Choice of mechanism for calculating the purchase amount in a transaction: "Locked Box" or "Completion Accounts"?

When buying and selling businesses, there is often a period of time between the contract formation and the completion of the transaction. The parties should thus agree on who will bear the risk for the business's development during this period. Should the seller bear the risk and allow for a subsequent adjustment of the purchase price? Or should the buyer bear the risk and commit to the purchase price determined in the agreement? Essentially, this is the choice between "Completion Accounts" and "Locked Box". Both are mechanisms for determining and calculating the purchase price in a transaction, each with its own advantages and disadvantages. The choice between them will often depend, among other things, on the target company's income stream, the parties' negotiating position and risk tolerance. So, what do you choose?

Locked Box - agreed fixed price

With a Locked Box mechanism, the parties set a purchase price that is not to be adjusted after the formation of the contract. The purchase price is determined based on a snapshot of the condition of the business on a given historical date. This Locked Box date can be weeks or months prior to the contract formation. The snapshot will typically be an annual report or a more recent interim balance prepared for this purpose; a so-called Locked Box balance. With a Locked Box mechanism, cash and debts arising after the Locked Box date will not be factored into the purchase price.

The advantage of using the Locked Box mechanism is the predictability it provides both the buyer and seller. Already at the time of the contract formation, the parties will know the exact purchase price for the transaction. Any subsequent changes to the company's balance sheet after the date of the Locked Box balance sheet will not affect the stipulated purchase price. This simplifies the negotiation process between the parties and eliminates the need for complicated adjustment mechanisms after completion of the transaction.

The disadvantage of using the Locked Box mechanism is that the seller has less incentive for value creation and efficient operation after the Locked Box date, as any profit after this date will solely benefit the buyer. Similarly, any increase in debt will be the buyer's risk. To address the disadvantages of a Locked Box mechanism, it is common to include specific provisions in the transaction agreement regulating what the company and the seller can do in the period between the Locked Box date and the time of completion of the transaction. These so-called leakage provisions prevent the seller from depleting the company for funds during this period. Breach of such provisions typically gives the buyer a claim for compensation against the seller, which in practice can be equated with a reduction in the purchase price.

Completion Accounts - adjustment of the purchase price

With a Completion Accounts mechanism, the parties agree on a preliminary purchase price based on an estimate of the company's financial condition at the future time of completion. The buyer pays the preliminary purchase price upon completion. After completion of the transaction (for example, three months later), a new balance sheet is prepared reflecting the actual financial condition of the company at the completion date. In practice, two balance sheets and purchase prices are thus prepared in connection with the transaction; one provisional and one final after completion of the transaction. The difference between the two constitutes the adjustment amount, which is either paid by the buyer (if the final purchase price is higher than the provisional purchase price) or reimbursed by the seller (if the final purchase price is lower than the provisional purchase price).  

The advantage of using Completion Accounts is that the buyer pays for what they actually receives, i.e. the actual financial conditions on the completion date. Both buyer and seller are thus protected against unexpected changes that may affect the company's financial position after the contract is formed. Moreover, the seller retains the incentive to work for increased financial gain even after the contract formation, as the purchase price is adjusted for the actual conditions right up until the buyer takes over the business on the completion date.

The disadvantage of using Completion Accounts is the uncertainty that comes with the mechanism. Neither party will be able to know with certainty what the final purchase price will actually be until a period after completion (regardless of one’s ability to predict the future). The mechanism also entails several complicated regulations in the transaction agreement, such as regulation of the purchase price-calculation and dispute resolution procedures, which may lead to lengthy and intricated contract negotiations for both parties. In addition, the adjustment mechanism can prompt new discussions between the buyer and seller after completion, at a time when the seller may mentally be disengaged with the transaction.

The choice between the two mechanisms - what should you think about?

The choice between Locked Box and Completion Accounts depends on several factors. Perhaps the most important factor is which side of the table you are on and the degree of stability the company has in its ongoing operations. Locked Box provides greater predictability for the seller and is often preferred when there is a low risk of significant changes and fluctuations in the company's finances. On the other hand, when there is a high degree of uncertainty regarding the company's financial position, Completion Accounts provide better protection for the buyer. Therefore, the choice of mechanism will depend on various factors such as the company's operations and income, length and size of contracts, practice in transactions within the same industry, the market situation, the size of the transaction and the risk appetite of the buyer and seller.

In both Norway and in the rest of Europe, both mechanisms (or hybrids of these) are used frequently, without us seeing a clear predominance of one or the other. Locked Box is often preferred in transactions where the company's net working capital is low, the customer/supplier contracts are long-term and the revenue streams are predictable. At the opposite end of the scale, in transactions where the company's net working capital is high or uncertain, we often see that Completion Accounts are preferred. As mentioned, both mechanisms have their own set of advantages and disadvantages. These are assessed differently from party to party and from transaction to transaction. However, one thing remains consistent: careful planning is essential for the successful execution of the transaction, regardless of the chosen mechanism. This encompasses drafting a robust contract, conducting a thorough review of the company's legal and financial conditions, clarifying the parties' individual circumstances and needs, and identifying and allocating the financial risk between the parties.

At AGP, we have extensive experience in drafting purchase contracts and completing transactions. One thing we have learned is that the mechanism for calculating the purchase price always requires individual adjustments, regardless of whether you choose Locked Box or Completion Accounts. Tailoring is thus the key to a good result. Feel free to contact us so that we can help you make the best choice for your situation.