What happens during a locked box pricing deal?

Quite simply, the buyer and seller fix the price by referring to historical financial accounts. It is a price certainty mechanism – not a price adjustment.

These records commonly consist of the most recent audited financial statements, although unaudited management accounts or specially prepared accounts may sometimes be used.

These records, known as “locked-box accounts,” establish the equity price based on the actual cash, debt, and working capital existing in the target business as at a historical date – called the “locked-box date”. This equity price is incorporated into the sale and purchase agreement (SPA).

Once the locked-box date is established, the target company operates in a manner that primarily benefits the buyer, particularly regarding financial risks. Any value or “leakage” that could benefit the seller is strictly prohibited from leaving the business. As long as the box remains locked, the purchase price outlined in the SPA remains unchanged, and there is no need for any adjustments or post-closing reconciliations.

This pivotal characteristic defines the essence of the “locked-box” mechanism: The buyer assumes the financial risks and rewards associated with the target company from the specified locked-box date onward.

Protecting the locked box

To assure the buyer that no value has been extracted by the seller or since the locked-box date, the SPA will include protective measures in the form of a dollar-for-dollar indemnity against any potential leakage.

In practice, the seller will assure that no value has been leaked from the business between the locked-box date and the closing date by giving a no-leakage covenant, supported by warranties, within the SPA. So, paying a dividend could reduce the price.

Permitted leakage and adjustments benefitting the seller

This covenant can also consist of agreed exceptions known as “permitted leakage”. This permitted leakage can cover payments to employees in the ordinary course of business.

As compensation for operating the business to the economic advantage of the buyer from the locked-box date until the closing date, the seller may occasionally negotiate an upward adjustment to the consideration to account for the “value accrual.” Typically, the target company’s cash flow during the locked-box date and closing is the foundation for determining this value accrual. Another approach involves applying an interest-based value accrual to the equity value, utilising an agreed rate of return for the seller during the period leading up to the closing date. This approach is sometimes referred to as a “ticking fee.”

The rationale behind these upward adjustments is that the buyer benefits from profits earned during the locked-box period without shouldering the burden of servicing the acquisition costs. However, it’s worth noting that the negotiation of adjustments for value accrual or ticking fees tend to be more intensive when the target company is incurring losses, and such adjustments are less prevalent in those cases.

When is a locked box beneficial?

  1. Stand-alone business: A locked-box approach is more suitable when the target business operates independently with distinct accounting records and reliable financial history. This applies even when the target comprises a group of companies, as long as a suitable “box” exists to be locked. On the other hand, if the seller possesses multiple businesses that are being divided (such as in a corporate carve-out or restructuring) or engage in numerous affiliate transactions, the locked-box approach becomes less fitting due to the heightened risk of value leakage.
  2. Seasonal fluctuations: Using a locked-box mechanism is less appropriate for a target business that experiences significant seasonal variations or exhibits uncertain short-term financial performance. These circumstances make it challenging to accurately price the seller’s compensation for operating the business during the pre-closing period.
  3. Deteriorating performance: From a buyer’s standpoint, a locked-box mechanism is less appropriate when there is a perceived risk of the target business’s performance worsening before the closing date.
  4. Extended signing-to-closing duration: If there is an expectation of a substantial time gap between the signing of the agreement and the closing, a locked-box approach becomes less suitable.


Key Considerations

Locked-box accounts

The integrity of the locked-box accounts holds immense importance. Audited accounts are preferred to instil confidence in the buyer as they involve third-party review and provide an opinion on the quality of those accounts. However, regardless of whether the accounts are audited, the buyer must conduct additional financial due diligence on the locked-box accounts. This is necessary to ensure that both the buyer and its advisers are comfortable with the basis of preparation and accuracy of the reports. If there are time constraints or limited opportunities to conduct financial diligence, the locked-box account approach may not suit the buyer.

Defining leakage and permitted leakage

The SPA will meticulously define “leakage” and “permitted leakage.” These terms serve as the buyer’s primary protection against value being drained from the target business by the seller or any affiliated parties. They establish the contractual basis on which the seller can make ordinary course payments, known as permitted leakage, between the locked-box date and the closing.

Typically, leakage encompasses any transfer of value from the target business to the seller or its affiliates during the locked-box period. This may include dividends, distributions, returns of capital, transaction expenses, payments to directors, deal-related bonuses, and other non-ordinary course intra-group payments.

Permitted leakage, on the other hand, depends on the nature of the target business but generally includes intra-group payments conducted in the ordinary course of business and on arm’s-length terms. It may also cover identified items agreed upon by the parties and factored into the purchase price (e.g., dividend strip/monitoring fee), payment of salaries in the ordinary course of business, and debt breakage costs, such as repaid bonds.

Funding considerations

As the closing approaches, third-party bank debt, intra-group debt, and cash balances in the target business may fluctuate due to factors like trading activities, interest accruals and payments, loan repayments, and additional borrowings. In a locked-box mechanism, the actual cash and debt levels in the business at closing are irrelevant for valuation purposes.

However, it’s important to note that the seller is not responsible for funding cash and debt requirements after the locked-box date. The buyer must arrange the necessary funds to facilitate repayment of existing intra-group debt payables at closing and potentially repay bank debt, depending on the change of control considerations and their financing structure. Additionally, the target business needs to maintain sufficient cash to support its ongoing operations. For buyers, especially those employing a leveraged finance acquisition structure such as private equity or other financial buyers, understanding the anticipated cash and debt movements and forecasting funding requirements at closing is crucial for properly structuring funding arrangements.

Tax safeguards

Sellers typically do not offer specific tax protection for the tax consequences arising from business operations after the locked-box date.

Addressing the intricate issues regarding the interaction between tax protections (such as a tax covenant) and the locked-box pricing mechanism necessitates in-depth discussions with the seller’s advisers.


Examining the particulars of each transaction is a crucial step that will reduce your risk and increase your likelihood of success:

  1. Thoroughly evaluate the transaction’s specifics as well as your position and bargaining power.
  2. In a competitive auction process, for example, you may want to offer the simplest and least burdensome mechanism, whereas in a one-on-one situation with no competition, you may want to optimise the process for yourself and maximise the benefits.
  3. Regardless of the completion mechanism you and the other party agree upon and regardless of whether you are the buyer or the seller, it is essential to pay close attention to the mechanics and corresponding safeguards outlined in the SPA and to have experienced lawyers and accountants by your side.