Purchase Price Mechanisms in M&A: Locked Box or Closing Accounts?

The purchase price in an M&A transaction is rarely just a fixed number written into the share purchase agreement. Several calculation steps often sit between the agreed enterprise value and the amount ultimately paid at closing.

This raises one of the key questions in many M&A transactions: How is the final purchase price determined?

Two purchase price mechanisms are particularly common:

• Locked Box
• Closing Accounts, also referred to as Completion Accounts

Both mechanisms are designed to determine the economic value transferred from seller to buyer.

Enterprise Value and Equity Value

Many purchase price discussions start with the Enterprise Value.

In simplified terms, this reflects the value of the operating business independently of its specific financing structure.

The amount ultimately payable to the shareholders is generally based on the Equity Value.

A simplified calculation may look as follows:

Enterprise Value
+ Cash
− Financial Debt
+/− other agreed adjustments
= Equity Value

Depending on the transaction, further items may be relevant, including working capital, shareholder loans, certain liabilities or provisions.

The purchase price mechanism determines when these items are measured and how changes up to closing are treated.

What is a Locked Box?

Under a Locked Box structure, the purchase price is determined by reference to a financial date prior to signing.

This date is known as the Locked Box Date.

The calculation is usually based on financial statements or other financial information relating to that date. The Equity Value is therefore determined before the SPA is signed.

Example:

The company has an Enterprise Value of EUR 5 million at the Locked Box Date.

At that date, it has:

• EUR 500,000 of cash
• EUR 300,000 of financial debt

The simplified Equity Value would be:

EUR 5,000,000
+ EUR 500,000 Cash
− EUR 300,000 Debt
= EUR 5,200,000 Equity Value

This amount forms the basis for the purchase price.

As a general rule, there is no subsequent purchase price adjustment based on closing accounts.

The economic concept behind a Locked Box

In a share deal, legal ownership of the shares transfers to the buyer at closing.

The economic risks and benefits of the business from the Locked Box Date are generally allocated to the buyer.

For this structure to work, value must not be extracted from the target for the benefit of the seller between the Locked Box Date and closing.

This is where Leakage becomes important.

What is Leakage?

Leakage refers to value transferred from the target to the seller or related parties between the Locked Box Date and closing.

Examples may include:

• dividends
• distributions
• repayment of shareholder loans
• certain management fees
• payments to affiliated companies
• transfers of assets

The seller will therefore usually undertake in the SPA that no prohibited Leakage has occurred or will occur.

If Leakage does occur, the seller will generally be required to reimburse the relevant amount.

Permitted Leakage

Certain payments may be expressly agreed as Permitted Leakage.

Depending on the transaction, this may include agreed bonus payments, payments to shareholders or other items disclosed and accepted in advance.

Clear drafting is important.

The buyer should know at signing which payments may still be made before closing.

Advantages of a Locked Box

The main advantage is price certainty.

The purchase price is largely fixed at signing. Buyer and seller know at an early stage what amount is expected to be paid at closing.

The post-closing process is also simpler. There is generally no need to prepare detailed closing accounts followed by a purchase price adjustment.

This reduces post-closing work and limits the scope for later disputes over individual balance sheet items.

A Locked Box can also be attractive to sellers because the purchase price is generally not recalculated after closing on the basis of updated financial figures.

What buyers should consider in a Locked Box

The quality and currency of the financial information used for the Locked Box are particularly important for the buyer.

Where the Locked Box Date is several months before closing, the financial position of the business may change during that period.

Key considerations therefore include:

• reliable Locked Box Accounts
• Financial Due Diligence
• clear Leakage provisions
• buyer information rights
• covenants between signing and closing

The longer the period between the Locked Box Date and closing, the more important these protections become.

What are Closing Accounts?

Under a Closing Accounts mechanism, the final purchase price is determined by reference to the financial position of the target at closing.

A provisional purchase price is often agreed at signing.

Following closing, closing accounts or a similar calculation are prepared. These figures are then used to determine the final Equity Value.

Common adjustment items include:

• Cash
• Financial Debt
• Net Debt
• Working Capital
• other agreed purchase price adjustments

The provisional purchase price is then adjusted upwards or downwards.

Example of Closing Accounts

Assume that buyer and seller agree an Enterprise Value of EUR 5 million.

At signing, the estimated closing figures are:

• EUR 400,000 Cash
• EUR 300,000 Debt

The provisional Equity Value is therefore EUR 5.1 million.

After closing, the actual figures show EUR 300,000 of cash and EUR 350,000 of financial debt.

The final Equity Value is therefore lower.

Depending on the SPA, the seller may be required to repay part of the amount initially received.

Working Capital adjustments

Closing Accounts often include more than Cash and Debt.

For many operating businesses, Working Capital is a significant part of the purchase price calculation.

The buyer will usually want the business to be delivered at closing with an agreed or normalised level of Working Capital.

A target Working Capital amount is therefore often agreed.

If actual Working Capital at closing is below the target, the purchase price may be reduced.

If it is above the target, the purchase price may be increased.

The definition is critical. The SPA should clearly state which receivables, liabilities and other items are included.

Where disputes often arise

Closing Accounts can become technically complex.

Discussions often focus on questions such as:

• What qualifies as Cash?
• What qualifies as Debt?
• Which items are already included in Working Capital?
• How are provisions treated?
• Which accounting principles apply?
• How are exceptional or unusual items dealt with?

For this reason, SPAs using Closing Accounts often contain detailed definitions and accounting rules.

They also commonly include a procedure for resolving disagreements. Specific accounting disputes may, for example, be referred to an independent accountant or expert.

Locked Box or Closing Accounts?

The appropriate structure depends on the transaction.

A Locked Box may be suitable where reliable financial information is available and the parties want a high degree of price certainty at signing.

Closing Accounts may be appropriate where material balance sheet items may still change before closing or where the parties want the final purchase price to reflect the financial position of the business at completion.

Relevant factors include:

Quality of financial information

The more reliable the figures at the Locked Box Date, the easier it is to implement a Locked Box structure.

Time between signing and closing

The longer this period, the more important the treatment of changes before closing becomes.

Working Capital volatility

Businesses with significant seasonal or operational fluctuations may be more suited to a Closing Accounts mechanism.

Deal dynamics

The competitive situation in a sale process may also influence the chosen mechanism.

Complexity

Complex balance sheets can make the Closing Accounts process more time consuming and increase the scope for post-closing discussions.

Definitions in the SPA matter

The labels “Locked Box” and “Closing Accounts” alone do not determine how the purchase price operates in practice.

The detailed definitions in the SPA are critical.

For Closing Accounts, the key concepts often include:

• Cash
• Debt
• Working Capital
• Accounting Principles
• calculation methodology
• timelines
• dispute resolution procedures

For a Locked Box, key concepts usually include:

• Locked Box Accounts
• Leakage
• Permitted Leakage
• Leakage Period
• seller warranties or undertakings
• any agreed interest or value accrual

Small differences in these definitions can have a material impact on the final purchase price.

Should the purchase price mechanism already be addressed in the LOI?

The basic purchase price mechanics should be discussed early in the transaction.

A Letter of Intent can already specify:

• the agreed Enterprise Value
• whether a Locked Box or Closing Accounts mechanism is envisaged
• the relevant reference date
• whether Net Debt will be taken into account
• whether a Working Capital adjustment is intended
• the key assumptions underlying the valuation

Not every technical definition needs to be fully negotiated at LOI stage.

The parties should, however, have a common understanding of how the agreed Enterprise Value will translate into the amount ultimately payable to the seller.

For buyers acquiring a company for the first time, the purchase price mechanism is therefore one of the issues that should be considered early in the process. More information on the acquisition process is available on our page for Searchers and Entrepreneurs through Acquisition.

Purchase price mechanisms should reflect the economics of the deal

Purchase price clauses can quickly become technical.

The underlying commercial question is straightforward:

What economic value is the buyer acquiring and what amount should the seller receive for it?

The purchase price mechanism translates that commercial understanding into contractual rules.

Valuation, financial data and SPA drafting therefore need to work together.

An unclear definition of Debt, an incorrect Working Capital mechanism or an overly broad Permitted Leakage provision can directly affect the amount ultimately paid.

Conclusion

Locked Box and Closing Accounts are the two key purchase price mechanisms used in M&A transactions.

Under a Locked Box, the purchase price is determined by reference to a date before signing. There is generally no post-closing purchase price adjustment. Leakage provisions are used to protect the buyer against value being extracted from the target between the Locked Box Date and closing.

Under a Closing Accounts mechanism, the final purchase price is determined by reference to the actual financial position of the business at closing. This allows the price to reflect the economics of the target at completion and requires an additional post-closing calculation and reconciliation process.

The appropriate structure depends on the business, the available financial information and the specific transaction.

We advise buyers and sellers throughout the M&A process, from transaction structuring and due diligence to SPA negotiations, signing and closing. Find out more about our work on M&A transactions.