On Different Purchase Price Mechanisms
In mergers and acquisitions, the balance sheet date can be set either in the past or the future, which affects the purchase price mechanism used. If the effective balance sheet date is in the past, the locked-box mechanism is typically employed. In this approach, the bridge between enterprise value (EV) and equity value is calculated based on the existing balance sheet. If the determining date is in the future, the closing accounts mechanism is used instead.
Simply put, from a financial perspective (though not legally), the economic benefits and risks of the business transfer to the buyer on the determining balance sheet date. Events occurring after this date are the buyer’s gains and risks, while those occurring before remain the seller’s responsibility.
In some cases, a hybrid solution is adopted, combining elements of both mechanisms. There are various reasons for choosing such a mechanism, often driven by practical considerations. In the hybrid model, the determining balance sheet date falls between the signing and closing dates. In contrast, in the locked-box mechanism, the determining date precedes both signing and closing, while in the closing accounts mechanism, it comes after these events. A hybrid model may be used, for example, when the purchase price is largely fixed, but adjustments are still desired. However, hybrid models can create complications, such as blurring the components of the EV-to-equity value bridge or leakage, potentially causing one party to gain or lose unfairly in the deal.
Why Does Locked-Box Sometimes Involve Interest?
In the locked-box mechanism, the seller must wait to receive the agreed purchase price until the deal is finalized. For this reason, it is common for the seller to seek compensation for the delay in receiving the funds, given that the economic risks and benefits of ownership have already transferred to the buyer.
Who Benefits, and How Is Compensation Determined?
If the compensation is based on the seller waiting for the funds, many argue that the seller should be paid interest because it cannot use the purchase price for investments, for example. In this sense, the seller is effectively providing the buyer with a secured loan, with the collateral being the business being sold.
Another view is that the profits generated by the business between the locked-box date and the transaction closing should belong to the seller. Under this logic, the seller should be compensated for the cash flow generated during this period. The question is: who owns the economic benefits of ownership? It can be argued that they belong to the buyer, as the risks of ownership have transferred to them. In this case, the seller should only be compensated for the cost of capital, i.e., interest. Conversely, if the benefits are deemed to belong to the seller, compensating cash flows may be a more appropriate solution.
It can also be argued that the EV valuation already accounts for the expected returns after the locked-box date, meaning the seller does not need separate compensation beyond the cost of capital.
Locked-Box vs. Closing Accounts – Should the Result Be the Same?
One could argue that the locked-box mechanism and the closing accounts mechanism should lead to the same outcome. This view is based on the idea that the purchase price mechanism should not affect the purchase price, as it is primarily a technical matter. Furthermore, if all cash flows after the locked-box date belong to the seller, the result should be the same as in the closing accounts mechanism.
However, if the mechanisms involve different dates when the economic benefits and risks of the business transfer, the purchase price need not be identical. In this case, the difference lies in the fact that the seller is waiting for the purchase price and effectively lending money to the buyer for the period between the locked-box date and payment.
Speed Is Key, but Delays Have Their Benefits
M&A transactions are challenging partly because the business being sold is continuously evolving, and its financial situation changes over time. A faster transaction process is therefore better for liquidity and cash flow management. On the other hand, delays can bring other advantages, such as more thorough analysis, better understanding (due to information asymmetry, the buyer typically has less knowledge of the business than the seller), or improved negotiation outcomes when there is less uncertainty.
Capton Partners advises clients on purchase price mechanisms as part of an effective due diligence process. Please check out our services to learn how we can support your transaction with tailored expertise: