The price of a company cannot always be fixed at signing: locked box, completion accounts and earn-outs
In the sale and purchase of companies, the price is rarely a static figure fixed once and for all at the moment of signing. The initial financial valuation, based on assumptions as to debt, cash, working capital and results, does not always match the amount that the buyer must ultimately pay. To manage this uncertainty, practice uses various contractual mechanisms for determining and adjusting the price, chief among them locked box structures, adjustments by means of completion accounts and earn-outs. What is apparently a financial question becomes a central part of the contractual architecture of the transaction, with direct implications for the allocation of risk, for the definition of economic concepts and for the potential for subsequent litigation.
1.Locked box: a fixed price set on an economic date prior to completion
Under a locked box structure, the parties agree that the company will be valued by reference to historical accounts drawn up at a date prior to completion, which becomes the “economic date” of the transaction. The price is fixed on the basis of those accounts, adjusted for certain agreed parameters, and remains unchanged from signing to completion, save for very narrowly defined adjustments. The logic is that the seller warrants that, from the locked box date to completion, there will be no leakage of value for its benefit or that of related parties beyond what is expressly permitted. To that end the parties agree leakage clauses, which prohibit disguised distributions of value, such as extraordinary dividends, payments to related parties, non-ordinary remuneration or sales of assets below market price, and permitted leakage clauses, which allow certain previously identified cash outflows.
This mechanism shifts to the seller the risk of how the business performs between the economic date and completion, in so far as the price is not adjusted for subsequent variations in debt, cash or working capital. The buyer, for its part, assumes the risk that the locked box accounts faithfully reflect the company's position and that no unauthorised leakage of value occurs. The buyer's protection is built around accounting warranties, indemnities for leakage and rights of information and oversight over management during the interim period. Precision in defining what constitutes leakage and in delimiting permitted leakage is essential in order to avoid disputes.
2.Adjustments by means of completion accounts: a variable price depending on the position at completion
Under the completion accounts structure, the price is initially fixed on the basis of a valuation, but is subject to later adjustments depending on the company's actual position at the completion date. The parties agree that, once completion has taken place, completion accounts will be drawn up, normally audited or reviewed by an independent expert, reflecting net financial debt, cash, working capital and other relevant parameters. The price is then adjusted upwards or downwards according to the difference between the actual figures and the agreed target values.
The logic is that the buyer pays for the company according to its actual financial position at the moment it acquires control, and that the seller bears the risk of departures from the agreed parameters. If net debt is higher than expected, the price is reduced; if it is lower, the price is increased. If working capital is below the target level, the price is adjusted downwards; if it is above, upwards. This mechanism requires precise definitions of what is meant by financial debt, which items are included in cash, how working capital is calculated and which accounting standards apply.
Disputes tend to arise precisely around these definitions. The classification of particular instruments as debt or as an operating liability, the inclusion or exclusion of particular items of restricted cash, the valuation of inventory, the accounting treatment of provisions or the determination of normalised working capital may all give rise to disagreement. Practice usually provides for accounting dispute resolution procedures, such as the intervention of an independent expert whose decision is accepted as binding, but clarity in the contractual drafting is the first line of defence.
3.Earn-outs: deferred price linked to future performance
An earn-out is a mechanism whereby part of the price is deferred and made conditional on the future performance of the company or of the business unit acquired. The parties agree that, in addition to the initial fixed price, the seller may receive further payments if certain targets for EBITDA, net profit, revenue, margin or other indicators are met over one or more financial years following completion. The purpose is to align incentives, particularly where the seller or its management team remain involved in the company, and to share the risk as to how the business performs.
The earn-out introduces a temporal and conditional dimension into the determination of the price. The key lies in defining with precision the indicators, the measurement period, the applicable accounting standards and any extraordinary circumstances. EBITDA, for example, may be calculated in different ways depending on whether particular items are included or excluded, whether non-recurring items are adjusted for or whether normalisation criteria are applied. Delimiting what counts as EBITDA for the purposes of the earn-out, which adjustments are allowed and how extraordinary transactions are treated is essential in order to avoid litigation.
Disputes over earn-outs tend to revolve around the running of the business during the measurement period. The seller may fear that the buyer will take decisions that artificially reduce EBITDA or restructure the company in a way that makes the targets harder to meet, while the buyer may take the view that the earn-out should not restrict its freedom to manage. Contractual practice responds with best efforts clauses, clauses requiring the maintenance of certain business lines, clauses prohibiting substantial changes without consent, or by defining adjustment scenarios in the event of significant corporate transactions. Documenting management decisions and ensuring transparency in financial information during the earn-out period are crucial.
4.Debt, cash, working capital and EBITDA: financial concepts turned into contractual clauses
Locked box, completion accounts and earn-out mechanisms share one feature: they turn apparently financial concepts into essential contractual questions. Net financial debt, cash, working capital and EBITDA cease to be mere accounting parameters and become legal definitions that determine the price. The way in which the clauses governing them are drafted may significantly alter the allocation of risk and the economic outcome of the transaction.
Net financial debt, for example, may be defined so as to include only bank loans and debt issues, or so as to extend to credit lines, factoring, leasing, financial guarantees, derivatives and other obligations. The inclusion or exclusion of particular items may change the price adjustment. Cash may be understood as cash and cash equivalents, or may include restricted deposits, escrow accounts or balances held in certain subsidiaries. Working capital may be defined as the difference between current assets and current liabilities, or may be adjusted for specific items, such as obsolete inventory, doubtful receivables or provisions.
EBITDA, as an indicator of operating performance, is especially sensitive. Contractual practice usually defines it as earnings before interest, tax, depreciation and amortisation, but introduces adjustments for non-recurring items, for changes in accounting standards, for restructurings or for extraordinary transactions. The argument as to what is recurring and what is not, as to which adjustments are legitimate and as to how the company's integration into the buyer's group is to be treated may be intense.
The consequence is that the negotiation of the price is not confined to the initial figure, but extends to the detailed drafting of the adjustment and earn-out clauses. Precision in the definitions, consistency with the applicable accounting standards and provision for mechanisms to resolve disagreements are central elements of the contractual architecture.
5.From financial formula to the core of the transaction
The aim of these mechanisms is to manage uncertainty as to the company's financial position and as to its future performance, but their impact goes further. The choice between locked box, completion accounts and earn-out reflects the allocation of risk between buyer and seller, the confidence placed in the available information and the integration strategy. A locked box favours simplicity and price certainty, but requires confidence in the historical accounts and in the absence of leakage of value. Completion accounts make it possible to adjust the price to the position at completion, but introduce accounting complexity and potential for litigation. The earn-out aligns incentives and shares risk as to the future, but may generate tension over management and over the interpretation of indicators.
From a legal perspective, the price formula becomes an essential core of the transaction. It is not a mere financial annex, but a set of clauses determining who bears which risks, how disagreements are resolved and what incentives are created. Litigation practice shows that many disputes in the sale and purchase of companies turn not so much on the existence of hidden defects or breaches of warranty as on the application of the price adjustment and earn-out clauses.
The conclusion is that, in the sale and purchase of companies, the price cannot always be fixed at signing, and that the way of managing that impossibility is a contractual question of the first order. Locked box, completion accounts and earn-outs are different tools for addressing the same problem: how to translate an initial financial valuation into a final price that reasonably reflects the reality of the company and the agreed allocation of risk. The quality of the contractual drafting and an understanding of the implications of each mechanism are as important as the financial valuation itself.
