Closing and pricing mechanisms in Corporate Transactions: Locked Box or Completion Accounts
Within the world of Corporate Finance and in company acquisition processes, it is important to define the moment and the closing methodology of the financial statements that will be used as a reference both for the calculation of the price of the Company and the transfer of responsibilities between the buyer and the seller.
Below are the two formulas that are commonly used and whose choice can lead to important implications in the final price:
Locked Box Mechanism
The Locked Box mechanism supposes taking as a basis a cut-off date of the financial statements prior to the closing of the operation.
A Locked Box period is set between the reference date and the closing of the operation where the value of the Company is not allowed to leave, therefore, the term refers to the “box being closed”.
It is common that the distribution of dividends, investments of a high amount, or extraordinary expenses are not allowed during the interim period in order not to reduce the cash. Although it is true that, if the normal evolution of the business or the corporate operation requires it, it can be agreed with the buyer to carry them out.
This closing mechanism requires that the buyer and seller agree in advance which actions can be carried out and which cannot. It must be taken into account that, despite having reached an agreement to purchase the Company, its main shareholders are the sellers and, therefore, the buyers do not have management power.
If the Locked Box period is prolonged, it can be a risk for both parties since the Company can improve or worsen its evolution, impacting the price.
Completion Accounts Mechanism
When the Completion Accounts mechanism is applied, the financial statements used are those of the closing date of the operation, which are prepared after said date.
This method implies the preparation of a closing estimate and study of provisions, with which the closing of the operation will be carried out. After the closing date, the final financial statements are reviewed and issued, to which the agreed adjustments are applied.
The agreed adjustments usually involve the valuation multiples, Savings or Net Financial Debt, or significant variations of Working Capital. For this reason, it is important that the forecast used is as accurate as possible, thus avoiding possible significant variations in the final price.
As a consequence, any price adjustment is not defined until some time after the closing of the operation, when the financial statements are prepared.
The Completion Account mechanism requires detailed negotiations between the seller and the buyer to stipulate the rules for the preparation and validation of the closing financial statements, with the aim of reducing uncertainty and post-closing disputes of the operation. If necessary, if there are discrepancies, a third party is usually appointed, who in a short period of time and independently, will agree with one or the other of the parties.
All these mechanisms are regulated in the Purchase Agreement (or SPA) that the parties have previously agreed upon.
The objective of both systems is to avoid surprises at a delicate moment, since by transferring control of a Company we are also transferring economic rights but also a series of responsibilities and obligations.
We must take into account both closing and pricing mechanisms so that the corporate operation is a win-win for buyers and sellers. There is no better or worse methodology, simply the optimal one must be used for each operation, as they are all unique.
The presence of a financial adviser in this type of transaction is the best guarantee of its success and the defense of the interests of the parties involved.
Javier Navarro Enguídanos, analyst at Vinca Capital