Price adjustment and locked box in purchase and sale transactions
In M&A transactions or company sale and purchase agreements, the price determines the most relevant business circumstance. However, given the length of time required for this type of transaction, it is difficult to establish a balanced price from the outset. Bear in mind that the company’s activity continues while negotiations are ongoing, so that changes in the company’s growth may in turn determine changes in its valuation.
To prevent negotiations from being frustrated by this circumstance, or to avoid requiring constant negotiation of the price each time the company’s economic results change, it is advisable for the parties to agree on a price determination criterion at the outset. In this way, the final price can be adjusted according to changes in the company’s situation.
The most common formulas for determining the final price are the price adjustment or completion accounts (variable price or adjustment variable) and the locked box (closed box). In this article, we will analyze the main differences between these two formulas, their advantages and disadvantages, and their use in the current context of intercompany transactions.
The price adjustment is a clause that allows the price of the transaction to be determined based on the company’s financial results in a subsequent period, usually referring to the closing date of the transaction (closing).
The main benefit of the price adjustment is that it allows the parties to adjust the transaction price based on the financial reality of the company after closing, which can be particularly useful in situations where the company’s situation is uncertain or constantly changing. In addition, this formula may be desirable to incentivize the seller to maintain good management of the company while negotiations are ongoing, and especially during the interim period between signing and closing, since their final price compensation depends in part on the financial results at closing.
On the other hand, the main disadvantage of the price adjustment is that its calculation can be complex and subjective, which can lead to disagreements and disputes between the parties. In addition, this type of clause can be less attractive to the seller, as he does not know exactly what the final compensation will be, which can make long-term financial planning difficult.
It will always depend on the specific case. A seller who has full confidence in the growth of his company will have an additional incentive to enter into a price adjustment agreement, which will allow him to increase his revenue expectations due to the positive drift of the financial statements.
The locked box, on the other hand, is a clause that establishes a fixed price for the company at a date prior to the closing of the transaction (for example, the date of the audit or the date of signing of the contract – signing), and which excludes any variation in the subsequent financial result. In these cases the final price will be the price agreed from the outset, regardless of the company’s financial results at the conclusion of the negotiations or at the date of closing.
The main advantage of the locked box is its simplicity and transparency, as the price is set in advance and there is no need for post-closing calculations or adjustments. In this sense it can be a more attractive solution for the seller, as it provides immediate financial certainty and is not subject to possible disputes or subsequent readjustments. However, as noted above, you will also not be able to increase the price if the company’s results improve.
Conversely, for the buyer, it may be less attractive in situations where the company’s financial situation is uncertain or constantly changing. In addition, the locked box may discourage the seller from continuing to manage the company once the terms have been agreed, since his final price compensation does not depend on subsequent financial performance.
In practice, the appropriateness of the price adjustment versus the locked box will depend on the specific circumstances of the transaction. For example, if the company is in a highly competitive and constantly changing industry, the price adjustment may be more appropriate to better reflect changes in the market. On the other hand, if the company has a more stable position, the locked box may provide greater price certainty and transparency without the risk of causing excessive imbalance.
The locked box formula means that it is not necessary to prepare new financial statements at the time of closing, nor to check the company’s fundamentals again. But there is a risk that the seller has made accounting movements during the interim period (the period of time between signing and closing). To this end, and when working with a locked box agreement, it seems reasonable to require the seller not to make cash outflows or collection of items not contemplated and agreed with the buyer. And all this under the warning of qualifying such actions as improper leaks, more commonly known as leakage, unless they have been expressly authorized by the buyer (permitted leakage). The SPA, or purchase and sale contract, must contemplate the regulation of penalties in case of breaches of this nature by the seller.
It should be noted that, although price adjustment and locked box are different formulas, they can be combined in the same purchase and sale contract. For example, a locked box approach can be used to establish an initial price, and then a price adjustment can be agreed to reflect specific changes in the company’s financial situation after closing. In this case the changes would not affect the entire price, but only a portion of it.
In conclusion, both the price adjustment and the locked box are useful clauses for adjusting the price in business purchase and sale contracts. Each has its own advantages and disadvantages, and the choice will depend on the specific circumstances of the transaction. It is important that the parties negotiate price adjustment clauses carefully to avoid disputes and ensure a successful and balanced transaction.
José Luis Casajuana Ortiz
Socio de J. L. Casajuana y responsable del área internacional
08/05/2023
