M&A Completion mechanisms: Completion Accounts or Locked Box?

As part of our ‘M&A Deconstructed’ series, M&A experts Nick Davies and Justin Levine discuss Completion Accounts and ‘Locked Box’ completion mechanisms in mergers and acquisitions.

In addition to covering the basics, such as ‘what is a completion account?’ and ‘what is a locked box mechanism?’, the two M&A specialists cover the pros and cons of each completion mechanism and take a ‘deep dive’ into caps and collars, permitted and unpermitted leakage and more in their quest to demystify another key component of corporate mergers and acquisitions.

Take a look at this in-depth discussion in the video or read through the transcript below…

Video sub-topic timestamps:

00:00 – Introducing completion accounts vs locked box mechanism
00:40 – What are completion accounts?
02:30 – Caps and collars and de minimis provisions
03:00 – Completion accounts: the seller’s perspective
03:21 – Completion accounts: mechanism definition
05:05 – Completion accounts: Debt free, cash free transactions
05:40 – Working capital and net-debt positions
06:35 – Importance of internal/external corporate finance
07:00 – Business cycles and seasonal cycles
08:40 – Increasing usage of locked box over completion accounts
09:20 – What is the essence of a locked box mechanism?
10:15 – Locked box mechanism: for sellers who want certainty
10:45 – Equity value
11:00 – Normalised working capital
11:10 – Leakage and permitted leakage
12:50 – Equity price at locked-box date and equity tickers
13:31 – Completion accounts vs locked boxed and satisfying debts
14:48 – Decisions before Heads of Terms

Video Transcription

Introducing completion accounts versus locked box

Justin Levine:
So Nick, welcome back.

Nick Davies:
Hello.

Justin Levine:
So this video, we’re going to be talking about completion accounts.

Nick Davies:
Yes.

Justin Levine:
What are completion accounts versus it’s… not nemesis… it’s alter ego, which is the locked box mechanism? So what I hope to do is we can just dive into it in a bit of detail and try and explain to people who might be interested. If you’re selling a company, what’s the benefit of doing completion accounts? What’s the benefit of doing locked box mechanism?

What are completion accounts?

Justin Levine:
So I think if I just start off, just broadly, the notion of completion accounts: Selling a company, selling shares in a business, typically a deal is agreed. It could be on the basis of the net asset value, the book value of the business. It could be on the basis of an EBITDA, multiple.

We’ll talk about that probably in another video, but effectively a value is put on the business and, in effect, the buyer will have looked at that value and will want to have a final set of accounts produced at the point of completion to understand the final financial position of that business. And we can talk in a bit of detail to saying that there might be some truing-up of the price that’s paid or the consideration shortly after, or even a period of time after the deal is done, once the completion accounts are done. Is that how you see completion accounts?

Nick Davies:
Yes, that’s right. I mean, completion accounts are what they say on the tin. They’re a set of accounts which are drawn up for the purposes of completion to allow the parties to verify or check estimated values, which are used at the point of completion.

At the point of completion, you might have an estimated value for cash, for debt, for working capital, but it may not be possible on the day of completion to actually verify those numbers. It’s a moving target essentially. 30 days, 60 days, whatever, post-completion the buyer or the seller will draw up the first draft of the completion accounts, performing a look back to verify what the actual, rather than estimated, number is for cash, debt, working capital. And depending on the outcome of those accounts, that can adjust the price upwards if there’s a lot more cash, or it might adjust it downwards, if there’s a lot more debt.

Caps and collars

Nick Davies:
You can set some people off to talk about caps and collars. So you might have a de minimis provision in your completion accounts, which say, well, actually, if there’s a difference of, I don’t know, £10k on a five or ten million pound transaction, perhaps the party is going to say, “Well, actually we don’t need to change the price of that.” If the swing is much bigger, then the parties will be expecting the price to be adjusted and a payment to be made one way or the other. So that in a nutshell really is how completion accounts work.

When are completion accounts drawn up?

Justin Levine:
But I think you point to, it’s interesting because I think you point to something quite important and that is; in the minds of the seller, let’s assume we’re acting for the seller, always the question is “how much do I get on the day of completion?” And again, we’re going from that notion, which we’ve used in previous videos of: Seller is offered £10 million for his or her business. How much did they get on the day of completion? Of course, with the completion accounts mechanism by definition, it means that the buyer is going to want to withhold a certain amount of money, or typically want to withhold a certain amount of money. I think we’ll just drill down on that one step further. Completion accounts are drawn up after the deal is completed.

Nick Davies:
To the date of completion. Yes. Looking backwards, yes.

Justin Levine:
Yes. So on the day of completion, the day, that’s the happy day the seller and buyer come together, usually in physically separate places, but it can be together, sign the documents, the consideration is passed over, but effectively on that day, the completion accounts are not yet done, because of course the accounts can only be done later. So it does mean for the seller, and for the buyer for that matter, is probably, not always the case, but probably there will be a certain retained amount that is sat there that effectively sits there in an account somewhere, could be escrow, could be a lawyer’s account or could be somewhere, but effectively is the seller cannot touch it until the completion accounts are done. And it may be that amount goes up or down after that.

Nick Davies:
Yes, that’s right. There’s often a smallish amount held back pending agreement or determination of those completion accounts. The parties would generally hope that the swing wouldn’t be too great. And with some decent forecasting, looking forward, you should be able to predict where your cash and or debt will be at the point the completion accounts are prepared. So yes, you’ve covered it pretty well.

Justin Levine:
It is, I mean from my side, it’s quite… I always find this quite a complicated element to explain to a seller. Because of course, typically as an M&A firm, one introduces the notion, if one’s selling on a completion accounts basis of a debt-free, cash-free transaction. I think we’ll cover that in a separate video, the minutia of that.

Nick Davies:
Yes.

Justin Levine:
But the notion of it means in short, is any surplus cash on the day of completion is to seller’s account. And any debt, of course, we have to define what debt is, any debt has to be paid off by sellers at the point of completion. So that, from the point the heads are signed to the point we have completion, the business is trading. And of course the working capital position, the net debt position, which is cash minus debt, is a moving feast.

Nick Davies:
It is.

Justin Levine:
It is a moving feast. And this can be to the advantage of the seller. It could be to the disadvantage of the seller.

Nick Davies:
Depends if the business is in an upward trend or a downward trend.

Justin Levine:
Correct.

Nick Davies:
Yes.

Justin Levine:
Correct. And it’s not only the notion of those movements as well. It’s how the controls on working capital are maintained or altered from the period of heads to completion, which can be months.

Nick Davies:
Yes.

Justin Levine:
And I think that’s probably where, for the unsophisticated seller, most sellers (even running great companies) are unsophisticated in the sense that they won’t have run their business with the notion of watching net debt, watching working capital. And I think that probably the message that I would bring to the video, to people listening to it is, it’s a really important, actually critically important, part of what may or may not be left on the table once the completion accounts are done. And if you don’t have somebody, either inside your organisation that’s competent in corporate finance say, or externally as an advisor, it can really catch you out. Because of course, what can happen is that once completion accounts are done, and if you have no idea on that movement within it, if it’s moving adversely against you, you can suddenly find that a retention of 10%, 20% of the proceeds can disappear.

How do completion accounts affect seasonal businesses?

Nick Davies:
That’s absolutely right. And I think a point worth making is that some businesses have cycles and have seasonal cycles. You can think of certain businesses which do better in the summer months and certain businesses which do better around Christmas or worse in winter months. So depending on where you’re planning on completing in that cycle can mean that your completion accounts results may go one way or they may go the other. Completion accounts can, in some respects, create a little bit of uncertainty at the point of completion. That uncertainty should be capable of being mitigated with good advice. You should have a good steer and good visibility on where you are likely to end up. But what you can be sure of is that if the completion accounts process is dealt with properly, you will end up with an accurate result.

What are the advantages of completion accounts versus locked box?

Nick Davies:
The price will be accurate because you will be establishing actual values. Numbers are objective. There may be some differences in terms of interpretation, but so long as you have got a good completion account schedule in your SPA recording the basis on which the completion accounts are prepared, any specific accounting policies which may be particular to your particular business, so long as those are in there, you will end up at an accurate result. It may just take you 30, 60 days post completion to get there. So that’s probably the advantage of completion accounts versus the distinction with locked box, where you don’t have that post-completion look back.

What are the advantages of locked box versus completion accounts?

Nick Davies:
You work against a locked box accounts balance sheet, up to a date pre-completion, and you sort of fix the value at that point. And we’re seeing those being increasingly common. Locked box deals now are probably more popular than completion accounts deals. They don’t require the post-completion accounting analysis and work. They do provide an amount of certainty, which I think parties like. Again, you need decent accounting input to establish your locked box accounts, to work out what should be permitted leakage, what should not be permitted leakage, but what’s your view on locked box accounts? Are you seeing more of those?

What is a locked box completion mechanism?

Justin Levine:
I think before I answer that, I’ll come back to that good question. I think it’s the notion that for a lot of people don’t understand that the essence of a locked box mechanism, this is quite often, I see it being asked. I’m not historically aware of where it’s come from, but I think it’s an American phenomena that’s gradually moving over Europe. And the notion of a locked box mechanism is simply a fixed price deal.

Nick Davies:
You’re sort of locking the box, aren’t you? You’re locking the value at that point. Your locked box balance sheet date might be X and you’re effectively locking the box at that point in time, saying there should be no extractions of value from that locked box in favour of the sellers. They shouldn’t be stripping out excessive amounts of cash or dividends or assets or whatever. And so that’s, I think the justification for the locked box name as it’s so-called.

Why are locked box completions becoming more popular?

Justin Levine:
Yes, and it’s a simple, I like it in the sense for clients… and I am seeing an uptake, so that’s the direct answer to it. I am seeing an uptake and in fact, actually we’re deploying it for certain projects. And the reason is, primarily what’s interesting is; it’s attractive to sellers who want certainty.

Nick Davies:
Absolutely. Yes.

Justin Levine:
If you want to know how much money you’re going to receive, I’ll come back to that point, because it’s a bit more detailed. But if you want to know how much you receive at completion, then a locked box mechanism kind of works because it defines it.

Nick Davies:
Correct.

Justin Levine:
And so I find it’s a corporate finance term. Most sellers don’t understand the difference between enterprise value and equity value. And they’re fundamentally different.

Nick Davies:
That’s a separate video.

Justin Levine:
It’s a separate video, yes, it’s a separate video. But a locked box mechanism, we’re talking about equity value. Basically what is left on the table once the deal is done, and it fixes the number. And it avoids, which we didn’t discuss in the completion accounts mechanism, the notion of normalised working capital, for example. It does avoid all of these thorny issues that can happen between heads of terms and completion.

Permitted and unpermitted leakage

Justin Levine:
It takes all of the weight, it says here’s a fixed value, but there is this notion of leakage. There is this notion of permitted leakage, and these are issues that are sort of quite salient when it comes to a locked box mechanism. In the sense that once you agree a deal in a locked box way, effectively you can run the business ordinarily as you normally do: You pay your salaries of your staff, your employees, et cetera, you purchase your materials or purchase your services, sell your services. You continue, you can draw your dividends as you already have done in a quantum that is sort of…

Nick Davies:
Ordinary.

Justin Levine:
Ordinary, and lies with historical norms.

Nick Davies:
Yes.

Justin Levine:
But that’s, permitted leakage. And then you have unpermitted leakage and that’s, which can be a little bit thorny. And that’s where the shareholders decide that they want to go and sort of renovate their homes and book the cost to the company and assume that the buyer will pick up the debt. That’s unpermitted leakage. I’m giving an example.

Disadvantages of the locked box mechanism

Justin Levine:
But the answer is yes, I’m seeing more uptake on locked box. The only disadvantage of it, I have to say, speaking on the record, candidly, is the disadvantage to a locked box mechanism in my perspective is if the business is making profits between the point of heads and completion, the business will accrue those profits. And the balance sheet will increase in value. And if one is unsophisticated about a sale of a business using locked box, that benefit will accrue to the buyer. So of course it is very important that you have an M&A advisor, a corporate finance lead, and an M&A legal team that can put a ticker on that.

Nick Davies:
Yes, that’s right. You want to see some interest or a ticker is the terminology that’s used. And that’s absolutely right. If you’re a profit generating entity, why should you give that profit away for the period between the locked box date and completion, which might be two months or more. There’s value there, and the buyer should pay for that value. It’s a case by case basis, really in terms of what the parties agree, what the quantum of the profit might be, but it’s something to not miss if you’re a seller, because it’s an opportunity to extract more value from the deal. And that’s typically why people are selling, because they want to maximise their return.

Justin Levine:
There is one other benefit, which I’ll just tack on at the end. And that is it’s, perhaps I don’t know how much important it is to people who might be listening, but there is quite a difference. On a completion accounts mechanism, typically, it means that debt is satisfied. So if the business carries debt, mortgages, loans, invoice discounting, and so on, HP for example, hire purchase, typically those debts are satisfied at the point of completion. Typically. So the buyer says, “I’ll buy it, but I don’t want the debts.” So in a locked box mechanism, a buyer can acquire the business based on an equity value and inherit the debt.

Justin Levine:
That’s quite important because we’re living in an era of low debt interest. So actually on a pound for pound basis, on an equity value basis, it’s attractive to buyers because a buyer can acquire a business potentially for less cash outlay, but taking on board the debt, which has a low interest level, historically low interest level, and make it very attractive to buyers. So I think it’s, from a selling point of view, and if you have an M&A firm in between, it can be quite interesting to position the business on a locked box basis because it can make it a lower cost of initial investment for a buyer to acquire that business. It can be substantial.

Nick Davies:
There are commercial reasons on both buying and selling side for looking at both mechanisms. I think it’s the same old message and I’m going to sound like a stuck record, but it’s take advice. It’s consider this before you get to your heads of terms stage. I mean, the heads of terms should be setting out whether your transaction is proposed to be dealt with on a completion accounts or a locked box basis. You don’t want to get beyond the heads stage and that still be an open question, because whoever’s going to have the joy of drafting the SPA is going to need to capture whatever the parties have agreed and people may not have run the numbers and may not have worked out what works best for the buyer, what works best for the seller. So, yes. Early advice, consider both options and work out what you want to do.

Justin Levine:
Yes. Nicely touched. I think we’ve covered that off. Hopefully put a degree of light on this ephemeral subject of completion accounts versus locked box.

Nick Davies:
Excellent. Good stuff, speak again. Cheers.

_ _ _ _ _ _ _ _ _ _ _ _

More from Series 1 of M&A Deconstructed

As part of this in-depth series, other topics discussed include:

• What is EBITDA?
• What are Heads of Terms?
• What is Due Diligence in Mergers and Acquisitions?
• The difference between a Share Sale and an Asset Sale?

Connect with the M&A experts

Justin Levine, Managing Director, The NonExec Limited M&A Boutique 
Justin leads a boutique exit advisory firm specialising in manufacturing, technology, IT, digital, healthcare, wholesale and distribution markets. With the support of a 15-strong virtual team of analysts and researchers, he helps private business owners with growth and exit strategies. Connect with Justin >

Nick Davies, Partner and Specialist M&A Solicitor, Steele Raymond LLP
Nick acts for a wide range of business clients across various sectors, advising on complex corporate transactions including company sales, purchases and mergers. Nick also advises on on mergers, de-mergers and re-organisation. Connect with Nick >

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If you have any questions regarding your business, a business exit, a merger or any other corporate legal query, please contact Nick Davies on 01202 294566 or email [email protected]