Through the Keyhole – Locked Box Completion Mechanism

Unlike a property, a company can comprise many different assets and liabilities, the values of which may regularly fluctuate. Because of this, it is usually insufficient to simply agree the headline purchase price of a company ahead of completion and leave it there, as is standard in a property transfer. In company sales, the parties will normally agree to adjust the purchase price after completion based on a set out accounts for the company as at completion. For example, the parties may agree that a company is worth £500k on the basis of it having net assets of £100k (which it may well have done when the headline price was agreed). If, following completion, specially prepared accounts show that (at completion) the company had net assets of £80k, the company would have fallen £20k below the net asset target and the contract for sale will usually provide that the seller will repay the buyer £20k to compensate for the shortfall. This is known as a completion accounts price adjustment mechanism. However, for parties that would prefer completion to be final and not subject to a subsequent price adjustment, they may prefer a locked box completion. A locked box completion also relies on the price being fixed to a set of company accounts, but the main difference is that these accounts state the financial position of the company on a date falling before completion. These accounts may be specially prepared shortly before completion or they may be the most recent statutory or management accounts of the company.

How Locked Box Works – Example

1. Mr Jones owns 100% of the shares in Happy Food Ltd and has agreed to sell his shares to Mr Smith for £300k, with completion proposed for 30th September 2020. The purchase price was agreed based on the latest management accounts of the company.
2. Mr Jones has asked the company’s accountant to prepare a set out accounts for the company as near to completion as possible. A set of accounts are prepared and finalised (Locked Box Accounts) showing the financial position of the company as at 20th September 2020 (the Locked Box Date)
3. On review of the Locked Box Accounts, Mr Smith can see that its net asset position on the Locked Box Date has reduced since the purchase price was agreed. Because of this, the parties agree to reduce the purchase price to £250k.
4. On completion, Mr Smith pays £250k to Mr Jones and takes ownership of the company. There are no subsequent purchase price adjustments.
5. To guard against Mr Jones making significant changes to the company between the Locked Box Date and completion, the sale contract will almost certainly include contractual assurances from Mr Jones as to how the company has been run since the Locked Box Date, including confirmation that certain matters that would extract value from the company (such as management charges and dividends) have not occurred. The occurrence of these matters is known as leakage. If there has been leakage, it would be typical for Mr Jones to recover the amount of such leakage from Mr Smith under a contractual indemnity (other than in respect of leakage that they expressly agreed was permissible).

Advantages of the Locked Box Mechanism

• This method increases price certainty.
• If there is disagreement as to the value of the company after preparation of the Locked Box Accounts, the parties are able to walk away from the deal.
• Completion is final. The parties do not need to spend time and money on negotiating and agreeing completion accounts and price adjustments after completion.

Disadvantages of the Locked Box Mechanism

• A buyer will often need to carry out even more detailed due diligence (especially financial due diligence) given that he acquires financial risk in the company from the Locked Box Date and will have no opportunity to clawback value post-completion other than via the indemnity).
• The transaction may take longer to complete due to the enhanced due diligence required by the buyer and the negotiations required in relation to the conduct of the company and its finances during the period between the Locked Box Date and completion.
• A seller may be disadvantaged if the company thrives between the Locked Box Date and completion as the value of the company may have increased. If this is likely to be the case, a buyer may agree to pay interest on the purchase price from the Locked Box Date to completion.

If you would like to discuss the matters raised in this article, or a business acquisition generally, please contact the Corporate and Commercial team at Morrisons by getting in touch with your usual advisor.