M&A and the Locked Box

M&A and the Locked Box

Author: Joris Kersten MSc/ Owner Kersten Corporate Finance

Kersten Corporate Finance: M&A advisory in The Netherlands, deals in all industries, 5m to 100m enterprise value transactions (EBITDA range 1m – 10m) + Business Valuations. Full info on: www.kerstencf.nl

Corporate Finance training: Business Valuation & Deal Structuring, 5 day training @ Amsterdam South (Zuidas): 4th until 8th November 2024. Financial modelling: DCF + LBOs (IRR + credit statistics) + M&A model (accretion/ dilution + credit statistics) + EBITDA multiples + ROIC/ WACC + cash & debt free (adjusted net debt) + equity bridge. Registration form & full training manual can be found on: www.joriskersten.nl

Source used: Book Bedrijfsovername, Van Buuren & Koster, Wolters Kluwer, Deventer 2023, Ch. 9 Locked Box Mechanisme, Mr. Gijs Linse.

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Introduction

An enterprise value of a company is calculated without taking net debt and the level of net working capital into account.

In practise this is called “enterprise value - cash & debt free”, which basically means that net debt is deducted from the enterprise value, including taking a normal level of net working capital into account.

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Locked box

With a locked box mechanism buyer and seller agree that net debt and (a normal) working capital will be settled based on a balance sheet from BEFORE the date of the share purchase agreement.

So basically parties agree that when the closing takes place, parties have (economically) made the transaction already.

So for example the balance sheet date is 31st December, and from 1st January on, the company is (economically) from buyer.

Since January 1st is before the closing date (with a “locked box”), parties agree that no value can be subtracted from the effective date until closing date.

Otherwise this will be labelled as “leakage”.

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Completion accounts

Another way to conduct an M&A deal is to work with “completion accounts”, and here the shares will be legally supplied to buyer first, and only then the final level of “net debt” & “normal net working capital” will be calculated, and settled.

The disadvantage here is that seller is not owner of the company anymore when net debt is calculated.

This disadvantage is not here with a “locked box”, because at the moment of signing the share purchase agreement, the full purchase price of the shares is already agreed on.

This including the level of net debt (and a normal net working capital) since it is based on a prior balance sheet date (e.g. 31st December of the year before).

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Locked box / completion accounts

When a company is doing well in the last months before the closing, this advantage will be for the buyer.

As a result, there will be more cash in the company, or otherwise a higher net working capital position, and the net debt settlement has taken place already.

This potentially is a disadvantage of a locked box for a seller.

With completion accounts the net debt position will be settled at the legal delivery date of the shares, so buyer then needs to pay for the better results (more cash and/ or more net working capital will be settled in the net debt calculation).

The Netherlands

I am from The Netherlands, and here we often (most of the time) work with a locked box in (private) sell side, and buy side, M&A transactions.

This since it is a relatively easy method, and it is relatively easy to compare bids based on an “enterprise value - cash & debt free” based on a locked box 31st December or for example 30th June.

Another reason why it is popular is that after the closing of the deal no more calculations need to be made, so no more potential arguments about net debt positions.

This because all of these net debt arguments have been settled already before the closing.

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Effective date & leakage

When the balance sheet date is 31st December, then the effective date is January 1st, which means that the company then is “economically” from buyer.

And at this moment in time the company is not “legally” from buyer, so seller should not subtract value from the company (called “leakage”).

E.g. dividends, M&A transaction costs, virtual data room costs, transaction bonusses etc.

Break fees for current financing agreements (due to change of control) are often debated in a sense of whether they are leakage or not.

Of course there can also be “permitted leakage”, like high salaries of shareholders, and these are all defined in the share purchase agreement.

And this agreement is drafted, and checked, by M&A lawyers, so here corporate finance (M&A) consultants work closely with lawyers in order to draft the contracts.

Business operations from the effective date

With a locked box the company is economically from buyer from the effective date on.

In the meantime, until closing, the buyer does not want abnormal material transactions to take place.

Since with a locked box the price is settled already, so abnormal issues need to be settled again through the defined “warranties” in the share purchase agreement (not through net debt calculations anymore, because this is settled already).

So the buyer wants to have a lot of protection from abnormal operations with a locked box mechanism, from the effective date until closing.

Again, M&A lawyers define these "abnormalities" in the share purchase agreement, in good cooperation with the corporate finance (M&A) advisor.

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Locked box compensation

The business results are from the “effective date” (economic ownership date) for the buyer of the company.

So the seller wants to be compensated for this in the form of for example interest.

This since basically the company is bought already (economically), without paying for it.

And this is generally called a "locked box compensation" for a seller.

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I hope this article gave you some new insights,

see you next time again with a new blog,

best regards,

Joris

Source used: Book Bedrijfsovername, Van Buuren & Koster, Wolters Kluwer, Deventer 2023, Ch. 9 Locked Box Mechanisme, Mr. Gijs Linse.