Completion Accounts and Locked-Box Mechanisms
Completion Accounts
What are Completion Accounts?
Completion accounts are special purpose transaction accounts used in M&A deals.
Why are they used?
They are often used to verify the target company’s actual financial position at completion mirrors the accounts on which the parties based their valuation on and expected when signing the deal. The reason for the use of completion accounts is to enable the price to reflect the actual position and price of the target company upon completion, as opposed to using potentially inaccurate financial information from past accounts. In addition, the buyer may be assuming that the target company has a certain level of working capital, net assets or net debt and may wish to adjust the final purchase price based on the assumptions made being incorrect.
How are they used?
The completion accounts will always be accompanied by a mechanism which will establish what the completion purchase price is, in accordance with an agreed formula or on a specified basis, that will adjust the price as appropriate (usually covering the period from the date of the last set of the target’s accounts to the date of completion).
There are usually three different adjustments that are used to make the appropriate price adjustments based on completion accounts.
- The Working Capital Adjustment – Involves adjusting the purchase price based on the working capital of the target company at completion (so current assets minus current liabilities). If at completion the working capital of the target company is either inadequate or below an agreed level, the buyer will be required to pump more money into the business therefore the purchase price is adjusted to consider this fact.
- The Net Assets Adjustment – Involves adjusting the purchase price to what the actual net asset value of the target company is at completion through considering fixed assets and long-term liabilities, as opposed to a previously agreed figure.
- The Net Debt Adjustment – Involves adjusting the purchase price based on the determination of the levels of debt and cash in the target company at completion. The value previously agreed between the buyer and target, usually based on a multiple of EBITDA, will increase according to any excess cash unaccounted for in the valuation while debt will be deducted from the agreed value.
It isn’t unusual for all three price adjustment mechanisms to be used in transactions in order to protect the buyer’s position.
Key components of a completion accounts mechanism
In order to ensure the completion accounts mechanism properly reflects the agreement and doesn’t miss anything out, a number of issues will have to considered including:
- Format of the completion accounts.
- Accounting principles to be applied in preparing the completion accounts.
- Procedure for drawing up and agreeing to the completion accounts.
- Resolving any potential disputes.
- How the price will be adjusted as a result of the completion accounts.
- When the adjusted payment must be made and how.
Format of the completion accounts
Completion accounts can be any relevant documents related to the accounts of a company as agreed between the parties and often dependent on the price adjustment mechanism being used. This could be either a profit and loss account, a net assets statement or a balance sheet.
Accounting principles to be applied
Specific accounting principles are incredibly important for any SPA and to enhance certainty it is recommended that specific accounting standards, policies and practices are referred to.
The completion accounts are usually prepared in accordance with the target’s past accounting policies and practices, typically the target’s last audited set of accounts. However, there may be issues where the previous accounts aren’t prepared to the same accounting standards as to what the buyer is used to or the completion accounts require further items to be included that haven’t been included in the target’s previous accounts.
In light of any issues in preparing the completion accounts in accordance with the target’s past accounting practices, the parties are open to agree their own accounting policies, practices and methodologies for certain items.
This aspect of the completion accounts mechanism is the most disputed aspect and care must always be given when determining the accounting principles and policies to be applied, particularly if there are a mixture of approaches being used when accounting for various items. Please note that when using various approaches for completion accounts you must specify an order of priority in the event of any disputes over preparation of the accounts.
Procedure for drawing up and agreeing to the completion accounts
This is where one party draws up a first draft of the completion accounts and sends it over to the other party for review. The parties will usually have a specified period of time to agree on the completion accounts. If there are any outstanding matters after this period, the matter snot agreed on will usually be referred to an expert for determination.
It is common for both parties to wish to have control over the process of drafting the completion accounts, however it is usual for the buyer to end up having control over drafting the accounts due to the buyer being the owner of the business at the time.
The parties should also agree on a timetable to produce the final completion accounts, where by the final date the preparing party must send off the completion accounts to the other side for review.
Each reviewing party should also request a contractual right of access to information to ensure the preparation of the completion accounts is transparent and enable them to easily review the figure reached.
To prevent delaying tactics sometimes it is recommended to hold cash in an escrow account to encourage the parties to finalise the deal, as the cash will be of no use to anyone until the completion accounts have been prepared.
Resolving any potential disputes
It is recommended that in any completion accounts mechanism being drafted, there should always be a clause allowing the parties to have a negotiation or resolution period afforded to them in the event of a dispute, saving time and expense. If the parties cannot agree past this resolution period then a clause should be drafted to provide for an independent expert to give a final determination on the matter, preventing the need to go to court.
How the price will be adjusted
Usually a provisional payment is made by the buyer to the seller at completion, therefore before any completion accounts have been finalised, and this provisional payment should usually be as close to the final purchase price as possible.
To prevent either party from gaining an unfair advantage with either a significant underpayment or overpayment at completion, it is common that a completion accounts mechanism involves an escrow arrangement. Under these arrangements part of the estimated purchase price will be payed by the buyer into the escrow account until the final determination of the purchase price.
Any payment into the escrow account should be able to cover any foreseeable price adjustment to the purchase price. Alongside agreeing how much will have to be set aside to be held in escrow both parties will have to agree on the terms with which the money will be held, who will be an agent and how payments will be made from the escrow account.
Other areas to agree on in relation to the price adjustment include:
- whether there should be a minimum threshold for the price adjustment to take effect, irrespective of the final figure in the completion accounts;
- whether the mechanism should only provide for an upwards or downwards adjustment to the purchase price; and
- whether there should be a maximum cap on any upwards price adjustment.
When the adjusting payment must be made
Usually the parties agree that any adjusting payment must be made within a certain number of day after the completion accounts have been agreed. Please note that buyers may try and set-off any liabilities owed to them by the seller against the buyer’s requirement to pay any additional payment.
Warranty and indemnity claims
It is important that the seller prevents the buyer from recovering under any warranties if the matter has been covered under the completion accounts. Without such a clause, the buyer could get ‘double-recovery’, firstly for the breach of warranty and secondly for making the necessary adjustments to the completion accounts.
Locked-Box Mechanisms
With a locked-box mechanism, the price payable for the target company is based on a balance sheet prepared at an agreed date prior to completion providing for a fixed equity price. Usually the most common locked-box date used is the target company’s last financial year end, allowing the latest set of audited accounts to be used when calculating the equity price. Once determined, the price can no longer change, providing certainty and avoiding time and money being spent on preparing completion accounts.
One other key feature of a lock-box mechanism is that any risks or rewards in a business will pass to the buyer on the locked-box date. Usually a period of two to three months is deemed appropriate between the locked-box date and completion. To protect a buyer in this scenario, a clause is usually drafted to prevent ‘leakage’ in the target company. This essentially prevents the seller affecting the balance sheet negatively, such as through preventing the seller from awarding dividends to themselves after the locked-box period, director payments or transactional expenses.
To allow a business to continue running it is in the buyer’s interests to allow the seller to do actions that are necessary for the day-to-day running of the business. This is otherwise known as ‘permitted leakage’. This may include agreed salaries or management fees payable to the seller during the post locked-box period.
The final feature of a locked-box mechanism is the ‘value accrual’. As the seller is still running the business from the locked-box date through to completion and isn’t receiving any rewards or any funds until completion, it is likely that the seller will wish to include a provision for a specific interest rate on the equity price or a daily profit charge in the aforementioned period as compensation.
Advantages and Disadvantages
Completion Accounts
- Advantages
- Speed up the transaction process, with no pressing need to negotiate the price up front.
- Accuracy of the final purchase price, being based on current data as opposed to past financial accounts.
- Disadvantages
- Can be a very costly process for both parties.
- Considerable scope for disputes due to disagreements on how the accounts have been prepared, potentially leading to further costs when using an expert to determine a matter.
- The seller usually has limited control over the preparation of the accounts and can be subject to the performance of the business post-completion. If trading conditions are not great during the completion accounts period, this may be reflected in the final price adjustment leading to a lower final purchase price than what may have been expected.
Locked-Box
- Advantages
- Price certainty and no fluctuation or future adjustments.
- For the seller risk passes to the buyer after the locked-box date while, for the buyer, they can control what the seller is permitted to do after this date.
- The buyer may benefit from a profitable business after the locked-box date.
- For the seller, the purchase price will be based on their own previously prepared accounts.
- Disadvantages
- The seller will be restricted in how they can run the business as a result of the ‘leakage’ clause.
- Enhanced due diligence required for the buyer to reduce any potential risks after the locked-box date, such as the risk of unprofitable trading.
- The transaction process up until completion will be slower.
- The seller will have control over the preparation of the balance sheet involved in reaching the fixed price, which may not be adequate for the buyer.
Summary
There are advantages and disadvantages for both and ultimately it will come down to personal preference as to what mechanism a party would prefer in each case. Although completion accounts usually spewed up the transaction process, they are particularly complex and heavily disputed over between parties even after drafting the mechanism itself. Completion accounts may be preferable for parties to use if they wish to reach a purchase price that is representative of the target at the time. On the other hand, locked-box mechanisms are becoming increasingly popular for both sellers and buyers with the certainty that entails. If the circumstances involved are suitable for a locked-box mechanism (i.e. no volatile businesses) and the buyer can undertake extensive due diligence and negotiate a leakage provision that effectively locks the box, then parties usually prefer to go ahead with the locked-box mechanism as opposed to the completion accounts mechanism.
This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.
