These are two different approaches to dealing with the make-up of the balance sheet which transfers at the legal completion of the sale of the shares of a business. The Locked Box Method is often preferred by acquirers but vendors need to be wary of its implications. The main differences between the 2 methods are:
- Locked Box enables the parties to fix the price of the shares by removing the need for post completion adjustments relating to the balance sheet – this in turn should make the legal stages smoother;
- In a sense, it brings forward the date of transfer of the economic risk to the acquirer but the vendors need to be careful that longer than expected legal stages do not leave them out of pocket.
- Completion Accounts
Under both arrangements the buyer ‘inherits’ the balance sheet with whatever the actual level of assets and liabilities happens to be at the date of completion. Under the conventional approach, an adjustment is then calculated against the Target Net Asset Value (normally on a debt free, cash free basis) agreed as fair between the parties, usually a few weeks before completion.
Since the final completion accounts can only be drawn up a few weeks after the actual date of completion, the amount by which the Actual NAV varied from the Target NAV is not known until sometime after completion. The adjustment amount (ie the difference between Target and Actual NAV) is generally paid once the completion balance sheet has been agreed by both parties.
This is the traditional method of selling a business.
- Locked Box
Under this arrangement, the parties agree a price for the shares based on the most recent (trustworthy) balance sheet. This is often the closing balance sheet for the most recent financial year as per the statutory accounts or otherwise an interim balance sheet will have to be prepared by the accountants and agreed between the parties. This balance sheet is then “locked” for the purposes of the sale and the date of the balance sheet is termed the “Locked Box Date”.
So called “Leakages” have then to be agreed between the parties which enable the vendors to draw from the business in a controlled way after the Locked Box Date. It is understood, under this approach, that all the normal flows of the business will continue, and it is only, usually, the owner’s drawings which are subject to the leakage calculation. The negotiation of Agreed Leakages needs to be handled with care. Vendors should expect to receive an appropriate level of remuneration (assuming they are working in the business) plus a share of the post locked box profits, both up to the date of final completion.
Under this method, there should not be any post-completion adjustments in relation to the balance sheet, other than for agreed leakages. The Buyers effectively take over the economic risk (and reward) of the business being sold from the Locked Box Date albeit, of course, the Buyers can pull out of the deal at any time up to Completion if they are concerned about business performance.
The Locked Box approach is a relatively more recent innovation designed to try to free up management time, reduce costs and uncertainty.
The (traditional) Completion Accounts method can produce some difficulties in the legal process, which may include:
- There will always be a difference between the Actual and Target NAV so the amount the parties ultimately pay/receive will be different from the ‘top line’ agreed consideration for the shares.
- Changes to the purchase price can often be an area of dispute, which can consume a great deal of management and solicitors’ time and produce general conflict between parties. Whichever party does not produce the final accounts (normally the Buyer) will often challenge what has been produced by the other party.
- It inevitably delays the point at which the final price is agreed, sometimes by a significant time.
- The sale and purchase agreement will often be more complicated, as both parties (and their legal advisers) will argue for clauses and definitions likely to strengthen their negotiating hand. This may bring about extra costs to the transaction.
- This process can cause distraction to management from both parties and often goodwill between them and therefore value can be lost in this form of completion.
Anything which extends the time between agreeing Heads of Terms and Completion is usually bad for the vendor so there is something to be said for the Locked Box method. The best advice, however, is to seek legal advice in relation to the structure of the transaction at the earliest opportunity, as the Heads of Terms obviously need to reflect the agreed approach. Deals can fail if there are misunderstandings around this point.
We will provide more details about some of the specific items mentioned above in future articles, but this is designed to highlight the fact that the legal aspects of selling a business are important, but they can be complex. Such matters are not in the remit of most Sellers and they should therefore take advice around the legal aspects of a deal in order to be better prepared.
At Anderson Shaw Corporate Finance Ltd, we are always happy to both provide a free preliminary valuation and also work with the business owner through the period of exit planning, through legal stages, and then ultimately a sale.