In share purchase transactions, it is essential to establish a clear pricing mechanism. There are various methods for doing this, two of the most commonly used are the completion accounts and the locked box mechanism.
The locked box mechanism has become an attractive option, especially in transactions where the aim is to avoid post-closing adjustments and provide greater certainty to the parties. Nevertheless, its implementation requires regulating certain key aspects such as the potential value extraction from the company before the closing (i.e. leakage) and the exceptions which are allowed (i.e. permitted leakage).
This article examines in detail how the locked box mechanism works, the risks it may entail and how the parties can structure it to ensure efficient and transparent purchases.
Locked box
The process to buy a company does not occur immediately since there is a time lag from the start of negotiations to the execution of the transaction. As a result, the company’s valuation at the beginning of the negotiations is likely to differ from its valuation at the time of closing. Therefore, at an early stage of the negotiations, the parties should agree on clear criteria for the price valuation. Several formulas exist such as the completion accounts and the locked box mechanism, the latter of which we focus on in this article.
When the locked box mechanism is used, the parties initially set the final purchase price which, in principle, will not change at the end of the negotiations or of the transaction, regardless of the company’s financial results. The parties will normally use a reference date as the basis for determining the price (e.g. if the financial statements at 31 December 2024 are taken into account, this can be the reference date).
Leakage
In this context, and since there will not be any price adjustments, the seller must guarantee to the buyer that, between the reference date and the closing of the transaction (the locked box period), it has not carried out any actions or commitments involving an outflow of funds (leakage) in favour of the seller, its related parties, the advisors or the company’s directors or managers. Examples of such cash outflows are debt forgiveness to directors or managers, financing to related parties, or the payment of fees to advisors in the context of the transaction’s negotiation and execution.
In view of the above, the consequences of leakage during the locked box period should be regulated in the agreement, and it is customary to agree that the sellers are jointly and severally liable vis-à-vis the buyer for any outflow of funds, generally without being subject to the liability limits that are established for other claims in the agreement. Therefore, the seller should indemnify the buyer for the amounts arising from: (i) the outflow of funds, (ii) the costs incurred by the buyer or the company in determining and recovering the corresponding amounts, and (iii) any taxes incurred as a result of the compensation arising from leakage.
The agreement should also regulate the procedure for the indemnity in favour of the buyer (such as the deadlines and supporting documentation to justify the leakage). To avoid any discrepancies between the parties on determining the cash outflow amount, the parties should envisage submitting the dispute to a third party such as an expert accountant, whose opinion is binding.
Permitted leakage
Nevertheless, the parties may agree on exceptions for certain outflows of funds (permitted leakage) that occur with the buyer’s knowledge and consent during the locked box period, with the consequent implications for the transaction’s pricing. For example, if the permitted leakage consists of remuneration to one of the salespersons for services rendered to the company, the exact amount of such remuneration should be stated. In that way, if permitted leakage is regulated in a clear and exhaustive manner, it will prevent the parties from being involved in future disputes.
Conclusions
In these types of transactions, which are complex by their nature and case mix, choosing the locked box mechanism can be very attractive since it avoids having to resort to complex financial definitions, price adjustment mechanisms, or the need to prepare new closing accounts. In any case, the need to use one of the pricing methods will depend on the case in question (e.g. for a company whose sector is constantly changing, it might be unavoidable to use the completion accounts). Regardless of the above, the truth is that the locked box mechanism will normally favour the interests of the seller, which will have certainty about the amount to be received for the transaction, irrespective of the company’s future financial results.
Finally, our recommendation for this type of transaction is to seek lawyers specialised in M&A so that you can receive optimal legal advice based on the circumstances of each specific case. Contact AGM Abogados.
