M&A Vocabulary – Understanding Experts: “Closing Accounts, Locked Box Mechanism and Leakage”

In every transaction, the question of the purchase price is of central interest to both parties: A buyer does not want to overpay for the target, a seller does not want to sell below value or wants to optimize the sale proceeds. In this context, the parties must agree on a procedure for determining the correct purchase price and the basic rules required for a purchase price calculation.

As a rule, the balance sheet and profit and loss statement of the target company are used as a basis. Starting from these figures, the net financial debt – since a sale is usually agreed on a cash free & debt free basis – as well as any required working capital adjustment are determined.

This calculation is usually made based on data available during due diligence and leads to a preliminary purchase price. Using the same agreed methodology, the calculation is performed again based on the values available as of the closing date, the relevant final purchase price is determined as of that date, and any deviations are typically offset euro for euro in a purchase price adjustment.

This determination of the purchase price based on financial statements of the target company prepared as of the actual transfer date is referred to as the “Closing Accounts Mechanism.” On this day, the economic risk also transfers to the buyer. For practical reasons, it has become customary to realize this transfer on the last day of the month as a rule. The buyer thus only pays the value of the assets, taking into account the liabilities, that actually exists on the day of transfer.

A disadvantage of this method, however, is that such closing accounts can only be prepared with some delay after the transfer date. This is particularly true when not just a single company, but a group of companies (perhaps even in multiple countries) is to be acquired. If it has also been agreed that the calculation of the final purchase price should only be made on the basis of audited financial statements, this period can be further extended.

This relative uncertainty regarding the purchase price actually to be paid, or from the seller’s perspective to be achieved, makes another type of purchase price calculation attractive: the “Locked Box Mechanism.”

With this method, a calculation is performed according to the first variant, but as of a date already in the past. As a rule, this is the date of the last annual financial statements. Relevant documents are usually already available at the beginning of the transaction and can be thoroughly reviewed by the buyer during due diligence.

Based on these figures, all purchase price components are finally fixed as of the date of the “locked box accounts”; an adjustment at a later date does not take place. There may be an exception to this rule in the form of interest on the purchase price for the period between the reference date and the day of actual payment. The parties agree that the economic risk as well as the earnings of the company transfer to the buyer at this point in time and that the seller manages the company practically on behalf of the buyer until the day of legal transfer of the interest.

This methodology has the advantage that the purchase price to be paid is already fixed at the time of signing the purchase agreement. However, there is a certain risk for the buyer that after the “locked box date,” i.e., the agreed reference date for the transfer of economic risk, assets may still flow out of the company to the seller or persons or affiliated companies related to them, which, however, should belong to the buyer based on the purchase price methodology used.

Such outflows are referred to as “leakage” and are typically explicitly excluded in the purchase agreement. Examples of leakage include dividend payments after the locked box date, the transfer of assets, the waiver of claims of the target company against the seller, or conversely, the assumption of liabilities of the parent company by the target company. Contractually, the buyer is usually granted a period after closing to review such transactions. In the event of a detected violation, the seller’s obligation to compensate euro for euro is agreed.

Excluded from these sanctions, however, are payments by the target company to the seller or persons related to them that are made based on arm’s length service relationships and that have already been taken into account in the purchase price calculation and in the purchase agreement. Examples include payments for IT services by the parent company or license fees for trademarks or other IP rights. These outflows as “permitted leakage” are therefore also not subject to the buyer’s consent requirement that is usually otherwise agreed.

From the newsletter
“Corporate Law, Deals & Capital Markets” To our
M&A Vocabularies