Among different conditions of the M&A agreements, the parties must define if there will be price adjustment based on the financial variations between signing and closing. In case variations are considered then the method is the one called Closing Accounts. If there are no adjustment based on the results of this period, the method is called Locked Box. In order to define the method to be used the parties must know the consequences, benefits and risks of each of them.
In general the M&A transactions are structured with two different events. The first is the execution of the agreement which defines the rights and obligations of the parties and set forth corporate event to be performed (sale of shares, merger, spin-off etc.). The second is the closing when the transactions are concluded and it happens after certain conditions precedent are fulfilled. Taking as an example a plain vanilla purchase of shares, the closing normally is the event when the price is paid and the ownership of the shares are transferred.
Between the moment of the signing and the closing many different events may occur which change the figures and financial projections of the assets involved in the transaction. This may be a short period or a long period depending on conditions precedent for closing. During this period the target company continues to operate and its figures and financial statements consequently change, being necessary to determine which party takes the losses or gains during this period. Depending on the method elected it shall be the buyer or the seller.
In the closing accounts method, the financial statements or other financial results of the target company are prepared for closing and the price is adjusted based on the variations from the financial statements or other financial results presented at signing. The closing account method is the classic option which the investor does not have exposure during the period between signing and closing.
The other option is to set the price in the agreement as fixed without variations during signing and closing. This structured is called locked box because any variation remains "in the box" without any adjust to the price. In this case the investor assumes the risks of variations between signing and closing.
The classic method of closing accounts is more used in the United States. Most of the time the companies involved are public companies or corporations with the routine of drawing financial statements regularly.
The locked box is more used in Europe or by private equity funds. The main benefit is that this simplifies the transaction and prevents further adjustments. Therefore, the management does not waist time with financial statements and its verification and closing can happen faster. It is also interesting in the aspect the parties will have the price as it was their initial expectations.
The main concern of the locked box is to have a structure to prevent a leakage. The agreement should provide for clear clauses to avoid unusual variations, the so called anti-leakage provisions. Among the restrictions there are the straight forward examples, such as the restriction on distribution of dividends and agreements with related parties of seller, and more subtle matters as limitations on the daily operation of the company and certain financial investments.
The definition of the method to be used is a commercial call, but the decision should be taken with legal support and precaution. The length expected for the period between signing and closing, the size and sophistication of the target company, the trust in the management and the appetite for risk are examples of aspects to influence the option for the method to be used.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
