Completion Mechanisms: Completion Accounts and Locked Boxes

Author: Khaleem Ali, Senior Associate, Heligan Corporate Finance

In M&A transactions, ensuring a seamless and fair transaction is paramount. A key aspect of this process is the determination of the purchase price, which can be adjusted through various completion mechanisms. The three primary methods are the Locked Box mechanism, Completion Accounts, and to a lesser extent, hybrid models. 

In our previous article, we explained what Enterprise Value to Equity Value Bridges (“EV-EV Bridge”) are and their necessity in achieving a fair deal. If EV-EV Bridges decide the adjustments to determine the final equity value of a company, then completion mechanisms govern the timing and measurement of the adjustments. Completion mechanisms and EV-EV Bridges are two sides of the same coin, and you can’t reasonably have one without the other.

The EV-EV Bridge will determine what from the company’s balance sheet will be considered cash, debt or working capital and the adjustments will be applied to get the final Equity Value, which is payable to the Sellers, however the completion mechanism decides at what point in time the balance sheet is measured. Should the balance sheet be measured at the point of deal completion? Should a point in time before the deal completes? Based on the measurement period, when do the right and responsibilities of the company transfer in essence from the Seller to the Buyer?

Each method has its own set of advantages and limitations, and their application depends on the specifics of the deal and the preferences of the parties involved. This article will explore these mechanisms, comparing their benefits and drawbacks, and highlighting the trend towards the increasing popularity of Locked Boxes over the traditional Completion Accounts.

Completion Accounts

The completion accounts mechanism involves determining the purchase price based on the target's actual balance sheet at the completion date. This method requires the preparation of accounts as of the completion date, which are then reviewed and agreed upon to finalise the purchase price.

To facilitate the completion, estimated completion accounts are drawn up which aim to approximate what the balance sheet will look like on the completion date.  The adjustments are made based on these set out estimated completion accounts and the consideration is paid (less a small retention contingency to mitigate the chance of losses to the Buyer from the completion accounts ‘true-up’) on the completion date.

The final Completion Accounts are drawn-up by the Buyer in the weeks after the deal completion, based on pre-agreed parameters in the Sale and Purchase Agreement (“SPA”) and then any variation of the final Completion Accounts compared to the Estimated Accounts are adjusted through the True-Up to complete a final payment to the Seller.

The final Completion Accounts are issued to the Seller for review and approval.  Again, the SPA covers the mechanism to treat any potential disputes should they arise. Assuming the Completion Accounts are agreed, a “true-up” will take place by virtue of adjustments being made to the purchase price by comparing the estimated completion accounts to the actual completion accounts. Following the true-up, a payment will be made to either the Seller or the Buyer depending on which way the true-up lands.

Completion accounts have historically been very popular to a significant degree in Europe and to an even larger extent in the US and are generally Buyer friendly as the Buyer takes control of the business the same day completion occurs, protecting the Buyer against any adverse financial changes occurring up to the completion date, the Buyer also gets to prepare the completion accounts for which the true-up will be based upon. The completion accounts mechanism also reflects the true financial state of the target at the point of transfer, ensuring a fair valuation.

However, they are not without their drawbacks as there is significant uncertainty inherent in this approach, with the Buyer and Seller not knowing what the exact consideration will be until after the completion date, having to agree accounts that were not drawn up by the Seller post-deal and having to deal with any completion accounts true-up disputes after the fact.

For these reasons, Locked Box mechanisms have become an increasingly popular option, let’s explore why.

Locked Box

The Locked Box mechanism in contrast to Completion Accounts is a fixed-price mechanism based on the target company's balance sheet at a specific date prior to the completion date.  For example, the Buyer and Seller will decide that they will use 31st March as their Locked Box date.  This means that while the transaction will likely not formally complete until a period later, both parties agree that the EV-EV Bridge adjustments will be made based on the balance sheet as at the Locked Box date and anything that occurs after this date will not be adjusted for in the EV-EV Bridge, which means that pre-completion both parties will know the fixed price for the business and it will not be subject to change or adjustment following completion, providing certainty.

During the period from the Locked Box date to the Completion date, the Sellers and/or incumbent management will act in essence as custodians of the asset for the Buyer, they will be restricted in legal documents to act in good faith in the ordinary course of business and to pay themselves and other stakeholders at the market standard rate without drawing excess dividends or other distributions, all of which are formally agreed between the parties.

During the custodian period, it is often agreed that the Sellers will be awarded a “Profit Ticker”, which is the operating profit less any corporation taxes accrued during the custodian period. This reflects the cash generation of the business during the custodian period given they were still owners.

The fixed price provides both parties with certainty, reducing the scope for disputes and negotiations post-completion. Further, the absence of post-completion adjustments simplifies the transaction, allowing for quicker finalisation, as well as reducing the need for extensive post-completion audits and accounting work, saving time and costs.

The Locked Box approach has limitations however in that the Buyer bears the risk of any financial changes occurring between the custodian period of between the Locked Box date and completion. In spite of legal restrictions, Sellers may also delay necessary expenditures or manipulate financials up to the Locked Box date to present a more favourable position.
 

Why the Shift to Locked Boxes?

1. Market Competition: In a competitive market, Sellers prefer the certainty that locked box mechanisms offer, plus it mitigates the risk of trading between the locked box date and completion.
2. Deal Efficiency: The streamlined process aligns with the fast-paced nature of modern M&A transactions, where quick and decisive action is often necessary.
3. Cost Considerations: The reduced need for extensive post-completion adjustments translates to lower transaction costs, appealing to both parties.

While the Locked Boxed has gained popularity, Completion Accounts are unlikely to lose their appeal in a material way, as Buyers generally prefer the opportunity to undertake a subsequent review of the accounting of the business.

Hybrid Mechanism

To address some of these issues, a hybrid approach has been adopted in various transactions which incorporate the basic Locked Box approach but with some post-deal true-up adjustments which are pre-agreed, although this comes with its own set of complexities.

Conclusion

Selecting the appropriate completion mechanism is a critical decision in any M&A transaction, impacting the final purchase price, the speed of the deal, and the relationship between the parties. While Completion Accounts provide a precise and accurate valuation, the simplicity and certainty of Locked Boxes are increasingly appealing in today's competitive market, particularly to Sellers, who have certainty on their equity proceeds at completion.

By staying informed about these mechanisms and the latest trends, advisors can effectively guide their clients through the intricacies of M&A transactions, leveraging the most suitable approach for each unique deal. In summary, no one size fits all and advisors must use their judgement and intuition to suggest an approach that is most appropriate for the nature of the deal they are working on.