances to be explicitly permitted (“Permitted Leakage”).
Agony of Choice: Pros and Cons of the Mechanisms
The locked box mechanism is predominately used in transactions in which private equity investors are involved to provide transaction certainty, avoid delays and additional costs and preserve price certainty as of the signing date. However, for the very same reasons, it has also become popular in other M&A transactions. However, if the closing of the transaction is expected to occur much later after the Locked Box Date, it may be appropriate to use the closing accounts mechanism: From the Locked Box Date onwards, the target company’s business is managed on behalf of the buyer, including both opportunities and risks. This setup is usually acceptable to the buyer if the time between the Locked Box Date and the closing date is not too long.
Ultimately, the choice of the purchase price mechanism may be influenced by several factors, such as the commercial realities of the target company’s business or industry, identity of both the seller and buyer, overall transaction timeline and preferences of the parties involved.
