M&A Vocabulary – Experts explain: Closing Accounts, Locked Box Mechanism and Leakage

Typically they are focused on the balance sheet and the income statement of the target. Based on these figures, the parties determine the net financial debt – because sale is usually agreed on a cash free & debt-free basis – and working capital adjustment, if necessary. 

This calculation is usually made on the basis of the data available during due diligence and results in determining a preliminary purchase price. Using the same agreed method, the parties perform the calculation again, this time on the basis of the values as of the closing day, and determine the relevant final purchase price as of this day; respective deviations are usually compensated by adjusting the purchase price euro for euro. 

This determination of the purchase price based on the financial statements of the target prepared as of the actual day of share transfer is called  “Closing Accounts Mechanism”. Also on this day, the economic risk is transferred to the buyer. For practical reasons, the parties usually agree to transfer this risk as of the last day of the month. The buyer thus only pays the value of the assets, taking into account the liabilities, actually existing on the transfer date.

A disadvantage of this method is, however, that such closing accounts can only be set up with some delay after the actual transfer date. This is in particular the case if not only a single company but a group of companies (maybe even located in several countries) is to be acquired. If additionally the parties have agreed that the calculation of the final purchase price may only take place based on audited financial statements, this period may be further extended.

This relative uncertainty regarding the final purchase price to be actually paid or – from the view of the seller – to be achieved, makes another method for calculating the purchase price attractive, i.e. the “Locked Box Mechanism”. 

When using this method, the parties calculate the purchase price in the same way as in the first option, but with reference to a point in time in the past. This is usually the balance sheet date of the last annual financial statements. The relevant documents usually are already available at the beginning of the transaction and can be thoroughly examined by the buyer during due diligence process. 

Based on these figures, all purchase price components are finally determined as of the “Locked Box Accounts” decisive date; no adjustment is made later. Possibly, there may be an exception to this rule if the parties agree on interest being computed on the purchase price for the period between the decisive date and the day of actual payment. The parties agree that the economic risk and the earnings of the company are transferred to the buyer already as of this date and the seller practically runs the business of the company for account of the buyer until the date of legal transfer of the shares.

This method has the advantage that the purchase price is already fixed at the time of signing the purchase agreement. However, it involves a risk for the buyer that after the “Locked Box Date”, i.e. the agreed decisive date for the transfer of the economic risk, there might be still an outflow of assets from the company to the seller or his related persons or related parties, which, however, should belong to the buyer because of the method used for purchase price determination. 

Such outflows are called “leakage” and are normally explicitly excluded in the purchase agreement. Examples of leakage are dividend payments after the Locked Box Date, the transfer of assets, the waiver of claims of the target against the seller or, conversely, the assumption of liabilities of the parent company by the target. Usually, the buyer is contractually granted a limited period of time after closing for checking relevant transactions. If any violation is detected, the seller is obliged to compensate the buyer for every single penny. 

However, these sanctions do not apply to payments made by the target to the seller or related persons based on arm's length transactions that have already been taken into account in the purchase agreement. Examples are payments for IT services performed by the parent company or licence fees for trademarks or other IP rights. These outflows as “permitted leakage” are thus not subject to the buyer’s consent which is usually contractually required otherwise.