Issue 4 • October 2019
Mergers and Acquisitions Guidance Note
IntroductionThe M&A process can move towards completion faster
than you expect. It is therefore important to understand
the impact of your every decision as a participant to the
mergers and acquisitions related transactions along the deal
continuum. Regardless of whether you are on the buyer or
seller side, signing the agreement will be a key stage in the
deal: it sets out the terms to ensure the buyer is acquiring
(and the seller is disposing of) what they expect, at the
agreed deal price and without inappropriate risk.
As the market evolves, the Locked Box is becoming a
more common closing mechanism. What is it, and how is
it different from a more typical approach – Completion
Accounts? What should I consider before choosing Locked
Box over Completion Accounts? What are the pros and
cons? If you feel unsure about any of the above questions,
read below and you will find answers.
The Locked Box mechanismIn short, a Locked Box deal is a fixed price deal. Under the
Locked Box mechanism, the equity price is ‘locked’ with
known amounts of cash, debt and working capital at a
pre-signing date (Locked Box date) based on a historical
balance sheet (Locked Box balance sheet). This is unlike
the Completion Accounts mechanism, where the enterprise
value is agreed upon at signing date and then adjusted for
actual cash, debt and working capital movements between
the signing and closing date to determine the equity price.
There are no subsequent adjustments post-completion
under the Locked Box approach. As such, under the Locked
Box mechanism the buyer bears performance risk from the
Locked Box date onwards.
Especially if the target is a profitable and growing
company, the Locked Box mechanism can bring positive
benefits to the buyer in the period between the Locked
Box date and the completion date (the gap period). To
protect the buyer from any value extraction by the seller
(for example cash, assets, etc.) during the gap period –
during which the seller still controls the target operation
– terms and definitions should be set out clearly in the
share purchase agreement (SPA) to avoid ‘leakage’. Under
the SPA, the seller will undertake not to extract value for
their own benefit, unless specifically agreed to for normal
business operations (permitted leakage).
At the same time, the buyer needs to compensate the seller
for the opportunity cost of the continued profit generation
during the gap period (that is, expected cash flow changes
in net debt) by applying an interest rate or per diem rate as
proxy for measurement. This is because the buyer takes the
economic interests and risks from the Locked Box date but
does not pay the deal price until completion date.
This guidance note gives company secretaries and governance professionals an overview of the locked box mechanism, which is becoming a common closing mechanism for mergers and acquisitions (M&A) transactions.
Public GovernanceMergers and Acquisitions Guidance NoteIssue 4 • October 2019
Locked Box vs Completion AccountsThe key difference between the two mechanisms is the timing
of the transfer of the economic interests and risks arising from
the target’s business. The transfer of risks and rewards takes
place earlier under the Locked Box approach at the Locked Box
date compared to at completion date under the Completion
Accounts approach.
If the Locked Box is properly locked and there is no unpermitted
leakage to the seller, other than the net profit generated from
the operation, the working capital movement in the gap period
should mirror the net debt movement at completion. In such
case, neither party wins or loses. The pricing considerations
would be the same under the two approaches, but the timing
differs. Both parties can benefit from the cost-savings due to
the simplicity of the SPA under the Locked Box approach.
Please refer to the ‘Locked Box vs Completion Accounts
illustrative process’ graphic for more details of the deal
process under the two mechanisms, as well as the ‘Locked
Box vs Completion Accounts key SPA features’ graphic for a
comparison table of the key SPA features.
Locked Box vs Completion Accounts illustrative process
Locked Box
CompletionAccounts
Ultimate cash consideration includes compensation for gap period cash flows
Locked Box’s time line
Completion Accounts’ time line
Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18
Equityprice agreed
Enterprise value
agreed
Adjustment basis for debt and working capital agreed prior to signing, but the actual adjustments are made
after signing based on completion accounts
Completion accounts prepared
Leakagereview
No adjustment, unless there has been unpermitted leakages
Completion accounts review process
(as defined in SPA)
AuditedFY17
Accounts
Due diligence and SPA drafting
SPAsigned
Completion
SPA Signing Date
SPA Signing DateReference Date
Locked Box Date
Key date when economic interest/risk passes to Buyer
Completion Date
Completion Date
No unpermitted leakage of value from the locked box date
Adjustments for debt and working capital agreed prior to signing based
on historical balance sheet
Public GovernanceMergers and Acquisitions Guidance Note
When to use Locked Box over Completion Accounts?The Locked Box mechanism is particularly attractive for
transactions where the parties value greater certainty on the
transaction price (for example, existence of private equity or
financial sellers), or when a quick integration is required post-
completion. It also provides a way for the seller to minimise
the risks and complexities of post-deal negotiation with the
buyer, who may attempt price-chipping (that is, bridging a
value gap through Completion Accounts adjustments).
However, the adoption of the Locked Box mechanism relies
heavily on the buyer’s confidence in the quality of the Locked
Box balance sheet and how leakage is controlled, that is
how the box looks and whether the box can be effectively
locked. It is also crucial for the buyer to ensure that there
are adequate systems in place to identify leakage post-
completion. The buyer’s confidence level could be affected
by:
• strength of target’s finance function
• quality of financial information
• existence of any independent reviewers (for example,
audited accounts) and their competency
• complexity of the deal (for example, carved-out business)
• provisions for Leakage review/completion review post-
completion, and
• confidence in the profitability/performance under the
seller’s control in the gap period.
Further steps to consider for a Locked Box mechanism1. Effective date – setting the Locked Box dateAn appropriate Locked Box Date is essential to a successful
Locked Box mechanism. The financial year-end date is a popular
choice, as the accounts will have been subject to an audit or
independent review, with key metrics in transactions (including
working capital and net debt) readily available. It offers higher
comfort to the buyer while saving time for the target’s finance
function to prepare additional information. However, it is also
important to consider whether there will be a long gap between
the last audit/review date and the proposed completion date,
so as to minimise the risk of Leakage and changes in business
performance or structure. At the same time, both parties should
agree on a reasonable time period for the due diligence process
of financial statements as at Locked Box date.
2. Protecting the buyer – leakage and permitted leakageAs discussed earlier, the buyer should seek protection through
the SPA against any form of value extraction from the business
during the gap period. To address the buyer’s concern, the seller
will normally deliver indemnities, accompanied by covenants/
warranties in respect of the leakage. Generally speaking, the
greater the uncertainty, the more the buyer would like the seller
to provide warranties in the SPA with a broader definition of
leakage as protection. This may make negotiations harder, as
the seller may be reluctant to agree. Examples of leakage and
permitted leakage are set out in the following graphic.
Issue 4 • October 2019
Locked Box vs Completion Accounts
Key SPA features
Areas Locked Box Completion Accounts
Price • Fixed equity price • Enterprise value agreed but subject to completion adjustment to come up with the equity price
Priceadjustments
• Known amount of price adjustments for cash, debt and working capital at completion, agreed prior to signing
• Definitions of cash, debt and working capital are agreed prior to signing, amount is uncertain until completion
Reference of balance sheets
• Based on historical balance sheet • Adjustments for cash, debt and working capital are based on a completion balance sheet prepared after closing
Leakage • Seller provides indemnity and affirms that there will be no “leakage” from the locked box date
• Leakage concept is irrelevant. SPA is likely to contain ‘conduct of business’ provisions
Completion review
• No completion accounts and associated review process and no adjustment to purchase price after closing
• Process/mechanism for preparing, reviewing and agreeing completion accounts is set out clearly in SPA
Public GovernanceMergers and Acquisitions Guidance NoteIssue 4 • October 2019
Leakage Permitted leakage
• Dividends and distributions/return of capital.
• Payments to directors and their connected persons.
• Deal-related costs, such as:- fees and expenses incurred in connection with the sale
(for example fees to advisors), and- bonuses paid to staff (subject to closing of deal).
• Non-ordinary course intra-group payments or payments for services (not on commercial/arm’s length terms).
• Waiver of amounts due from seller(s).
• Discount on transactions to related parties.
• Intra-group payments in the ordinary course of business and on arm’s length terms.
• Any payments provided for in Locked Box accounts (and therefore priced) or indemnities.
• Items agreed prior to signing
• Payment/commercial basis increment of employee remuneration/wages in the ordinary course of business.
• Matters specifically agreed between the two parties
3. Compensating the seller – per diem and interest rate (value accruals)From the Locked Box date – when the economic
interest has effectively passed to the buyer – the
buyer is entitled to enjoy the benefit of cash profits
generated from the business. In contrast, the seller
incurs an opportunity cost, as it will not receive any
benefit from operating the business in the gap period
and will not receive transaction proceeds until the
completion date. To compensate for the delayed
payment (or the loss of profits in the gap period), the
seller will typically demand either:
(i) an interest charge on the unpaid portion of the
equity price, reflecting the seller’s loss for not
having received the proceeds at Locked Box date,
or
(ii) a proxy for the profits earned (for example per
diem/daily rate) during the gap period.
These two ways of interpretation may give rise to different
compensation for the opportunity cost – that is the loss of
interest income from the proceeds or the loss of profit from
the business, of which the return rate can be higher or
lower than the interest rate. Either method should reflect
the expected ‘cash profits’ of the target or the opportunity
cost from the sales proceeds after the Locked Box date,
not the operating cash flow. No matter how this is agreed
between the buyer and the seller, this calculated accrued
value, plus the purchase price (equity value) shown in the
Locked Box SPA, forms the final consideration for the deal.
Pros and ConsIn summary, it may appear to be more advantageous for
a seller to adopt a Locked Box mechanism. However, if
appropriate comfort can be offered to the buyer over the
integrity and accuracy of the Locked Box balance sheet,
accompanied by sufficient warranties and indemnification
over the Locked Box accounts, the mechanism can still be
attractive to the buyer.
Public GovernanceMergers and Acquisitions Guidance NoteIssue 4 • October 2019
The Hong Kong Institute of Chartered Secretaries (HKICS) 香港特許秘書公會(Incorporated in Hong Kong with limited liability by guarantee)
Disclaimer and CopyrightNotwithstanding the recommendations herein, this publication is not intended to constitute legal advice or to derogate from the responsibility of HKICS members or any persons to comply with the relevant rules and regulations. Members and readers should be aware that this publication is for reference only and they should form their own opinions on each individual case. In case of doubt, they should consult their own legal or professional advisers, as they deem appropriate. The views expressed herein do not necessarily represent those of HKICS. It is also not intended to be exhaustive in nature, but to provide guidance in understanding the topic involved. HKICS shall not be responsible to any person or organisation by reason of reliance upon any information or viewpoint set forth under this publication, including any losses or adverse consequences consequent therefrom.
The copyright of this publication is owned by HKICS. This publication is intended for public dissemination and any reference thereto, or reproduction in whole or in part thereof, should be suitably acknowledged.
The members of the Takeovers, Mergers and Acquisitions Interest Group are: Michelle Hung FCIS FCS (Chairman), Dr David Ng FCIS FCS, Henry Fung, Kevin Cheung, Lisa Chung, Patrick Cheung and Philip Pong. Gratitude is expressed to PY Chui, Partner, Advisory Services, PwC, and Margot Lam, Deals Services, PwC, as the authors of this paper. Mohan Datwani FCIS FCS(PE) serves as secretary. Please contact Mohan Datwani, Senior Director and Head of Technical & Research, HKICS, if you have any suggestions about topics relevant to this interest group at: [email protected].
Ultimately, the pricing considerations and mechanisms are
the same for Locked Box and Completion Accounts. Both
mechanisms end up with the buyer paying the seller the equity
price (that is, enterprise value adjusted for cash, debt, and
difference between the target and actual working capital).
However, different mechanisms should be selected under
different circumstances. A wrong choice can make negotiations
complex, or may even risk failure to complete the deal. It is
therefore important to make wise decisions to protect your
interests. HKICS
Pros-seller
• Gives certainty of price, resulting in ability to distribute process quickly.
• Encourages less aggressive interpretations of potential debt items in an auction process.
• Avoids post-deal negotiations by buyers.
• Greater control of the deal process.
• Consistency with previous accounting policies – there is no debate over completion accounts policies pre-completion.
• Time saving – no management time spent debating completion accounts post-completion.
• Cost saving – no completion mechanism process.
• Beneficial if the business is loss making.
Cons-seller
• Difficult to apply where there is no separately identifiable balance sheet (for example, carve-out business).
• Requires a competent finance function with sufficient deal-related knowledge.
• Loses out if post-Locked Box interest rate is set too low (especially for fast developing business).
Pros-buyer
• Gives certainty of price.
• Cost saving – no completion mechanism (we do however recommend leakage reviews are completed).
• Time saving – allows quick integration post-completion.
Cons-buyer
• Needs to consider reliability of Locked Box accounts (subject to audit/review by client’s auditor).
• No completion mechanism to exploit – need to rely on warranties.
• Limited ability to get management on-side while bearing the business risk in the gap period without any control.
• Risk of business deteriorating (or operating loss) between Locked Box date and completion.
• Subsequent leakage review may be restricted if the deal is an acquisition of minority interests.
• Requires quick understanding of debt and working capital for earlier debate of price adjustments.