Hi all, could someone explain to me the locked box process as if I was 5? I understand the concept of it but I'd be curious to learn more about it in greater detail. Also, how do you think about it? Common issues, negotiation points, reasoning behind it, amount of leakage in practice, how important it is in the grand scheme of things and so on. Thanks a lot!
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Hello there,
So locked box has been one of the two main options to reach final Equity Value. The other one being completion/closing accounts. As your question evolves on the first one I will focus on it but it’s good to understand the main differentiator.
The main characteristic of the locked box vs completion accounts is the timing of flows and their nature.
In a locked box context, let us imagine Company A is the buyer of Company B. Company A says: I will purchase you, Company B for a specific price - which is determined upon signature of the agreement. In this Purchase Price, I will factor in a bridge leading to Equity value which takes into account what Company B’s balance sheet should look like at the date of the Locked Box. From the moment between signing and locked box any leakage is forbidden so that the nature of the BS remains relatively the same and there is no unwanted leakage: dividends, specific management fees etc. - but you may keep permitted leakage; like normal working capital flows.
This enables Equity Value to be identified / paid earlier than under closing accounts formats where payment occurs after closing of the transaction.
In Closing accounts, a clear computation from Enterprise Value to Equity value is agreed in advance including a Net Working Capital level but there is no definitive value pointed on Equity Value. All statements need to be re-computed as of closing accounts date which makes the process longer during the negotiation and for the final adjustments.
Hope this clarifies.
This is very helpful! How should one think about it though from a LBO perspective where you would arrange a new debt package for the purchase EV?
Lets say you want to buy Company B as a PE firm, and you estimate that Company B is worth 10x the EBITDA. Let's say EBITDA is 10, so the purchase EV is 100. Existing debt is 40 and the Company has 10 in cash i.e., the equity is worth 70 (100 - 40 + 10 = 70).
Following the transaction, the PE firm will have to inject the purchase EV cash free / debt free (financed with equity and lets assume 7x EBITDA of new debt (70)), which will be 100 (debt is 40 and cash is 10, so on a cash / debt free basis there will be 30 in debt that can't be repaid and that the buyer has to pay up for i.e., 70 of equity + 30 of net debt = 100 purchase EV). What does the PE firm want to negotiate for in terms of what will be part of debt and what will be cash as part of the EV to equity bridge before the box is 'locked'? I am slightly confused as in terms of the valuation you're working from EV to equity, rather than the other way around, and you're paying for the purchase EV
Erm, I'm not sure I fully understand the question, but the seller is not overly-concerned with the new capital structure.
In the EV to Equity bridge negotiations what the PE, in your example, typically argues for is to include additional debt-like items in the bridge that reduce the equity value attributable for the seller. In your example, there's usually little ambiguity about needing to pay off the existing 40 of debt; it is what it is. So the PE needs to find an additional 60 to pay to the prior owner as their equity. But maybe we're good negotiators, and we find an unpaid legal liability that the new owner will need to pay for at some point. The liability was incurred during the prior owner's tenure, so they should really pay for it. If the liability is worth 5, then that gets deducted from the 60 that gets paid to the prior owners.
Hope this helps but I'm not sure I fully understood your question.
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