Demand for assets provides sellers leverage to lock prices pre-closing

Private M&A may see more “locked box” arrangements as sellers look to secure deal certainty in a seller-advantaged market; but the mechanism may yet see conventional use in the broader Canadian business context, according to some experts.
Demand for assets provides sellers leverage to lock prices pre-closing
Stefan Stauder

An uptick of strategic buyers for top assets will increase the likelihood of more seller-favourable “locked box” arrangements in the private M&A space in 2015, according to some experts.

To “lock the box” in a private M&A transaction is to secure a final purchase price between a buyer and a seller before formally closing a deal. In the conventional “completion accounts” mechanism, by contrast, the purchase price is finalized only after closing, when all balance sheet audits and necessary pricing adjustments are made.

“There’s definitely an uptick in these structures, certainly in the last year, probably the year before as well,” says Stefan Stauder, a lawyer in the New York office of Torys LLP. “I think it’s just an outgrowth of the very frothy sellers’ market that we’ve seen continue in 2014.”

Jamie Avey, an M&A partner at Deloitte in Calgary, says his firm has seen locked box arrangements more commonly in resource-based transactions, such as upstream oil and gas deals. He says this is because resource-based companies have reserve reports – estimates of remaining quantities of the assets expected to be recovered – that can provide a good starting point on valuing the company, where bid and ask price gaps can be the biggest hurdles to completing a deal.

Lawyers at Torys LLP suggest that this trend of “locking the box” can be expected to continue in their annual M&A Top Trends 2015 bulletin, published January 2015. According to the bulletin, there were examples of the mechanism used in the early 2000s in the UK and it made inroads in North America in 2005-2007.

The firm observes that, in the US, there is a competitive market for buyers, as “there’s been a lot of capital chasing, quality assets…overhang in the private equity market; there’s a lot of capital available for strategic players; time is one where sellers have been able to not only extract top dollar for top assets, but also impose very seller-favourable terms,” Stauder says.

“In the conventional private M&A deal, the classical purchase price adjustment structure is probably the one piece of deal architecture that lends itself to disputes following the closing, so much more so than indemnification claims,” Stauder says. “There’s a lot of built-in potential for disagreeing.”

Disagreement in the conventional structure can stem from differing views on the accounting work. In the process, the seller estimates working capital and adjustment items, such as cash and indebtedness, at closing, while the buyer prepares a closing balance sheet of its own, which can elicit disagreements from the seller requiring the parties to hire a third-party accountant to resolve it, according to Stauder.

This conventional structure is unlike the public M&A process, where post-closing price adjustments are not practical.  “In a public company context, there’s never been a practical way to achieve any sort of purchase price adjustment to say to shareholders after closing, ‘well, OK, we’re going to calculate the balance sheet as of closing and do an adjustment for any cash that may have leaked out,’” says Thomas Yeo, a lawyer in the Toronto office of Torys LLP. In essence, companies in a public M&A already agree to a price per share for the company when they go firm, so anything that happens between then and closing becomes irrelevant to the agreed share price, Yeo adds.

Much can happen between going firm on a deal and actual closing in the private space. A seller can dividend-out cash in the business, give bonuses to employees, pay management fees to the seller, and compensation can be increased – all “leakage” scenarios that the buyer and its counsel are under a lot of pressure to address in its due diligence, according to Yeo.

“Buyers need to protect themselves around things like shareholder dividends, management fees, divestment transactions, other asset transfers, anything where you’re basically taking something out of the 'box' in the balance sheet outside of the business that the buyer won’t be getting at closing,” Avey adds. “They’re effectively expecting everything that they see in the balance sheet on the locked box date to effectively be married or in the business at closing.”

It can take approximately four months for a deal to close, according to Stauder. Ultimately, the buyer has only one shot at getting its due diligence right before locking in its final purchase price. “Buyers need to spend a fair bit of time scrubbing that reference balance sheet; everything is riding on getting it right at that point in the deal; there isn't sort of the second bite at the apple that you have in the conventional structure,” Stauder says.

The locked box mechanism is a seller-friendly arrangement that can disadvantage the buyer willing to take on the risk of paying accounting and legal costs upfront for a deal that could fall through at closing; or paying for a company where its working capital, for example, drops substantially from the locked box date to closing.

Jon Levin, a lawyer at Fasken Martineau DuMoulin LLP, offers another potential problem that can occur between when a purchase price is locked to closing – that of aligning interests.

Once a price is locked in the box, Levin asks, what is the motivation on the part of management to continue running the company with the same effort when now there is no risk?

“What we’re dealing with is, who assumes risk when?” Levin says. “And generally speaking, the danger of the locked box mechanism is the buyer is assuming the risk but doesn't have any management control or only has limited management control through covenants and doesn’t have the level of visibility and scrutiny that a buyer would typically have or that would exist in a public company environment.”

Avey says that there would be more alignment between buyer and management under the traditional completion account mechanism because both buyer and management are seeing through to the deal from agreement to closing; but says there can be some ways to salvage some of that after locking the price.

“Typically there is compensation to the seller for locking in a price at a locked box date because they’re going to get the proceeds at closing, so there are ways of keeping things aligned in that respect,” Avey says. “So, for example, there might be interest paid on the purchase for the period of the locked box date, or there could be ... a proxy for the cash profits during the period, or your change in net assets can help keep them aligned to make sure that there isn’t value erosion.”

Stauder says the current situation with oil has thrown a monkey wrench into the mix, but says he expects these arrangements to persist in other industries.

Avey says that his firm sees more completion accounts used in more traditional sectors, such as energy services and manufacturing, because it’s the mechanism that people understand.

As such, despite what Torys is calling a continuing trend in Canadian private M&A in the past couple of years, the experts say the mechanism is unlikely to be the primary method of dealmaking in the Canadian M&A landscape. 

“The vast preponderance of deals in my experience are done with an audit and price adjustment measured as at closing,” Levin says. “I think that the risks associated with a locked box arrangement are such that they will typically be very much the exception.”

Lawyer(s)

Thomas H. Yeo Stefan P. Stauder Jon Levin