Completion Accounts and Locked Box

Question 1

Explain completion accounts to a client

Answer 1

• The price for the shares is based on the actual financial position of the business at completion and as such, risk and reward in the business only transfer to the buyer at completion.
• That price is subject to certain adjustments, usually for cash, debt and working capital, which is determined in accordance with accounting policies and procedures that will be agreed and set out in the SPA.
• Because it won’t be possible to work out what the financial position of the business is on the day of completion, an estimate of the purchase price is paid on completion which is usually based on the seller’s good faith estimates of the adjustments.
• Then after completion, completion accounts will be prepared to show what the actual cash, debt and working capital position of the company was on completion, and what the actual purchase price is.
• Once the actual purchase price has been determined, there would likely need to be a true up payment (from the seller to the buyer or from the buyer to the seller), of the difference between the estimate of the purchase price that was paid on completion and the actual purchase price.
• In addition to setting out the accounting policies and procedures that the buyer and the seller have commercially agreed will be used to calculate the purchase price price, the SPA will set out how the purchase price will be determined if the buyer and seller don’t agree it. Usually, by expert determination by one of the big four accountancy firms.

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Question 2

What are the key advantages of using completion accounts?

Answer 2

• Ability to true up - buyer only pays for what it will get (buy side)

More of an advantage if there is an expectation / risk the business will deteriorate before completion.

• Price chip - potential to price chip post- completion and test valuation assumptions (buy side)
• seller gets economic benefit of business until completion and receives profit until then (contrast with LB where there might be a ticker from LB date to completion).

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Question 3

What are the key disadvantages of using completion accounts?

Answer 3

1 - Price uncertainty - equity price not known until after completion.

2 - SPA - more complex, focus on accounting policies, accounts process and disputes process.

3 - Cost - management time and advisors’ costs (lawyers and accountants)

4 - Disputes - scope for disputes/manipulation/price-chipping

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Question 4

What hierarchy of accounting policies is typically used for completion accounts?

Answer 4

1. Specific policies agreed between the parties
2. Consistency with statutory or management accounts
3. Applicable GAAP.

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Question 5

What are specific accounting policies?

Answer 5

Where the parties agree a specific accounting treatment to be used in the completion accounts for certain items (which may not necessarily be in accordance with the last accounts or GAAP)

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Question 6

When might a specific accounting policy be required?

Answer 6

• To deal with ambiguous or subjective areas - eg bad debt provision or litigation provision.
• Where an item did not exist when the statutory/management accounts were prepared
• Where there is a commercial agreement between the parties to treat an item in a particular way.

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Question 7

What would the completion accounts schedule typically comprise?

Answer 7

Four parts

1 - hierarchy of accounting policies
2 - specific accounting policies
3 - form of completion accounts
4 - mechanics for preparation, review and determination of the completion accounts

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Question 8

What are cash equivalents

Answer 8

• investments that mature within 3 months meaning they can be easily liquidated to generate cash
• therefore generally treated as equivalent to cash

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Question 9

List examples of cash equivalents.

Answer 9

Will be specific to the target business but examples may include:

• Short-term bonds
• Treasury bills
• Marketable securities
• Money market instruments
• Commercial paper

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Question 10

What is cash collateral?

Answer 10

Cash that is subject to a security interest - eg held in a blocked account, a rent deposit

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Question 11

What are examples of trapped cash?

Answer 11

1 - regulatory capital
2 - cash collateral
3 - cash in an overseas subsidiary that cannot be extracted from that jurisdiction (eg dividend block)
4 - cash in tills / cash floats
5 - cash in transit

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Question 12

What is the buy-side perspective on cash acquisition?

Answer 12

1- Narrow definition is better as cash increases the purchase price

2 - Exclude trapped cash

• only pay for cash that is freely available in the business

3 - Avoid paying for excess cash

• increases stamp duty liability
• esp commercially undesirable if using debt funding to pay PP
• consider cap on cash on completion

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Question 13

What is the sell-side perspective on cash?

Answer 13

• will want cash to include cash and cash equivalents
• broad definition is better as cash increases the purchase price

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Question 14

Why use completion accounts

Answer 14

1 - buyer friendly
2 - uneven past performance - eg Covid, Ukraine, energy price affected
3 - carve-out
4 - complex working capital / net debt position

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Question 15

When doing working cap come back to page 7/8 plus add pic of manipulation of working cap example

Question 16

Why is a ticker sometimes included in locked box deals?

Answer 16

• Mechanism to pay the seller for value created in the target group from the LB date to completion
• Provides the buyer with an incentive to satisfy the conditions as soon as possible

NB: charged on the equity value

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Question 17

Why do PE sellers prefer locked box?

Answer 17

It gives certainty of price at completion and certainty of the amount they can distribute to LPs following completion.

Therefore helps them achieve a better IRR.

The equity price is written into the SPA on a LB deal.

On a CA deal, an estimate of the equity value is paid on completion but the actual equity value is only known after completion.

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Question 18

Are balances between target group entities covered by the SPA?

Answer 18

No, they do not need to be and should not be covered by the SPA.

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Question 19

What does the SPA typically provide regarding trading amounts between the target group and the seller’s retained group?

Answer 19

• That they will be settled after completion in the ordinary course / in accordance with their terms.
• They would be part of working capital if a completion accounts adjustment was being made (not treated a debt)

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Question 20

What does the SPA typically provide regarding payables/receivables between the target group and the seller’s retained group?

Answer 20

• That they will be settled [ at ?] completion by the relevant target group company or the seller/buyer on trust for the relevant target group company and treated as ‘Debt’.
• ie the enterprise price will be reduced by an amount equal to the net intra-group debt balance - ie having netted one off the other

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Question 21

What would the equity value be if a client agrees on an enterprise price of £100 million if there was £0 cash and £20 million of debt?

Answer 21

£80 million.

The client would receive £80 million for the shares, and the holder of the debt would receive £20 million for the debt.

If shareholder debt rather than external debt, client gets the full £100 million.

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Question 22

What is Enterprise Value?

Answer 22

How much you would pay to buy an entire business (the PP), typically based on a multiple of EBITDA.

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Question 23

What does Enterprise Value include?

Answer 23

The target’s debt

So it often reflects the total cost to the buyer of the acquisition, if some of the purchase price paid by the buyer will be used to repay target debt.

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Question 24

What is the formula for calculating enterprise value?

Answer 24

Enterprise vale = Equity value + debt less cash

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Question 25

What is equity value?

Answer 25

What the shareholders would receive on a sale at the enterprise value after the debt is repaid. Checked

Question 26

What is the formula for calculating equity value?

Answer 26

Equity value = enterprise value less debt plus cash Checked

Question 27

What is the buy side approach to debt in the context of the completion accounts?

Answer 27

To have a broad definition of debt as debt will be deducted from the enterprise value and reduce the purchase price. Push for - debt equivalent/debt like items to be treated as debt - eg deferred consideration - additional items to be commercially agreed to be debt - eg litigation Checked

Question 28

What is the sell side approach to debt in the context of the completion accounts?

Answer 28

To have a narrow definition of debt as debt will be deducted from the enterprise value and reduce the purchase price. Checked

Question 29

What are examples of items that are generally accepted to be debt?

Answer 29

- bank loans - break fees/repayment fees - overdrafts Checked

Question 30

What are examples of items that may be commercially agreed to be debt like / debt equivalent or may be treated as debt?

Answer 30

- invoice discounting - transaction costs - deferred consideration - pension deficits - transaction bonuses - litigation - unspent capex vs budgeted capex - declared but unpaid dividends checked

Question 31

What is working capital?

Answer 31

Current operating assets less current operating liabilities Shows a company’s short term financial health Assets that can be into cash within 12 months Liabilities that mature within 12 months Checked

Question 32

What are current operating assets

Answer 32

- stock/inventory - trade debtors eg. receivables from customers unpaid bills - prepayments eg rent or insurance premiums paid in advance Checked

Question 33

What are current operating liabilities?

Answer 33

- trade creditors - eg unpaid supplier bills - accrued expenses eg utility bills - payroll liabilities - eg unpaid salary/wages Checked

Question 34

What will a buyer’s concern be in relation to the target’s working capital?

Answer 34

1 - comfortable target can continue to operate normally after completion 2 - avoid need for a cash injection immediately after completion Checked

Question 35

How could a seller manipulate the working capital position?

Answer 35

Could increase cash by: - delaying payments to suppliers (ie don’t pay cash out - collecting debts early from customers (ie get more cash in) Checked

Question 36

What should the buy side consider in relation to the initial cash consideration?

Answer 36

If security for payment is required This may be a concern if there are a large number of sellers or concerns re the seller’s credit strength. An option to address this would be escrow arrangements (esp if multiple individual sellers) or parent company guarantee. Checked

Question 37

What should the sell side approach be to matters disclosed in the context of the completion accounts?

Answer 37

Ensure that no provisions are included in the completion accounts accounting policies for any matters that have been disclosed. On the basis that the buyer should: 1 - accept the risk 2 - factor the potential liability into its headline price, or 3 - request an indemnity Checked

Question 38

Explain locked box to a client

Answer 38

- The buyer and seller agree a fixed price for the business on the basis of commercially agreed accounts. - The accounts might be the target’s last audited accounts, but they don’t necessarily have to be. - The agreed price for the business is written into the SPA, and as such the equity value for the business is agreed when the SPA is signed. - As the buyer will take the risks and rewards of the business from the date of the agreed accounts, protections will be included in the SPA to ensure that value is not extracted from the business to the seller (or its group) after the accounts date. - The seller would agree to pay the buyer on a pound for pound basis for any value leakage other than permitted value leakage. - On completion, the buyer would pay the equity value (sometimes plus interest from the LB date), less any leakage. - There would be an agreed period of time after completion for the buyer to make a leakage claim. NB: - The buyer needs visibility on actions taken since the LB date to completion so that it can be comfortable that there has been no value extraction to the seller since then. - As there’s no post-completion price adjustment, the integrity of the financial information is key, and the buyer must get comfort from diligence before signing with the price it is paying that they there has been no leakage since the LB date. - Typically would expect the LB date to be no more than 9 months before SPA signing.

Question 39

What are factors to take into account when assessing whether to use a LB or CA pricing mechanism?

Answer 39

1 - carve out / not standalone / reorganisation 2 - improve / decline 3 - integrity of financial information 4 - uneven past performance 5 - long period to completion 6 - complex working capital / net debt position 7 - highly cyclical or high working capital variability 8 - distressed NB: 1 - if no standalone accounts for the target, makes more sense to use CA to ensure pay correct price

Question 40

What are the key advantages of using a LB pricing mechanism?

Answer 40

1 - Price certainty - fixed price at completion 2 - SPA - simpler 3 - Cost - less management and advisor time (preparing/debating accounts/drafting) 4 - Disputes - less scope for disputes, manipulation, price-chipping

Question 41

What are the key differences between LB and CA?

Answer 41

1 - When economic risk and reward passes from the seller to the buyer (CA - from completion, LB - from historic LB date) 2 - Price certainty - fixed price vs price adjusted after completion Checked

Question 42

What are examples of permitted leakage?

Answer 42

- dividends / distributions - RoC - debt waivers - transaction costs - deal bonuses checked

Question 43

What are examples of permitted leakage?

Answer 43

- ordinary course payments - eg salaries paid to employees of the target who are also shareholders - payments between the seller’s group and the target group in the ordinary course and on arm’s length - any items that are agreed pre-SPA signing or provided for in the LB accounts, and as such factored into the purchase price checked

Question 44

What approach might the buy side want to take to permitted leakage?

Answer 44

- ensure each permitted leakage item has a cap / specific value - is linked to a specific payment obligation - eg resist payments made in the ordinary course