Locked-box mechanism in M&A transactions

Over the past 10 years, India’s M&A landscape has become more sophisticated, adopting international best practices. Parties are negotiating, at length, clauses relating to purchase price adjustments, completion conditions, representations, warranties and indemnifications in a share purchase agreement (SPA), and the locked box mechanism for determining price is gaining recognition.

Under a traditional completion accounts approach, the purchase price is set using a valuation methodology specified in the SPA and is typically paid as an estimate at completion. Subsequently, the purchase price is adjusted based on the difference between the price paid and price determined from a set of special purpose completion accounts prepared as of the completion date. However, due to regulatory restrictions in India, merger valuation techniques include a mish-mash of the discounted cash flow method, enterprise value method, the net asset method or valuation determined on multiples of earnings before interest, taxes, depreciation and amortization.

Under a locked-box mechanism, the purchase price of the target company is fixed and calculated by reference to historical accounts and financial statements of the target company. The buyer bears the risk in, and reaps of the rewards of, the performance of the target company from the date of the historical financials (the locked-box date) up to completion of the transaction. Since the purchase consideration is fixed upfront, protection against any leakage in the value of the target company between the locked box date and the completion date of the transaction (the gap period) is provided by the seller to the buyer through strong covenants, warranties and indemnities for events since the date of the latest audited accounts.

Critical for using a locked-box mechanism for valuation is the quality of the historical financial statements. Locked box mechanism have not been much used in India because accounts traditionally have been viewed with a healthy amount of suspicion. However, this perception is slowly changing as industry and M&A in India develops and internationalizes.

Extensive negotiations take place between the seller and the buyer to determine what the buyer will accept as permitted leakages. Permitted leakages are expenses that a company ordinarily incurs to continue operating. Typically, such expenses exclude: (a) dividends, returns of capital, management fees and bonuses paid by the company to the seller; (b) waivers of rights or claims against members of the seller group or third parties; (c) changes to any “permitted” trading arrangements between the target and members of the seller group, or any new arrangements; and (d) transaction costs incurred by the target.

In addition, the SPA normally provides for extensive interim operating covenants and restrictions on what the target company can do during the gap period without the buyer’s prior consent.

Pros of locked-box deals

A locked-box mechanism obviates the need to prepare completion accounts, which automatically results in saving time and expenses of the seller and the purchaser. In addition, regulatory approvals for the completion adjustment will not be required. The locked-box structure provides price certainty, which makes it easier for a seller to compare bids in an auction.

From the buyer’s perspective as well the locked box mechanism is beneficial: with no need to prepare completion accounts, a seller is not motivated to manipulate the target business during the gap period to exploit any loopholes in the completion accounts adjustment. Further, a buyer can draw comfort from the locked-box mechanism as long as: (a) the SPA provides strong representations and warranties and sufficient control over potential leakages during the gap period; and (b) the purchaser has an opportunity to conduct an independent review and full due diligence of the historical balance sheet.

Disadvantages

The biggest concern in a locked box deal is the risk of the seller exploiting any potential leakage or engaging in an improper transfer of value from the target to the seller during the gap period. This leakage could be as obvious as a dividend payout or as elusive as the target incurring transaction costs which the parties have agreed are for the seller’s account.

A locked-box will not be appropriate if the transaction involves a long and uncertain gap period or if the acquisition of the target is a part of a larger transaction because the purchaser continues to run the risk of the seller entering into intra-group arrangements on terms other than on arm’s-length basis.

Given the number of secondary buyouts and exits by private equity players being seen today and the emphasis on extensive diligence on target companies, the locked-box approach to price setting should gain popularity considering the amount of time and money that it can save.

Raghubir Menon is a partner, Ekta Gupta is a principal associate and Deepa Rekha is an associate at Amarchand & Mangaldas & Suresh A Shroff & Co. The views expressed in this article are those of the authors and do not reflect the position of the firm.