When determining the actual purchase price in a M&A transaction, the parties have to mitigate the fact that the balance sheet of a company is actually a moving target. As goods or services are exchanged for cash, salaries and bills are paid and debt is amortized, the assets and debts will change on a daily basis and the exact financial standing of the company as per the closing date will be unknown to the parties and is very likely to differ from what appears from the financial information provided during the financial diligence exercise before the transaction.
Among the more straight forward means to mitigate this is what is commonly referred to as a “locked box” purchase price, entailing that the transaction is structured as-if it was actually completed as per the balance date of the accounts provided in the due diligence.
A typical locked box arrangement includes (i) a fixed purchase price agreed upon on signing based on the financial statements included in the due diligence, (ii) strict protective covenants to protect the purchaser from value transfers or extraordinary transactions between the balance date of the financial statements and closing and (iii) an interest on the purchase price payable by the purchaser to the seller from the balance date to the closing date. The interest serves to compensate the seller who has continued to finance the operations of the company from the balance date to closing, during which period the risk/reward of the operations is actually the purchaser’s.
The locked box is a relatively easy way to establish a fair purchase price without having to use complicated purchase price adjustments based on a specific balance sheet prepared as per the closing date. However, as the seller will normally remain in control over the business for a period after the risk has been transferred to the buyer, the buyer runs the risk that lack of motivation and incentives for the seller causes the business to be run in a less than optimal fashion during this period. It is therefore preferable to keep this period as short as possible, and also advisable to carefully tailor the no-leakage and other restrictive covenants and ensure that compliance can be monitored.