Introduction

There has been an increased use of the “locked-box” mechanism in M&A deals in Singapore to “fix” the purchase price, as an alternative to the completion accounts mechanism that has traditionally been used to determine the final purchase price of a target company. Although the locked-box mechanism is typically regarded to be seller-friendly, its rise in popularity can be attributed to the inherent advantages that it offers to both sellers and purchasers, such as: price certainty, reduced risk of post-completion disputes, simplification of the acquisition agreement, and increased operational efficiency.

Completion accounts mechanism

When using the completion accounts mechanism, parties would agree on a preliminary purchase price to be paid on completion. The preliminary purchase price is typically calculated on the assumption that the target company will be cash-free, debt-free, and have a normal level of working capital.

The final purchase price will be determined post-completion, by taking into account the actual cash, debt, and working capital of the target company as at the completion date. If the final purchase price differs from the preliminary purchase price, such difference will be resolved by the parties through a purchase price adjustment.

Although the completion accounts mechanism allows the parties to agree on a purchase price that accurately reflects the value of the target company on the completion date, there are three key disadvantages to using the completion accounts mechanism:

1. there is price uncertainty, as the purchase price is subject to post-closing adjustments;
2. there is a possibility that disputes will arise in respect of the calculation of the final purchase price post-completion, as the interpretation of the completion accounts can be challenged (e.g. in respect of the calculation of the working capital amount for the target company) – this can result in drawn-out debates and negotiations which can come at a financial cost to the parties in the form of fees to lawyers, bankers, and accountants, as well as extending the timeframe for the conclusion of the transaction, with disputes lasting for months; and
3. it consumes time and resources, as the purchaser’s management will be occupied with negotiations on the final purchase price, instead of focusing on integrating the target company into the purchaser’s group.

Locked-box mechanism

With a locked-box mechanism, the parties will fix the purchase price based on the most recent, usually audited, accounts of the target company at a pre-determined date (the Locked-Box Date), and there will be no post-completion adjustments thereafter. The purchaser accordingly assumes the risk or reward of the target company’s performance from the Locked-Box Date (as if it bought the target company on that date).

To mitigate the risk undertaken by the purchaser, the seller agrees not to engage in any activities which would result in any “leakage”, i.e. any transactions, payments or disposals resulting in a transfer of value from the target company to the seller or its connected parties, from the Locked-Box Date to the completion date. If there was any of such leakage (e.g. by way of dividends, borrowing of money by the seller from the target company, payment by the target company of fees in connection with the preparation or negotiation of the transaction, etc.), adjustments would be made to the purchase price to ensure that the purchaser is not receiving the target company at a lesser value than what they had paid for. The acquisition agreement will typically contain protection for the purchaser in the form of a “no-leakage” dollar-for-dollar indemnity – if there were any leakage between the Locked-Box Date and the completion date, the purchaser shall be entitled to deduct an amount equivalent to such leakage from the purchase price.

However, parties may agree for certain narrowly defined leakages to be permitted, and expressly provide for these in the acquisition agreement. Such “permitted leakages” are an outflow of funds that occur in the ordinary course of business and/or are very specific and subject to financial caps, e.g. trade debt incurred in the ordinary course of business or contractually agreed payments arising from employment contracts.

Benefits of the locked-box mechanism

There are four key advantages to using the locked-box mechanism:

1. there is price certainty, as the price is fixed;
2. there is a reduced risk of post-completion disputes, due to the absence of post-completion adjustments;
3. the acquisition agreement is simplified, as complex post-completion calculation formulas will not be required to be negotiated upon or included therein, which helps to streamline the deal; and
4. it is more time and cost efficient, as there are no risks, costs, or time associated with renegotiating post-completion adjustments.

In addition to the advantages set out above, parties should also consider when the use of the locked-box mechanism may be most advantageous, for example, where:

1. the volatility of the target company’s business is low, as there would not be much upside from a post-completion adjustment to adjust the purchase price for either party anyway;
2. there is sufficient and reliable information to evaluate the financial condition of the target company before the completion date, e.g. recently audited financial statements of the target company, such that post-completion adjustments will not be necessary; and
3. the period of time between the Locked-Box Date and completion date is not lengthy, as a shorter timeframe between the two dates reduces the risk that either party may suffer from the lack of a post-completion adjustment to the purchase price.

Conclusion

Although parties traditionally used the completion accounts mechanism to reach a final purchase price that is representative of the target company at completion, the substantial benefits of certainty provided by the locked-box mechanism makes it an attractive alternative. With the increased use of the locked-box mechanism in Singapore, it is imperative that parties consider if it would be more advantageous to use this pricing mechanism when structuring M&A deals.

Dentons Rodyk thanks and acknowledges Practice Trainee Dominique Yap for her contributions to this article.