The Locked Box Mechanism: An Alternative to Working Capital Adjustments in Private M&A Deals

Most acquisitions of private companies include a working capital adjustment. This is often a very sensitive part in the negotiation of a private M&A deal. However, it is possible to do away with it entirely by using the locked box mechanism. Under this method the purchase price is determined based on a date that precedes the closing date. A closing date balance sheet is not prepared and there are no post-closing purchase price adjustments on account of working capital. This method is popular in Europe and is gaining favour in North America. If you are looking for purchase price certainty and want to reduce post-closing price disputes, or are at an impasse in settling a traditional working capital mechanism, the locked box mechanism is something you should consider.

Traditional Working Capital Adjustment

Typically, the vendor and buyer in a private acquisition determine a target working capital amount that the target company must have on closing. To the extent the closing date working capital is greater than the target working capital, there is a positive adjustment to the final purchase price and vice versa if there is a deficiency. Typically, the buyer pays the closing date consideration based on an estimated closing date working capital. Afterwards, a closing date balance sheet is prepared within a specified time and an adjustment takes place, either disputed or undisputed, to true up (or down) the estimated closing date purchase price. This results in either the purchaser paying more or the vendor returning closing proceeds (or foregoing proceeds in escrow or held back).

Issues with Traditional Working Capital Adjustments

The working capital adjustment is a sensitive part of all private M&A deals. The adjustment is critically important since it directly impacts the purchase price – usually on a dollar-for-dollar basis. Negotiating the target working capital is fraught with disagreements, particularly in respect of seasonal businesses. There are complexities with "normalizing" working capital, determining an appropriate target and determining the line items that should be included in, and excluded from, the calculation. The process of negotiating disputes can be tricky. Preparing a closing date balance sheet is expensive, as is dealing with post-closing disagreements. Both sap management time and resources.

How a Locked Box Mechanism Works

Under the locked box mechanism the buyer determines the value of the company as of a date that precedes closing. This date, referred to as the "reference date", is usually the end of a fiscal period for which financial statements have been prepared. The purchase and sale agreement is drafted so as to "lock" the risks and rewards of the target company’s business from the reference date to the closing date. The vendor represents as to the quality of the reference date financial statements as well as to any "leakages" from the reference date, such as dividend payments or below market dispositions. Leakages are scheduled and reduce the purchase price. Furthermore, the vendor covenants, among other things, not to permit or cause any leakages from the signing date to the closing date. The buyer pays the vendor additional consideration to account for the time value of money between the reference date and the closing date, typically in the form of a per diem akin to a daily interest rate. Crudely, the final purchase price equals the reference date determined purchase price, less the monetary value of any leakages from the reference date, as scheduled, plus an amount to compensate the vendor for the time value of money from the reference date to the closing date. After closing, the buyer has recourse against the vendor (ideally from the first dollar) through the purchase and sale agreement’s indemnities  for any leakages that are unaccounted for or are not permitted.

Conclusion

If the working capital negotiation is derailing your private M&A deal, if you want more purchase price certainty or want to limit expensive post closing price determinations, then a locked box mechanism is something you should consider and speak with an experienced professional about.