Transaction Advisory Services
In addition to financial fair value, IRC 409a valuations and litigation support services, ABA’s San Francisco office has a focused transaction advisory practice. The office recently completed an eighteen (18) month engagement as the main transaction advisor to a local client with a national footprint and scope. One of the difficulties in the transaction was that the Seller (ABA’s client) was both (i) expanding into a new business unit with substantial upside but significant fixed asset expenditure and (ii) trying to negotiate a fair transaction price.
Standard practice might be to establish the transaction value (in this case as a multiple of EBITDA and confirmed by a discounted cash flow model) and then add the construction in progress and assets put in service at their cost less the debt incurred to purchase and construct the assets. Buyer and Seller simply could not agree who was to pay for what fixed asset additions, when and at what measurement date. All provided sales materials forecast the asset acquisition plan but as each month passed more was done with Buyer expecting Seller to provide the asset base that would produce the forecast cash flows and the Seller expecting reimbursement for its capital investment. What to do? A lockbox.
In its simplest form, a Locked Box deal is a fixed price deal determined and negotiated based on the Locked Box Balance Sheet. No “customary and standard deal” adjustments are required. Based on reps and warranties supported by an indemnity, the SPA provides for determination (and adjustment if required) of “leakage”…..a much simpler approach than the Closing Accounts (purchase price adjustments) approach.
The key to a successful Locked Box is making sure that the box is indeed “locked”. Any movement in working capital should be mirrored in net debt. Provided that no value has “leaked” from the target to the Sellers, the Buyer is indifferent to the Locked Box Balance Sheet. In actual UK and European deal experience leakage claims are not common.
Given that economic interest effectively passes to the Buyer at the Locked Box date, the Buyer has the benefit of the cash profits generated by the business from the Locked Box Balance Sheet date to Closing. In addition the Seller incurs an opportunity cost because the Seller did not receive payment at the Locked Box Date but instead received payment at Closing.
Independent research reports:
“In order to compensate the Seller for this opportunity cost, interest is typically charged on the Purchase Price (Equity Value) for the period between the Locked Box Date and the Closing. To achieve such compensation, the Seller typically demands either:
- An interest charge on the Purchase Price (Equity Value) between the Locked Box Date and the Closing. The interest charge reflects the Opportunity Cost of the seller not receiving the proceeds from the Buyer at the Locked Box date when the economic interest passed; or
- A proxy for the profits earned (e.g. daily profit rate) because Seller will not have been able to extract this value from the target business since the Locked Box Date.
The interest charge, whether proposed as compensation for the opportunity cost or proxy for profits, typically reflects the expected “Cash Profits” generated by the Target after the Locked Box Date, NOT the Operating Cash Flow….Cash Profits broadly represent the increase in net assets of the Target between the Locked Box Date and the Closing.”
Separate from the above, Ernst & Young also conducted independent research and found:
- E&Y observed that the SPAs included only an interest-based value accrual. The parties neither applied lump sums (at least not explicitly in the SPA) nor cash accruals.
- In 82% of the SPAs including a value accrual, the compensation covered the period from the locked box date to closing. The remaining SPAs contained a value accrual between signing and closing.
- The majority of value accruals applied a debt-like interest rate (>5.0%)
- The first use of explicit value accruals in SPAs was identified in 2006.
Importantly E&Y also opined “sellers accepting locked-box mechanisms have, based on the SPA sample we analyzed, left “cash on the table” by accepting low or no value accrual. We hope our analysis can allow buyers and sellers to be more comfortable in the use and estimation of a value accrual in locked box deals.”
The Locked Box deal structure and the interest accrual from the Lock Box date to closing bridged a difficult Buyer / Seller gap. A $500 million deal was saved.
Contact your local ABA office if you have transaction issues.