Locking the Box to Avoid Price Chipping
Traditionally, change in control transactions in Canada involving private targets have been completed using a "closing accounts" pricing mechanism under which the parties agree to an enterprise value (often an EBITDA multiple) and a price on a "cash free, debt free" basis. Consideration paid on closing is based on estimated values which are then subject to a post-closing true up.
The percentage of transactions using post-closing purchase price adjustments in Canadian deals remains high and a significant number of these transactions utilize more than one adjustment metric. As suggested in Andrew Wong's May 26 post it is not uncommon for buyers to use the post-closing adjustment mechanisms for more than just "truing up" the value of the target. Some buyers see the closing accounts process as an opportunity to bridge some of the value gap through post-closing "price-chipping". The greater the disparity between buyer and seller with respect to bargaining power and financial resources, the greater the risk that the post-closing adjustment process will result in a fundamental renegotiation of purchase price.
In certain circumstances, a closing accounts pricing mechanism may actually inhibit the completion of a transaction (i.e., if the parties cannot agree on the target working capital amount, if there is no consensus on how to calculate normalized working capital or normalized EBITDA, or if the seller perceives an EBITDA adjustment as a penalty clause). In these scenarios, an alternative deal structure may be needed in order to achieve consensus ad idem and to get the transaction over the goal line. Rather than using a closing accounts pricing mechanism, the parties may choose to use a "locked box" pricing mechanism.
Simply put, a locked box deal is a fixed price deal. Rather than calculate purchase price with reference to an enterprise value as adjusted at closing, a locked box pricing mechanism fixes an equity value at the time of signing, calculated on a historical balance sheet at a pre-signing date (the "Locked Box Date"). Because cash, debt and working capital are determined amounts at the Locked Box Date, the final adjusted price (i.e., equity value) is agreed upon by the parties and written into the purchase and sale agreement. In order to protect against value leakage (any form of value extraction from the target business including, without limitation, dividends, management fees, transfer of assets, waiver of non-arm's length liabilities) between the Locked Box Date and the closing date, the buyer typically requires a robust suite of representations, warranties and covenants pertaining to the interim period.
A locked box pricing mechanism differs from a closing accounts pricing mechanism more in terms of timing than the way in which a target is valued. Because economic exposure to the target transfer from the seller to the buyer at the Locked Box Date (rather than the closing date), in current market conditions it may be difficult to maximize shareholder value through a locked box pricing mechanism outside of an auction process. That being said, accepting a slightly lower equity value in return for price certainty may economically favourable.
Purchase and sale agreements that utilize a locked box pricing mechanism are typically expected to be considerably less complex documents given that they do not include any post-closing adjustment mechanisms; however, to ensure that the locked box pricing mechanism does not unfairly prejudice buyer or seller, the purchase and sale agreement may have added complexity in other areas. Most notably:
- Seller Retains Legal Ownership. Under a locked box pricing mechanism, the buyer prices the target as at the Locked Box Date. Thereafter, the buyer accepts the risk and reward of owning the target in economic terms. The seller will continue to own the target until the closing date in legal terms. Some commentary suggests that the seller will behave differently during the interim period and be less inclined to maximize the target's performance. The counter to this suggestion is that a well drafted "ordinary course" covenant coupled with a "material adverse change" condition precedent (plus the seller's desire to complete the transaction) should be ample motivators. To mitigate the risk which arises as a result of having economic ownership but not legal ownership, the buyer will typically seek a strong suite of covenants with respect to the operation of the target's business during the interim period. In many instances this suite of covenants will not be substantially different from those required in an agreement utilizing a closing accounts pricing mechanism; however, the buyer may seek additional involvement in operating decisions and may require a higher level of reporting during the interim period. With the exception of covenants pertaining to leakage, the seller should be wary to accept overly onerous covenants pertaining to the operation of the target during the interim period.
- Seller Loses Economic Ownership. Because the seller loses the benefit of the cash profits generated by the target after the Locked Box Date, the seller may seek compensation for this opportunity cost. To achieve this compensation, the seller may require a proxy for profits by way of pre-determined payment from the buyer. The amount payable should represent the cash profits of the target generated after the Locked Box Date (not the operating cash flow).
- Permitted Leakage. The locked box pricing mechanism requires the purchase and sale agreement to contain safeguards against leakage (any form of value extraction from the target business including, without limitation, dividends, management fees, transfer of assets, waiver of non-arm's length liabilities). That said, if certain leakage is required, for example the payment of dividends in conjunction with a pre-closing reorganization, such "permitted leakage" should be clearly identified in the purchase and sale agreement. Payments made in the ordinary course of business should not be considered leakage and should not impact price.
A locked box deal may not be appropriate in all circumstances; however, revisiting the structure of a transaction during negotiations may be a useful tool for bridging the valuation gap and protecting against post-closing price chipping.
Invitation for Discussion
If you would like to discuss this article in greater detail, or any other business law matter, please do not hesitate to contact one of the lawyers in the Business Law group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encourage to seek proper legal advice.