Pro’s and Con’s of the locked box purchase price mechanism

In the Netherlands, locked box purchase price mechanisms are still used in the majority of transactions. The locked box approach is the favored approach allowing a clean exit and providing the possibility to distribute the consideration more quickly. In the below blog we set out the pro’s and con’s of the locked box purchase price mechanism as used in M&A deals in the Netherlands. Please feel free to contact us if you have any further questions.

What is the locked box purchase price mechanism

Within the locked box mechanism, the most important aspect is that the final purchase price of a company to be acquired (the ‘Target’) is agreed upon on the basis of financial documents of the Target (‘Financial Documents’- usually the latest annual accounts), prior to the signing of the purchase agreement and that this final purchase price is not adjusted after the delivery of the shares (as is typically the case with the ‘closing accounts’ mechanism). In determining this final purchase price, the adjustments to the “cash and debt free” purchase price in connection with the levels of working capital and net debt present are also immediately negotiated and included in order to arrive at the final purchase price.

Since the final purchase price is determined on the basis of the financial figures as per the balance date in the Financial Documents, the purchase agreement of a locked box transaction always includes that the Target is financially for the account and risk of the buyer as of that date (‘Effective Date’). This makes sense because the Target is thus purchased based on the figures as of that date. Together with the space that exists between this Effective Date and the time at which the purchase price is paid at the time of the delivery of the shares, a number of specific issues must then be addressed in the purchase agreement, such as: (i) any locked box fee as compensation for missed profits in the period from the Effective Date or as interest compensation on the deferred payment of the purchase price (the Locked Box Fee), and (ii) making arrangements for permitted and unpermitted value withdrawals by the seller or an affiliate of the Target (Permitted Leakage and Leakage).

Moreover, shifts in the balance sheets related to the “ordinary course of business” are simply allowed within the locked box mechanism because, due to the transfer of beneficial ownership on the effective date, they do not affect the assumptions on which the final purchase price is based.

Advantages of the locked box mechanism

An advantage that comes along with the locked box mechanism for the seller is that the agreeing upon the final purchase price as of the effective date at the time of signing the purchase agreement provides price certainty. In this case, the purchase price is not adjusted afterwards, apart from, for example, any unknown Leakage or damages due to a breach of a warranty and/or indemnity. Additionally, this mechanism is an easy way to save time and costs, as the transaction and purchase agreement as well as their negotiations are less complicated.

Even after the delivery of shares, the mechanism can be considered straightforward as there is no need for complicated audits and calculations to adjust the purchase price in connection with working capital and net debt. The latter also reduces the possibility of litigation after completion of the transaction.

The aforementioned advantages apply to the same extent to a buyer, but it is added that the buyer will already receive the profits from the Target of the Effective Date. Negative results will, of course, also be for the buyer’s account. However, the estimation of whether this will be the case will usually be well in advance, in which case the buyer in question can insist on a different mechanism or even abandon a purchase.

Disadvantages of the locked box mechanism

The disadvantages of the locked box mechanism for a seller, as far as we are concerned, lie mainly in the fact that the seller has to wait longer on his money, while, as of the effective date, the seller is no longer entitled to the profits, and, in some cases, may also have no room to negotiate a (good) Locked Box Fee. Another significant disadvantage may be that during its due diligence, the buyer will want to examine the financial side of the Target extensively with the assistance of advisors in order to properly verify the assumptions it has based n its final agreed upon purchase price (including the amount of working capital and net debt to be agreed upon in connection therewith). Such an intensive financial due diligence obviously costs time and money, especially if additional financial documents also need to be prepared and delivered. The extent of this will depend on how comfortable the buyer feels with the documents and figures presented.

For a buyer, the latter also comes into play. The buyer has less knowledge of the Target’s business and thus will need to conduct an extensive due diligence to verify its assumptions and properly negotiate the final purchase price. The buyer will also need to be mindful that the Leakage provisions must be sufficiently comprehensive to recover all value wrongfully extracted by the seller and seller-affiliates. In this case, the buyer also has a backlog that it will want to make up through its due diligence. Finding out the Leakage after the fact can also be tricky.

A final disadvantage may be that the locked box mechanism is internationally less well known. Parties in, for example, the United State of America are less familiar with it and are therefore less likely to accept this mechanism in a deal. If they do accept the mechanism, it is possible that the process will take more time than normal because these foreign countries simply have less experience with it.

Blenheim: Specialized in locked box and closing accounts mechanisms

Whether or not the locked box mechanism is used in a transaction, will ultimately depend on the trade-offs of the various pros and cons of the deal at hand. At Blenheim, we are comfortable with both the locked box- and the closing accounts mechanism, and advised in many different transactions in which one or the other was at issue. With our accumulated expertise in this field, we like to help our clients stay one step ahead. Please feel free to contact us if you have any questions.