What is a Completion Mechanism?
In many acquisitions, the counterparties will negotiate the inclusion of an appropriate price adjustment mechanism. The objective is to test the valuation and the mechanism may, for instance, be designed to test profitability, net assets, or cash-free, debt free, and normalized working capital. In a transaction, a completion mechanism is used to determine the final acquisition price. There are two widely accepted mechanisms for adjusting the consideration: “Completion Accounts” and “Locked Box,” and the outcome can be different depending on the mechanism used.
Key learning points
- In many acquisitions, the parties will negotiate the inclusion of an appropriate price adjustment mechanism. A completion mechanism is used to determine the final acquisition price for the target company.
- There are two widely accepted mechanisms for adjusting the consideration: completion accounts or locked box. With completion accounts, only the enterprise value is fixed, and the equity value is determined at closing. In a locked box, the enterprise value and equity value are both fixed.
- It is crucial for buyers to agree which accounts to use and understand how they are prepared. Each completion mechanism has advantages, but if designed and implemented properly, the overall price determined using the different mechanisms should be similar.
Purpose of the Completion Mechanism
Most transactions must be adjusted to reflect the financial position (balance sheet) of the target business. This ensures negative behaviors that are not in the interest of the buyer or the company, such as value extraction prior to the sale, are not rewarded.
The problem, however, is that balance sheets are constantly in flux, making it very difficult to determine the final price. This is where the completion mechanism comes into play as it clearly outlines how the final price is to be calculated. If no completion mechanism is applied to a transaction, it is likely that one party will suffer a loss of value, as areas material to value may not be considered. An appropriate completion mechanism is necessary to adjust the equity value and finalize the consideration to be paid by the buyer.
Types of Completion Mechanism
The two most widely used completion mechanisms are:
- Completion Accounts: Completion accounts are a set of accounts created for the purpose of the sale or acquisition and used as a basis for adjusting the price. When completion accounts are used, the initial acquisition price is defined in the signed share purchase agreement (SPA). The final equity adjustment will be based on the actual balance sheet of the target that is prepared after the transaction at close of business on the date of completion. To avoid re-negotiations over the purchase price at completion, parties typically predetermine the adjustment method at signing. A completion accounts mechanism requires that the parties record their understanding and agreement regarding how various matters will be treated in the completion accounts and therefore how they will potentially adjust the price.
- Locked Box: The term “Locked Box” refers to a key feature of this type of mechanism, which is that no value is permitted to leave the business (for example, through issuing a dividend or extracting management fees) between the locked box date and until completion of the transaction. A locked box mechanism allows parties to agree on a fixed price at signing based on the target company characteristics known at that time, and there is no post-completion adjustment. It offers the advantage of price certainty, eliminates the requirement for a post-completion price adjustment, reduces the time and resources demanded by a lengthier closing process, and eliminates the potential for disputes in preparing closing accounts because the locked box accounts are agreed upon before the SPA is signed.
Access the download Completion Accounts vs Locked Box Mechanism for a comparison of Completion Accounts and the Locked Box Mechanism to explore price, economic interest, cashflow, and adjustments.
For some time, completion accounts have been the most used option in mergers and acquisitions. However, the locked box mechanism has gained popularity in recent years due to a strong seller’s market, increased market demand for M&A transactions, and the desire for clean-cut exits, particularly where financial investors are involved. Understanding the strengths and weaknesses of both mechanisms will help you make a more appropriate choice between the two methods and help ensure a successful transaction.
Example of a Completion Mechanism
Here is an example of how the locked box mechanism works:
Assume that A owns 100% of the shares in Company X and has agreed to sell his shares to B for £500k, scheduled to be completed on 31 July 2022. The purchase price was agreed based on the company’s latest management accounts.
A has asked the company’s accountant to prepare a set of accounts that is as close to completion as possible. A set of accounts (Locked Box Accounts) was prepared and finalized to show the company’s financial position on 20 July 2022 (the Locked Box date).
Based on the review of the locked box accounts, B can see that the net asset position of Company X on the locked box date has declined since the purchase price was agreed. Therefore, the parties agreed to reduce the purchase price to £450,000.
On completion, B pays A £450,000 and takes ownership of the company. There are no subsequent purchase price adjustments. Moreover, to prevent A from making significant changes to the company between the locked box date and completion, the sale contract will almost certainly include contractual assurances from A regarding the company’s management since the locked box date, including confirmation that any activities that would extract value from the company (such as management charges and dividends) have not occurred.
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There are two widely accepted mechanisms for adjusting consideration in a transaction: completion accounts or locked box. Both mechanisms involve a similar assessment of factors that affect the valuation of the target business and require the parties to reach an agreement on how these factors affect the price.
The essential difference between the two mechanisms is one of timing. The locked box mechanism requires both parties to commit to a certain price at contract signing, while the completion accounts mechanism requires both parties to settle on a certain price at some time following completion. The mechanism chosen in a particular transaction depends on a multitude of factors, including the contracting strength of the sellers and buyers, the time by which certainty of price is required, the nature of the target business itself, and the proposed sale process. Sellers often prefer the locked box mechanism over a completion accounts mechanism, while buyers often view a locked box mechanism with some degree of trepidation and tend to choose the completion accounts mechanism.