Issue 4 • October 2019

Mergers and Acquisitions Guidance Note

IntroductionThe M&A process can move towards completion faster

than you expect. It is therefore important to understand

the impact of your every decision as a participant to the

mergers and acquisitions related transactions along the deal

continuum. Regardless of whether you are on the buyer or

seller side, signing the agreement will be a key stage in the

deal: it sets out the terms to ensure the buyer is acquiring

(and the seller is disposing of) what they expect, at the

agreed deal price and without inappropriate risk.

As the market evolves, the Locked Box is becoming a

more common closing mechanism. What is it, and how is

it different from a more typical approach – Completion

Accounts? What should I consider before choosing Locked

Box over Completion Accounts? What are the pros and

cons? If you feel unsure about any of the above questions,

read below and you will find answers.

The Locked Box mechanismIn short, a Locked Box deal is a fixed price deal. Under the

Locked Box mechanism, the equity price is ‘locked’ with

known amounts of cash, debt and working capital at a

pre-signing date (Locked Box date) based on a historical

balance sheet (Locked Box balance sheet). This is unlike

the Completion Accounts mechanism, where the enterprise

value is agreed upon at signing date and then adjusted for

actual cash, debt and working capital movements between

the signing and closing date to determine the equity price.

There are no subsequent adjustments post-completion

under the Locked Box approach. As such, under the Locked

Box mechanism the buyer bears performance risk from the

Locked Box date onwards.

Especially if the target is a profitable and growing

company, the Locked Box mechanism can bring positive

benefits to the buyer in the period between the Locked

Box date and the completion date (the gap period). To

protect the buyer from any value extraction by the seller

(for example cash, assets, etc.) during the gap period –

during which the seller still controls the target operation

– terms and definitions should be set out clearly in the

share purchase agreement (SPA) to avoid ‘leakage’. Under

the SPA, the seller will undertake not to extract value for

their own benefit, unless specifically agreed to for normal

business operations (permitted leakage).

At the same time, the buyer needs to compensate the seller

for the opportunity cost of the continued profit generation

during the gap period (that is, expected cash flow changes

in net debt) by applying an interest rate or per diem rate as

proxy for measurement. This is because the buyer takes the

economic interests and risks from the Locked Box date but

does not pay the deal price until completion date.

This guidance note gives company secretaries and governance professionals an overview of the locked box mechanism, which is becoming a common closing mechanism for mergers and acquisitions (M&A) transactions.

Public GovernanceMergers and Acquisitions Guidance NoteIssue 4 • October 2019

Locked Box vs Completion AccountsThe key difference between the two mechanisms is the timing

of the transfer of the economic interests and risks arising from

the target’s business. The transfer of risks and rewards takes

place earlier under the Locked Box approach at the Locked Box

date compared to at completion date under the Completion

Accounts approach.

If the Locked Box is properly locked and there is no unpermitted

leakage to the seller, other than the net profit generated from

the operation, the working capital movement in the gap period

should mirror the net debt movement at completion. In such

case, neither party wins or loses. The pricing considerations

would be the same under the two approaches, but the timing

differs. Both parties can benefit from the cost-savings due to

the simplicity of the SPA under the Locked Box approach.

Please refer to the ‘Locked Box vs Completion Accounts

illustrative process’ graphic for more details of the deal

process under the two mechanisms, as well as the ‘Locked

Box vs Completion Accounts key SPA features’ graphic for a

comparison table of the key SPA features.

Locked Box vs Completion Accounts illustrative process

Locked Box

CompletionAccounts

Ultimate cash consideration includes compensation for gap period cash flows

Locked Box’s time line

Completion Accounts’ time line

Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18

Equityprice agreed

Enterprise value

agreed

Adjustment basis for debt and working capital agreed prior to signing, but the actual adjustments are made

after signing based on completion accounts

Completion accounts prepared

Leakagereview

No adjustment, unless there has been unpermitted leakages

Completion accounts review process

(as defined in SPA)

AuditedFY17

Accounts

Due diligence and SPA drafting

SPAsigned

Completion

SPA Signing Date

SPA Signing DateReference Date

Locked Box Date

Key date when economic interest/risk passes to Buyer

Completion Date

Completion Date

No unpermitted leakage of value from the locked box date

Adjustments for debt and working capital agreed prior to signing based

on historical balance sheet

Public GovernanceMergers and Acquisitions Guidance Note

When to use Locked Box over Completion Accounts?The Locked Box mechanism is particularly attractive for

transactions where the parties value greater certainty on the

transaction price (for example, existence of private equity or

financial sellers), or when a quick integration is required post-

completion. It also provides a way for the seller to minimise

the risks and complexities of post-deal negotiation with the

buyer, who may attempt price-chipping (that is, bridging a

value gap through Completion Accounts adjustments).

However, the adoption of the Locked Box mechanism relies

heavily on the buyer’s confidence in the quality of the Locked

Box balance sheet and how leakage is controlled, that is

how the box looks and whether the box can be effectively

locked. It is also crucial for the buyer to ensure that there

are adequate systems in place to identify leakage post-

completion. The buyer’s confidence level could be affected

by:

• strength of target’s finance function

• quality of financial information

• existence of any independent reviewers (for example,

audited accounts) and their competency

• complexity of the deal (for example, carved-out business)

• provisions for Leakage review/completion review post-

completion, and

• confidence in the profitability/performance under the

seller’s control in the gap period.

Further steps to consider for a Locked Box mechanism1. Effective date – setting the Locked Box dateAn appropriate Locked Box Date is essential to a successful

Locked Box mechanism. The financial year-end date is a popular

choice, as the accounts will have been subject to an audit or

independent review, with key metrics in transactions (including

working capital and net debt) readily available. It offers higher

comfort to the buyer while saving time for the target’s finance

function to prepare additional information. However, it is also

important to consider whether there will be a long gap between

the last audit/review date and the proposed completion date,

so as to minimise the risk of Leakage and changes in business

performance or structure. At the same time, both parties should

agree on a reasonable time period for the due diligence process

of financial statements as at Locked Box date.

2. Protecting the buyer – leakage and permitted leakageAs discussed earlier, the buyer should seek protection through

the SPA against any form of value extraction from the business

during the gap period. To address the buyer’s concern, the seller

will normally deliver indemnities, accompanied by covenants/

warranties in respect of the leakage. Generally speaking, the

greater the uncertainty, the more the buyer would like the seller

to provide warranties in the SPA with a broader definition of

leakage as protection. This may make negotiations harder, as

the seller may be reluctant to agree. Examples of leakage and

permitted leakage are set out in the following graphic.

Issue 4 • October 2019

Locked Box vs Completion Accounts

Key SPA features

Areas Locked Box Completion Accounts

Price • Fixed equity price • Enterprise value agreed but subject to completion adjustment to come up with the equity price

Priceadjustments

• Known amount of price adjustments for cash, debt and working capital at completion, agreed prior to signing

• Definitions of cash, debt and working capital are agreed prior to signing, amount is uncertain until completion

Reference of balance sheets

• Based on historical balance sheet • Adjustments for cash, debt and working capital are based on a completion balance sheet prepared after closing

Leakage • Seller provides indemnity and affirms that there will be no “leakage” from the locked box date

• Leakage concept is irrelevant. SPA is likely to contain ‘conduct of business’ provisions

Completion review

• No completion accounts and associated review process and no adjustment to purchase price after closing

• Process/mechanism for preparing, reviewing and agreeing completion accounts is set out clearly in SPA

Public GovernanceMergers and Acquisitions Guidance NoteIssue 4 • October 2019

Leakage Permitted leakage

• Dividends and distributions/return of capital.

• Payments to directors and their connected persons.

• Deal-related costs, such as:- fees and expenses incurred in connection with the sale

(for example fees to advisors), and- bonuses paid to staff (subject to closing of deal).

• Non-ordinary course intra-group payments or payments for services (not on commercial/arm’s length terms).

• Waiver of amounts due from seller(s).

• Discount on transactions to related parties.

• Intra-group payments in the ordinary course of business and on arm’s length terms.

• Any payments provided for in Locked Box accounts (and therefore priced) or indemnities.

• Items agreed prior to signing

• Payment/commercial basis increment of employee remuneration/wages in the ordinary course of business.

• Matters specifically agreed between the two parties

3. Compensating the seller – per diem and interest rate (value accruals)From the Locked Box date – when the economic

interest has effectively passed to the buyer – the

buyer is entitled to enjoy the benefit of cash profits

generated from the business. In contrast, the seller

incurs an opportunity cost, as it will not receive any

benefit from operating the business in the gap period

and will not receive transaction proceeds until the

completion date. To compensate for the delayed

payment (or the loss of profits in the gap period), the

seller will typically demand either:

(i) an interest charge on the unpaid portion of the

equity price, reflecting the seller’s loss for not

having received the proceeds at Locked Box date,

or

(ii) a proxy for the profits earned (for example per

diem/daily rate) during the gap period.

These two ways of interpretation may give rise to different

compensation for the opportunity cost – that is the loss of

interest income from the proceeds or the loss of profit from

the business, of which the return rate can be higher or

lower than the interest rate. Either method should reflect

the expected ‘cash profits’ of the target or the opportunity

cost from the sales proceeds after the Locked Box date,

not the operating cash flow. No matter how this is agreed

between the buyer and the seller, this calculated accrued

value, plus the purchase price (equity value) shown in the

Locked Box SPA, forms the final consideration for the deal.

Pros and ConsIn summary, it may appear to be more advantageous for

a seller to adopt a Locked Box mechanism. However, if

appropriate comfort can be offered to the buyer over the

integrity and accuracy of the Locked Box balance sheet,

accompanied by sufficient warranties and indemnification

over the Locked Box accounts, the mechanism can still be

attractive to the buyer.

Public GovernanceMergers and Acquisitions Guidance NoteIssue 4 • October 2019

The Hong Kong Institute of Chartered Secretaries (HKICS) 香港特許秘書公會(Incorporated in Hong Kong with limited liability by guarantee)

Disclaimer and CopyrightNotwithstanding the recommendations herein, this publication is not intended to constitute legal advice or to derogate from the responsibility of HKICS members or any persons to comply with the relevant rules and regulations. Members and readers should be aware that this publication is for reference only and they should form their own opinions on each individual case. In case of doubt, they should consult their own legal or professional advisers, as they deem appropriate. The views expressed herein do not necessarily represent those of HKICS. It is also not intended to be exhaustive in nature, but to provide guidance in understanding the topic involved. HKICS shall not be responsible to any person or organisation by reason of reliance upon any information or viewpoint set forth under this publication, including any losses or adverse consequences consequent therefrom.

The copyright of this publication is owned by HKICS. This publication is intended for public dissemination and any reference thereto, or reproduction in whole or in part thereof, should be suitably acknowledged.

The members of the Takeovers, Mergers and Acquisitions Interest Group are: Michelle Hung FCIS FCS (Chairman), Dr David Ng FCIS FCS, Henry Fung, Kevin Cheung, Lisa Chung, Patrick Cheung and Philip Pong. Gratitude is expressed to PY Chui, Partner, Advisory Services, PwC, and Margot Lam, Deals Services, PwC, as the authors of this paper. Mohan Datwani FCIS FCS(PE) serves as secretary. Please contact Mohan Datwani, Senior Director and Head of Technical & Research, HKICS, if you have any suggestions about topics relevant to this interest group at: mohan.datwani@hkics.org.hk.

Ultimately, the pricing considerations and mechanisms are

the same for Locked Box and Completion Accounts. Both

mechanisms end up with the buyer paying the seller the equity

price (that is, enterprise value adjusted for cash, debt, and

difference between the target and actual working capital).

However, different mechanisms should be selected under

different circumstances. A wrong choice can make negotiations

complex, or may even risk failure to complete the deal. It is

therefore important to make wise decisions to protect your

interests. HKICS

Pros-seller

• Gives certainty of price, resulting in ability to distribute process quickly.

• Encourages less aggressive interpretations of potential debt items in an auction process.

• Avoids post-deal negotiations by buyers.

• Greater control of the deal process.

• Consistency with previous accounting policies – there is no debate over completion accounts policies pre-completion.

• Time saving – no management time spent debating completion accounts post-completion.

• Cost saving – no completion mechanism process.

• Beneficial if the business is loss making.

Cons-seller

• Difficult to apply where there is no separately identifiable balance sheet (for example, carve-out business).

• Requires a competent finance function with sufficient deal-related knowledge.

• Loses out if post-Locked Box interest rate is set too low (especially for fast developing business).

Pros-buyer

• Gives certainty of price.

• Cost saving – no completion mechanism (we do however recommend leakage reviews are completed).

• Time saving – allows quick integration post-completion.

Cons-buyer

• Needs to consider reliability of Locked Box accounts (subject to audit/review by client’s auditor).

• No completion mechanism to exploit – need to rely on warranties.

• Limited ability to get management on-side while bearing the business risk in the gap period without any control.

• Risk of business deteriorating (or operating loss) between Locked Box date and completion.

• Subsequent leakage review may be restricted if the deal is an acquisition of minority interests.

• Requires quick understanding of debt and working capital for earlier debate of price adjustments.