Locked box vs completion accounts: the three ways to adjust the price in an M&A deal

When a company is bought and sold, the price in the heads of terms is almost never the price that is finally paid. Instead the share purchase agreement uses one of three mechanisms to adjust it: a locked box, a cash-free debt-free adjustment, or net asset value completion accounts. Each one answers the same question, which is how to deal with the fact that the business keeps changing between the day the price is agreed and the day the buyer takes over. Usually at least three months pass between those two dates, and in that time cash comes in and goes out, stock is bought and sold, and liabilities can appear that nobody budgeted for. Here is how each mechanism works and how the adjustment reaches the buyer's pocket.

How purchase price adjustments are paid

Usually only a percentage of the purchase price is actually paid on completion. The rest is deferred over a period of time, say two to three years. Purchase price adjustments are then usually made by increasing or decreasing those deferred payments, in other words by changing how much the buyer still owes the seller.

It is important to keep in mind that the adjustment is usually calculated after completion has already happened. Once the buyer owns the company, the accountants of the buyer and the seller typically get together and work out how the price should be adjusted. The deferred payments are what make this practical: rather than the seller handing money back or the buyer finding extra cash, the next instalments simply go up or down. It also means the mechanism you choose matters most to whichever side still has money outstanding, which in most deals is the seller waiting to be paid.

What is a locked box mechanism?

The first option is the locked box. In short, the purchase price is locked as at the locked box date. That is the point at which the parties agree the price, and from then until completion they also agree what can and cannot come out of the business.

Value that leaves the business during that period is referred to as leakage, and the locked box works by splitting leakage into two kinds.

Permitted leakage in a locked box deal

Permitted leakage is anything the parties have agreed can leave the business between the locked box date and completion. The obvious example is money spent on stock so that the company can keep trading. The business has to carry on operating, so the parties list in advance the outgoings that will not affect the price. Ordinary trading costs are the usual content of that list, and the more precisely it is drawn, the fewer arguments there are later about whether a particular payment was permitted.

Unauthorised leakage

Unauthorised leakage is value that leaves the business without that agreement. Typically the seller is not allowed to declare dividends and extract profits during the locked box period. If unauthorised leakage does occur, say the seller declares a dividend and distributes profit, that leakage decreases the purchase price. In practice it reduces the deferred payments, so the buyer owes the seller less.

The attraction of a locked box is certainty. Both sides know the price from the locked box date, and the only question after completion is whether any unauthorised leakage happened. The risk for the buyer is that the price is fixed on historic figures, so the protection depends entirely on how carefully the permitted leakage has been defined and how closely the business is watched until completion.

Completion accounts: cash-free, debt-free

The second way to structure the price is on a cash-free, debt-free basis. In short, the seller is supposed to hand the buyer the business without any liabilities and free of any excess cash.

The adjustment works in both directions:

• If there are liabilities left in the business as at completion, these typically reduce the purchase price pound for pound.
• If there is more cash in the company's bank account than expected, that typically increases the purchase price pound for pound.

The logic is that the buyer is paying for the trading business itself, its systems, people and assets, and not for whatever cash the seller happens to have built up or whatever debt the seller has left behind. The seller takes the surplus cash and clears the debt, or the price moves to reflect it. For a buyer, this is a straightforward protection against the seller leaving loans or unpaid bills in the company; for a seller, it means any cash built up before completion is not simply handed over for nothing.

Completion accounts: net asset value (NAV)

The third option is to structure the SPA on a net asset value basis. First, what is net asset value? It is a way of valuing a business to work out how much it is worth, calculated by taking all of the company's assets and deducting all of its liabilities.

A company's net asset value fluctuates. The amount of cash it holds and the stock it carries go up and down as it trades, buying and selling products. That is why the parties typically agree a target net asset value: how much the company should be worth as at completion. The target is the benchmark, and the adjustment is simply the gap between that benchmark and reality.

Net asset value adjustment: worked example

Suppose the parties agree a target net asset value of £1 million. The deal completes and the buyer now owns the business. Completion accounts are then prepared: financial accounts that record how much the company was worth as at completion.

• Actual NAV is £1.2 million. That is £200,000 more than the target, so £200,000 is added to the purchase price. The buyer owes the seller an additional £200,000 through the deferred payments.
• Actual NAV is £800,000. That is a £200,000 shortfall, so the purchase price is reduced by £200,000 and the buyer owes the seller £200,000 less.

The NAV mechanism therefore captures movements in the whole balance sheet, not just cash and debt. Stock, debtors, creditors and fixed assets all feed into the number, which makes it a broader test than cash-free, debt-free but also one that depends more heavily on the accountants agreeing the completion accounts.

Locked box or completion accounts: which is which?

It helps to see the three mechanisms as two families. The locked box fixes the price in advance and polices what leaves the business. Both cash-free debt-free and net asset value are completion accounts mechanisms: the price is settled after the event by reference to accounts drawn up at completion. Cash-free debt-free looks only at cash and liabilities; NAV looks at everything. Which one suits a deal depends on how the parties want to share the risk of the business changing between agreeing the price and completing. Sellers often prefer the certainty of a locked box. Buyers often prefer completion accounts, because the price then reflects the business they actually receive.

Tip for buyers: build rapport with the seller

Buying or selling a business typically takes at least three months and a great deal of energy. My tip for buyers is to meet the seller regularly, ideally weekly and even just by video call, to keep building rapport and trust. At some point the solicitors will probably fail to agree on a provision or some wording, and the price mechanism is a common sticking point. That is when the relationship you have built lets the two of you sit down and iron it out.

Tip for sellers: get help with due diligence

For sellers, my tip is to get support. You are likely running the business while trying to get the deal across the line, which is exhausting. Bring in someone, whether a colleague who can take on day-to-day duties or a spouse who can help with the buyer's due diligence requests, so that the process does not stall on your side.

Next steps

Before you agree a price in the heads of terms, decide which mechanism the deal will use, because that decision shapes what you will actually pay or receive. If you are the buyer, think about which risks you want the adjustment to catch; if you are the seller, think about what you can live with. A corporate solicitor and your accountant should agree the mechanism together before the SPA is drafted.