One of the key decisions when structuring a merger and acquisition (M&A) transaction is the optimal mechanism for determining the final purchase price. The consideration mechanism is not “just another clause” in the agreement – it is one of the primary tools for balancing risk between the parties and ensuring the transaction’s success.
The two most common and widely accepted methods in M&A transactions are the lockbox mechanism and the working capital adjustment mechanism.
Lockbox Mechanism: Price Certainty
Under the lockbox mechanism, the transaction price is determined based on historical financial statements and typically remains unchanged after closing. The buyer acquires the company at closing as reflected by the date of those financial statements (the lockbox date). The seller undertakes that the company will not execute disbursements to it or other relevant stakeholders during the period between the lockbox date and closing (“value leakage” clause).
Value leakage may include, among other things, dividend distributions, withdrawals of excessive management fees, or interested-party transactions not conducted at market terms. However, the parties may agree on permitted disbursements—a closed, straightforward list of permitted payments, ranging from pre-closing payroll expenses to existing stakeholders to agreed dividend distributions subject to predefined financial conditions.
The main advantage of this structure is price certainty and operational simplicity. Because the transaction price is based on historical financial statements, there is no need for post-closing account settling and no retrospective disputes over definitions or components of debt or equity.
On the downside, the buyer assumes some risk regarding changes that may occur up to closing. This underscores the importance of the value leakage clause and the seller’s covenant to operate solely within the ordinary course of business. Accordingly, the lockbox mechanism is particularly suitable when there is no significant gap between the lockbox date and closing.
Working Capital Adjustment Mechanism
Under this mechanism, a base price for the transaction is determined and the price is subsequently adjusted after closing based on the company’s actual working capital at closing compared to a pre-defined target working capital. Implementing this mechanism requires the parties to agree on the accounting rules for determining the working capital and its components, establish timelines for preparing the calculations, define objection periods, and set out dispute resolution mechanisms.
The primary advantage of this mechanism is economic accuracy and alignment with the company’s actual financial position at closing. It is preferable when there is a significant gap between the date of the financial statements used to determine pricing and the closing date and/or when the company’s operations are subject to volatility. However, it is a more complex mechanism, often involving post-closing account settling and the potential for disputes between the parties.
So, Which Mechanism Is Preferable?
The answer depends on the specific circumstances of the transaction. The lockbox mechanism is generally preferrable when up-to-date and reliable financial statements are available, and when there is a relationship of trust and transparency between the parties. Alternatively, the working capital adjustment mechanism is preferable when the company’s operations are volatile or when there is a significant gap between the financial statement date and closing.
In any case, precise drafting of the chosen mechanism, tailored to the specific circumstances, is critical to achieving an optimal economic and legal outcome.
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Adv. Tal Freilich Hay is an associate in our firm’s International Commercial Department.
Barnea Jaffa Lande is one of Israel’s leading law firms in the field of mergers and acquisitions. Our advises on all aspects of complex domestic and international transactions, from structuring and strategy, through negotiation and drafting, to execution and closing.