Completing an M&A deal is complex and fraught with hazards. Most investment bankers understand corporate valuation well. But often they do not understand completion mechanisms and issues. This article details the top three issues.

1. Completion and Working Capital

Multiple valuation methodologies assume the company has an average level of working capital at the valuation date. If the business is stable and non-seasonal, the working capital will also be steady and no valuation adjustment is necessary. But a business with seasonal working capital is a different story:

Ice Cream Vendors & Co. key numbers
EBIT 100
EV/EBIT multiple 10x
Working capital balances
Q1 10
Q2 200
Q3 50
Q4 20

The EV/EBIT multiple does not capture the seasonality in working capital. The purchaser wouldprefer to complete the deal in Q2 so they obtain a business pumped full of working capital which will liquidate into cash in a few months. The vendor would prefer to sell the business in Q1 when most of the working capital has liquidated and they can sweep up the surplus cash before completion.

A good M&A advisor would identify the problem and propose the following adjustments
Enterprise value, pre-adjustments 1,000 = 100 x 10
Average working capital 70
Actual working capital Q1 10
Adjusted enterprise value for Q1 completion 940 = 1,000 + (10 – 70)
Enterprise value, pre-adjustments 1,000 = 100 x 10
Average working capital 70
Actual working capital Q2 200
Adjusted enterprise value for Q1 completion 1,130 = 1,000 + (200 – 70)

2. Completion Accounts

When the buyer signs the heads of terms (letter of intent), they will usually have to estimate the level of working capital, capital and net debt in the completion accounts. The estimates may be wrong depending on the trading of the business.

After the completion accounts are prepared (often months after the heads of terms) there is a ‘true up’ to reflect the actual working capital and net debt. If there is a significant difference the purchaser may have to pay significantly more (or less). Private equity houses are particularly sensitive to consideration adjustments.

3. Locked Box Completion Mechanisms

In order to avoid consideration adjustments due to incorrect estimates of the completion accounts an alternative is a locked box mechanism. A locked box mechanism takes the most recent audited accounts and uses them as the completion balance sheet. Any cash receipts from that point on are put into a ‘locked box’. The term locked box, I assume, comes from restructuring history when a bank lending money to a business in distress would give the company a locked box with an opening in the top where all cheques had to be posted. The purchaser in effect has the economic interest from the date of the ‘locked box accounts’.

After the locked box accounts date, if working capital liquidates, net debt goes down. If working capital increases; net debt rises. The only valuation adjustment needed is at the locked box date. Lawyers will draft strict rules about ‘leakage’ (dividends, shareholder loan note interest, and capital redemptions) between the locked box date and completion. Leakage will require a valuation adjustment as value has left the corporate entity. Private equity houses prefer locked box mechanisms; it gives them certainty about purchase price and the amount of funds they need to raise.