Locked Box Mechanism

What is a locked box mechanism?

Locked box mechanism (German Locked-Box-Mechanismus, Festpreisverfahren) denotes a purchase price arrangement in a company acquisition in which the purchase price is finally fixed on the basis of a balance sheet at a reference date before the signing of the purchase agreement. From this reference date, the opportunities and risks of the business pass economically to the buyer, although the shares are transferred only at closing. Closing is the later day on which shares and purchase price actually pass. In return, the seller undertakes not to extract any value from the company until closing.

The image behind the name: at the reference date the company is, as it were, put into a locked box from which nothing may be taken for the benefit of the seller until handover. The mechanism is set out in the company purchase agreement (share purchase agreement, SPA), as a rule in a share deal, that is, the purchase of the shares in a company. The parties are seller and buyer with their financial and legal advisers. The counter-model is the purchase price adjustment on the basis of accounts drawn up as of the closing date (completion accounts), under which the price is determined only after closing on the basis of the actual values. In Europe, and in Germany too, the locked box is widespread mainly in structured auction processes, because it makes bids comparable and fixes the seller's proceeds early.

How the locked box works: reference date, fixed price and transfer

The basis is a balance sheet as of the locked box date, usually the last annual financial statements or interim financial statements; the price is derived from it. With signing, the parties bindingly agree this price. With closing, the shares pass and the purchase price is paid. Between signing and closing there are often several weeks or months, for example because of merger control clearance or an investment screening under foreign trade law.

The purchase price is calculated only once. The starting point is the agreed enterprise value, that is, the value of the ongoing business without regard to debts and cash balances. From it the financial liabilities and debt-like items of the locked box balance sheet are deducted, such as bank loans, tax debts and pension obligations, and its freely available liquid funds are added. This bridging calculation is called the equity bridge. Its result, the equity value (the value of the shares), appears in the contract as a fixed amount. Whether net working capital at the reference date corresponds to a normal level is checked by the buyer before signing; this means mainly inventories and customer receivables less supplier liabilities. No later adjustment takes place.

Economically, the purchase takes effect retroactively to the reference date. Profits that the company makes afterwards remain in the company and benefit the buyer; losses reduce the value of what the buyer receives. In German purchase agreements, the shares are therefore regularly sold including the profit entitlement for the current financial year and for undistributed profits of earlier years. Legally, the seller remains a shareholder until closing; the obligation and the assignment require notarisation under Section 15(3) and (4) of the German Limited Liability Companies Act (GmbHG).

Protection against value leakage

Because the price is fixed, the value of the company may not fall after the reference date for the benefit of the seller. The contract therefore prohibits any leakage of value from the company to the seller and persons related to the seller, unless expressly permitted. Depending on the definition, affiliated companies, family members and companies in which the seller holds an interest count as related.

Typical impermissible leakage

• overt and covert profit distributions as well as repayments from the capital reserve
• interest payments and repayments on shareholder loans
• management and advisory fees or cost allocations to the seller
• waiver of claims against the seller and transactions with the seller on non-arm's-length terms
• assumption of the seller's transaction costs and special payments to management or employees triggered by the sale
• taxes arising from any of these transactions

Permitted leakage

Exceptions are listed exhaustively and quantified where possible. Customary are the ongoing remuneration of shareholder-managing directors under existing employment contracts and rents for premises that a shareholder provides on arm's-length terms. Also permissible are payments that were already deducted when the fixed price was calculated, for example the repayment of a shareholder loan that is already taken into account there as a liability. What is not on the list is deemed impermissible.

Legal consequences

Impermissible leakage is generally reimbursed by the seller euro for euro. Unlike claims under warranties, neither allowances nor liability caps below the purchase price usually apply. The period for asserting the claim is short; six to twelve months after closing is common. Leakage that the seller discloses before closing is deducted directly from the amount payable.

Interest until closing (ticker or ticking fee)

Between the reference date and closing, the company generates earnings that belong to the buyer while the seller is still waiting for the purchase price. As compensation, the parties often agree interest on the fixed price for this period, called a ticker or ticking fee in the market. It is calculated either as a percentage per year on the equity value or as a fixed daily amount based on the expected cash flow. It usually runs from the locked box date to closing, sometimes only from signing.

Whether and in what amount interest is paid is a matter of negotiation; several interested parties in an auction process strengthen the seller's position. Buyers sometimes demand that the interest lapses to the extent that closing is delayed for reasons for which the seller is responsible. The longer the path to closing, the more it weighs.

Suitability of the locked box and allocation of risk

The mechanism requires a reliable locked box balance sheet. It suits companies with a stable business, reliable accounting and audited financial statements whose reference date is not too far back; in practice it is usually a few months before signing. It is less suitable where net working capital fluctuates strongly, where part of a business is carved out without its own financial statements (carve-out) and for companies in crisis.

For the seller, the locked box offers price certainty: the proceeds are fixed at signing, and a dispute about balance sheet values after closing does not arise. The buyer, by contrast, assumes the business risk from the reference date. It protects itself through thorough due diligence of the locked box balance sheet and through warranties on these financial statements. In addition come the leakage provision and obligations of the seller to continue the business in the ordinary course until closing (ordinary course of business). A review report commissioned in advance by the seller (vendor due diligence) makes it easier for buyers to accept a fixed price.

If the business deteriorates significantly between signing and closing, the buyer is helped mainly by an expressly agreed clause on material adverse changes (material adverse change, MAC for short). Under narrowly defined conditions, it allows the buyer to withdraw from the contract or refuse closing. If the clause is missing, the buyer must as a rule close as soon as the agreed closing conditions are met.

Worked example: locked box with interest and leakage

A software company is sold on the basis of an enterprise value of EUR 30.0 million. The locked box date is 31 December, signing takes place in mid-April, closing on 30 June. The net working capital of the locked box balance sheet corresponds to the usual level.

• Locked box balance sheet: financial liabilities EUR 6.0 million, debt-like items EUR 0.5 million, liquid funds EUR 2.5 million
• Fixed price: EUR 30.0 million minus EUR 6.0 million minus EUR 0.5 million plus EUR 2.5 million = EUR 26.0 million
• Interest of 4% per year for the six months from the reference date to closing: EUR 26.0 million × 4% × 6/12 = EUR 520,000
• Permitted leakage: remuneration of the shareholder-managing director of EUR 20,000 per month, EUR 120,000 for six months, permitted in the contract
• Impermissible leakage: an advisory fee to a company of the seller of EUR 150,000 and invoices of its transaction advisers paid by the target company of EUR 200,000, together EUR 350,000
• Payment at closing, if the seller discloses the leakage beforehand: EUR 26,000,000 plus EUR 520,000 minus EUR 350,000 = EUR 26,170,000
• If the buyer establishes the leakage only after closing, it first pays EUR 26,520,000 and claims EUR 350,000 back from the seller

An operating cash flow of EUR 1.1 million between January and June does not change the price. It remains in the company and benefits the buyer, who pays EUR 520,000 of interest for it. The difference of EUR 580,000 is its compensation for bearing the business risk from the reference date. Under completion accounts, by contrast, the cash inflow would have entered the purchase price through the liquid funds at closing and thus flowed to the seller.

Distinctions: locked box, completion accounts and purchase price adjustment

• Completion accounts (also closing accounts): the buyer pays a provisional price at closing, which is finally determined on the basis of accounts as of the closing date. The result up to closing thus belongs economically to the seller.
• Post-closing purchase price adjustment: the adjustment procedure after closing with deadlines, objections and an expert determination (Schiedsgutachter). With a locked box it does not apply; it is replaced by the claim for reimbursement of impermissible leakage.
• Working capital adjustment: the subsequent adjustment to a target value for net working capital. In the locked box, net working capital enters the price only through the assessment of the locked box balance sheet.

Common mistakes

• Outdated locked box balance sheet. The further back the reference date, the greater the risk the buyer assumes and the more strongly it reflects this in the price.
• Gaps in the leakage definition. If the clause covers only distributions, advisory fees, cost allocations or waivers of claims remain outside the protection.
• Permitted leakage not quantified. Blanket exceptions such as payments “in the ordinary course of business” to the seller lead after closing to disputes about their scope.
• Net working capital not normalised at the reference date. If it is below the usual level seasonally or because of special effects, the difference is missing from the fixed price to the buyer's detriment; if it is above, to the seller's detriment.
• Transaction-related payments overlooked. Bonuses or adviser fees triggered by the sale at the company's expense belong either in the fixed price or under the leakage rule.

Frequently asked questions

Who bears losses between the locked box date and closing?

The buyer. It bears the result of this period for better or worse; weaker performance does not reduce the price. Withdrawal is generally possible only through an agreed MAC clause.

Can the purchase price still change after the fact with a locked box?

Only within narrow limits. No adjustment to balance sheet values takes place. However, the buyer can reclaim impermissible leakage and assert claims for breach of warranty; an additionally agreed earn-out also changes the total purchase price.

Which balance sheet is suitable as a locked box balance sheet?

As a rule the last audited annual financial statements or interim financial statements that an auditor has reviewed. The figures must be prepared consistently and be traceable in due diligence.

May shareholder-managing directors continue to draw their salary after the reference date?

Yes, if the contract lists the ongoing remuneration as permitted leakage. A limitation to the existing employment contracts is customary; salary increases, special bonuses or severance payments after the reference date count as leakage without express permission.

The Roemer Capital view

At the start of a sale mandate, Roemer Capital clarifies on the basis of the monthly financial statements and the last annual financial statements whether the company is suitable for a locked box. This involves three questions: how reliable the balance sheet is, how strongly net working capital fluctuates and how long the path to closing is expected to take.

Before the first draft contract, Roemer Capital works with management on the list of permitted leakage and quantifies every item. Roemer Capital derives the interest from the planned cash flow up to closing so that it can be justified to the bidders. The wording of the leakage rules is handled by the client's law firm; Roemer Capital supplies the figures and represents the economic parameters in the negotiation.