Introduction
This third series covers purchase price mechanisms in share sale and purchase agreements, which are among the most critical and technical provisions. In share deal transactions in Malaysia, two primary types of purchase price mechanisms are commonly used:
(a) the ‘closing accounts’ mechanism and
(b) the ‘locked box’ mechanism.
In addition to these two core mechanisms, parties may occasionally encounter a third, complementary mechanism — the ‘earn-out’ mechanism — which can be used alongside either of the first two. However, the earn-out mechanism will not be discussed in this series as it warrants a separate write up on its own. Stay tuned!
To better understand how the closing accounts and locked box mechanisms function, it is important to note that the purchase price (or equity value) of a target is often fixed in many transactions using the following standard formula:
Purchase price | = | enterprise value - financial debt + cash +/- net working capital variation |
1. Closing Accounts Mechanism
In a closing accounts mechanism (also referred to as a completion accounts mechanism or price adjustment mechanism), the purchase price of the target is usually determined using the standard formula (or an alternative one) based on the accounts finalized as of the transaction's closing date (the "closing accounts").
However, since (a) the closing accounts are typically not available on the closing date and (b) the purchase price cannot be determined at that time, the seller and purchaser agree on a provisional purchase price. This provisional price is calculated using the same standard formula, based on accounts finalized before the transaction's signing date.
The provisional purchase price—calculated before and paid on the closing date—is later adjusted after closing based on actual financial debt, cash, and net working capital changes as of the closing date, once the closing accounts are available.
In other words, with a closing accounts mechanism, the enterprise value of the target is agreed upon before signing, but the equity price remains subject to post-closing adjustments. This mechanism is generally seen as favorable to the purchaser.
By using a closing accounts mechanism in a share deal, the seller continues to bear the economic risks and rewards related to the target until the closing date. This protects the purchaser from value erosion and potential leakage up until closing. Additionally, since the final purchase price is based on closing accounts that the purchaser should have sufficient time to audit in detail post-closing, this mechanism may ease the pressure on the purchaser regarding pre-signing financial due diligence of the target.
Moreover, the closing accounts mechanism indirectly protects the purchaser against the seller’s potential loss of interest in managing the target properly between the signing and closing dates, as any negative changes in debt, cash, or net working capital will reduce the final purchase price payable to the seller.
Given these key features, a closing accounts mechanism is especially suitable when a target lacks a stable or reliable financial history, does not have audited accounts, operates in a highly volatile industry, will undergo a complex carve-out between the signing and closing dates, or when a long delay is expected between signing and closing of the transaction.
2. ‘Locked-box’ mechanism
In a locked box mechanism, the purchase price of the target is determined using the standard formula (or an alternative one) based on accounts that were finalized on a date before the signing of the agreement (the "locked box date").
The locked box accounts typically refer to the target's most recent annual or interim financial statements. These accounts usually need to be audited by an independent auditor since they will be used to determine the final purchase price for the transaction, with no option for the purchaser to adjust them after closing.
In this scenario, since the purchase price can be calculated before the signing date, there is no need for a provisional price calculation or post-closing adjustments. In other words, with a locked box mechanism, the equity price of the target is known and fixed before signing, offering certainty to both the seller and the purchaser.
A locked box mechanism is generally considered favorable to the seller. This is because, under this pricing method in a share deal, the financial risks associated with the target are transferred to the purchaser from the locked box date. Similarly, the economic benefits of owning the target are also passed on to the purchaser from that date.
Further, in such a transaction, while the seller retains ownership and manages the target between the locked box date and the closing date, they are no longer entitled to benefit from its earnings. Economically, the seller essentially acts as an "agent" for the purchaser during this interim period. For this reason, in many locked box deals, the seller often negotiates—sometimes successfully—either an interest adjustment on the purchase price or compensation for the expected profits generated by the target during this period.
Given its key features, a locked box mechanism is often considered especially suitable for auction process deals (as it allows for easier comparison of bids) and/or transactions involving a private equity fund as the seller, as they typically seek price certainty.
Key advantages and disadvantages of both mechanisms from a purchaser’s point of view
Closing Accounts Mechanism | Locked Box Mechanism |
Advantages: | Advantages: |
o the seller continues to bear the economic risks and rewards related to the target until the closing date. This protects the purchaser from value erosion and potential leakage up until closing. o Additionally, since the final purchase price is based on closing accounts that the purchaser should have sufficient time to audit in detail post-closing, this mechanism may ease the pressure on the purchaser regarding pre-signing financial due diligence of the target
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o Transaction moves faster as parties are less likely to negotiate on the intricate legal definitions of financial debt, cash and cash-like items, and net working capital in their transaction documents.
o it can also alleviate the parties of the expenses related to the preparation, auditing, and discussions of closing accounts following the transaction's completion. |
Disadvantages
| Disadvantages |
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a. the locked box date is more than three months prior to the signing date;
b. the locked box accounts have not been audited by an independent auditor or may not undergo comprehensive financial due diligence before signing;
c. if the target lacks a historical stand-alone balance sheet and is currently undergoing or has recently undergone restructuring, or operates in a highly volatile sector;
d. if a lengthy period is anticipated between the signing date and the locked box date;
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Conclusion
In conclusion, the choice between the closing accounts and locked box mechanisms plays a crucial role in shaping the final purchase price in M&A transactions. Each mechanism has its distinct advantages and limitations, which may align differently with the objectives of the buyer and seller. For buyers, the closing accounts mechanism offers flexibility with post-closing adjustments to ensure the final price reflects the actual financial state at closing. Meanwhile, the locked box mechanism provides the seller with price certainty and a streamlined closing process by fixing the purchase price upfront.
Given the nuanced implications of each approach, it is essential for parties to engage in careful evaluation of the target’s financial profile, transaction timeline, and risk tolerance. By selecting the mechanism that aligns best with these factors, both buyer and seller can create a transaction structure that minimizes disputes and enhances value realization.
The above content presented in this article is meant solely for offering general information and should not be considered as legal opinion or professional advice. If you're looking to acquire a business and wish to know the best way to structure a purchase price clause to better protect you, contact us now for a complementary consultation.
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