THIS is a question which should arise on any disposal process. The choice of pricing mechanism included in a sale and purchase agreement (SPA) can have a real impact on the monies received for a business.

In recent years the use of locked box mechanisms has become an established feature in the deals market, particularly with private equity sellers. In the relatively buoyant sellers market of 2007 and 2008 there was a significant rise in the use of these mechanisms and although the trend was abruptly curtailed in the aftermath of the banking crisis, they have returned strongly in the current market.

This trend underpins the commonly held belief that locked boxes are very much the mechanism of choice for sellers.

So what is a locked box and how does it compare with completion accounts?

An offer for a business is typically expressed as “cash free, debt free”. The price or enterprise value offered presumes that the target business has no cash or debt and implicitly has sufficient working capital to support the earnings of the business.

In reality, a business will have cash/debt balances and so traditionally completion accounts were used to adjust enterprise value for the actual level of cash and debt (on a pound for pound basis) and working capital (against a target level) in the business at closing. The adjusted price, known as equity price, reflects the sum a buyer ultimately pays for the shares or assets acquired. In the case of completion accounts the equity price may not be known for months, even years after closing because the calculation uses a balance sheet which is not prepared until after the deal completes.

A locked box deal by contrast requires a buyer to calculate equity price using a recent historical balance sheet. The amounts of cash, debt and working capital are therefore known and the related adjustments are negotiated by the parties before signing the SPA. A locked box deal is therefore a fixed price transaction.

What advantages do locked boxes bring to sellers?

In theory at least, choice of pricing mechanism should not change the value of a business. However, in practice sellers prefer a locked box for a number of reasons:

Certainty of equity price at the point of completion

Greater comparability of competing bids in an auction process

The onus is on bidders to get comfortable through diligence on the balance sheet used for pricing.

Can a seller always use a locked box approach?

Not always; only if the box can be “locked” and a seller can provide a balance sheet which bidders regard as sufficiently robust to calculate a firm equity price. “Locking” a box involves including specific provisions within the SPA which restricts a seller from extracting value from the business (so called leakage) between the locked box date and completion. Businesses most suited to a locked box tend to:

Be separate legal entities or groups with relatively robust financial data;

Be in a ‘ready for sale’ state before the locked box date,

Have minimal transactions with the seller.

Should a buyer always resist a locked box?

Whilst the approach is favoured by sellers, buyers need not see this as a reason to reject it. Many features of a locked box are attractive to both parties, namely that it is a commercial, lean break mechanism which avoids the messy aftermath of completion accounts.

So long as a buyer can perform sufficient diligence on the pricing balance sheet and get comfortable over the leakage risk there is every reason to consider completing under a locked box.

Although their origins may have been in PE transactions, locked boxes are an increasing part of mainstream corporate deals. Considering pricing mechanisms at an early stage in a disposal process will allow the relative merits of a locked box to be thought through which can have significant rewards at the end of the process.

:: Debra Halcrow is forensic services director at PwC in the North East, email: debra.halcrow@uk.pwc.com