A Grant Thornton report looks at some of the leading causes of post-closing disputes in M&A transactions and provides insight into how to prevent them. The report surveyed deal professionals & found that the top areas of post-closing disputes were working capital adjustments, earnouts, and debt price adjustments.
According to the report, using a locked box mechanism was the most frequently cited method of avoiding post-closing disputes. This excerpt describes a typical locked box arrangement & how it contrasts with the typical approach to establishing the total consideration payable in U.S. deals:
The traditional approach to establishing the total consideration for a deal is to measure cash, debt and working capital as of the closing date. This ensures that the balances are accurate as of that date, but it cannot be done until after closing – and sometimes this can be a lengthy process, particularly when disputes arise.
Difficulties can occur when the preparer discovers balance sheet items that had previously not been discussed or considered, undisclosed or unidentified liabilities, or the valuation of assets may be called into question – and parties need to work together to derive the equity value adjustments. As the locked box mechanism (LBM) measures cash, debt and working capital at a historic balance sheet date, the parties have full clarity on the purchase price adjustments prior to signing the deal. Parties can even agree on these terms prior to signing exclusivity, perhaps including a locked box purchase price bridge at the Letter of Intent stage.
The purchase price adjustments are “locked in” as of an effective date and the parties mitigate the need to recalculate these post-closing. By omitting a post-close adjustment, the parties can alleviate the risk of post-close disputes arising. The date of the locked box balance sheet used to derive the price adjustments must be carefully considered. Sufficient time will be necessary to prepare an accurate set of accounts, but this should not be so long that it no longer accurately represents the business, and there is an increased risk of leakage during the period to closing. If timing permits, it can be advantageous to use an audited set of financials, though this is not necessary.
The seller will typically provide a warranty to the buyer as to the accuracy of the locked box balance sheets. If the locked box is subsequently found to be inaccurate, the buyer may be able to make a warranty claim for losses suffered as a result. While this may not offer the same level of protection as the closing balance sheet process, there are typically fewer disputes around this when compared to the traditional method.
The report acknowledges that many US dealmakers are not familiar with locked box mechanisms, but says that when used effectively, they provide a number of benefits not found in the traditional closing balance sheet approach. These include avoiding the need to prepare, review and fight about the closing balance sheet, permitting buyers to focus on post-closing integration & operations of the business, and allowing sellers to receive full payment at closing.
-John Jenkins, DealLawyers.com January 29, 2021
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