Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Locked Box That Cost a Seller 33 Million
Transcript
- Lucas: So picture this: you sell your company for a hundred million dollars, you sign the papers, you think it's done. And then three months later, you find out you're actually getting sixty-seven million. That's not a typo. Luna: Wait, how does that happen? Did they just not pay? Lucas: No, they paid. But the deal had a locked box, and the seller lost thirty-three million because of how that box was defined. This is one of those structures that sounds so clean on paper, and it's used all the time in UK and European deals, but it can be brutal if you don't understand it. Luna: Okay, I've heard the term, but I've never actually had to think about it. What is a locked box, exactly? Lucas: So normally, in a us style deal, you have a working capital adjustment at closing. You set a target, you do a true-up after closing, and if the company has more cash than expected, the seller gets a bit more. If less, the buyer gets a rebate. Luna: Right, which keeps everyone honest about what's actually in the company on day one. Lucas: Exactly. A locked box does away with that entirely. Instead, you agree on a fixed price based on a balance sheet drawn up at some date before signing — often months earlier. And from that date on, the company is 'locked' — the seller can't take any value out of it. The price is set, period. Luna: So the buyer is basically saying, 'I'll pay you based on what the company looks like now, and anything that happens between now and closing is on you.' Lucas: Right. And the benefit is certainty — no post-closing fights, no earnout ambiguity, no working capital disputes. The buyer knows the exact price, the seller knows the exact price, and theoretically it's simpler and cheaper to negotiate. Luna: But that's the trap. Because 'anything that happens' includes a lot of things. Lucas: Exactly. So the seller I'm thinking of — let's call them a mid-sized logistics company in the Midlands, family-owned, about twenty-five million in revenue — they agreed to a locked box with a private equity buyer. The reference balance sheet was drawn up at the end of March. Closing was supposed to be at the end of August. Luna: So five months in between. That's a long time for things to change. Lucas: And they did. The company had a really strong spring, so they were generating cash. And the owners, thinking they were being smart, took out a big dividend in June — you know, 'we've already sold, let's enjoy the fruits.' Luna: I can see where this is going. But wait, isn't that exactly what you're not supposed to do in a locked box? Lucas: It is, but here's the thing — the locked box agreement had a standard 'permitted leakage' clause. And it listed a few things you could take out without penalty: management bonuses, intercompany loans, stuff like that. But it didn't explicitly say 'no dividends.' Luna: So they took a dividend and thought they were fine because it wasn't on the forbidden list? Lucas: Exactly. But the definition of 'leakage' in the agreement was broad — it said 'any transfer of value from the company to the sellers or their affiliates.' That's a catch-all. The dividend was leakage, it wasn't permitted, and under the locked box, the seller has to repay it dollar for dollar, plus interest. Luna: Plus interest? Ouch. So they had to give back the dividend, and then on top of that, the buyer claimed the company had actually lost value in the months before closing because of customer churn. Lucas: Right. And this is where the locked box gets really dangerous. Because there's no post-closing adjustment, the buyer bears the risk of the business declining between the reference date and closing. But they protect themselves with the leakage provision. So if the company loses a big customer, the buyer can't claw back from the price — but they can claim that the loss was caused by something the seller did or didn't do. Luna: So it shifts the burden. Instead of 'prove what was in the box,' it becomes 'prove you didn't leak value.' Lucas: Which is backwards from the usual deal. In a normal working capital adjustment, the buyer has to show the company came in short. In a locked box, the seller has to show they didn't take anything out or let anything slip. And the definition of leakage is so broad that the buyer can argue almost anything. Luna: So what happened in this case? How did they get to thirty-three million? Lucas: So the dividend was about eight million. Then the buyer claimed the company had paid off an intercompany loan to the seller's holding company before closing — that was another four million. Then they said the owners had taken a 'management fee' that wasn't in the ordinary course — another two million. And then they claimed the decline in EBITDA from the reference date to closing was also leakage, because the seller had let a key contract lapse without telling them. Luna: Wait, they're counting lost EBITDA as leakage? That's not a transfer of value, that's just the business performing worse. Lucas: And that's exactly the fight. The buyer argued that the seller had a duty to operate the business 'in the ordinary course' and preserve value until closing. And by letting that contract lapse — which, by the way, the seller had been planning to do for months because the customer was unprofitable — they breached that duty. The buyer said, 'if you had renewed it, we'd have had that EBITDA, so you've taken value out of our pocket.' Luna: That's a stretch. Did it hold up? Lucas: It didn't go to court. The sellers were facing a huge legal bill, and the buyer had leverage because the locked box agreement had a very seller-unfriendly dispute resolution clause — any dispute went to arbitration in London, with the seller paying the buyer's fees if the seller lost. So the sellers settled for a nineteen million dollar reduction in the purchase price, on top of the fourteen million they'd already had to repay for the dividend, loan, and fees. Luna: So they lost thirty-three million in total. And they probably thought they were being smart by avoiding a working capital fight. Lucas: Yeah, that's the irony. They chose the locked box because it felt simpler and they didn't want to deal with a post-closing adjustment. But in the end, they got a much bigger fight, and they lost. Luna: So what's the lesson for someone who's being pitched a locked box? Besides 'don't take a dividend'? Lucas: Well, first, you have to understand that the locked box is not a simplification, it's a risk transfer. You're taking on the risk that the business might decline between the reference date and closing, and you're also taking on the risk of accidentally leaking value. So the price you accept should reflect that risk. Luna: Meaning you should push for a higher price than you would in a working capital deal. Lucas: Absolutely. You're giving up the upside if the business grows, and you're taking on the downside if it shrinks. That's worth something. And you have to negotiate the leakage definition very carefully — make it exhaustive, list every thing you're allowed to do, and make sure 'ordinary course' is defined with enough detail that the buyer can't invent new obligations. Luna: And what about the reference date? Is there anything you can do there? Lucas: The shorter the gap between the reference date and closing, the better. If it's six months, that's a lot of time for things to go wrong. You want to push for a reference date as close to signing as possible, and you want to make sure the balance sheet is clean and audited. If the buyer insists on a long gap, you need to price that in. Luna: And the dispute resolution clause — you mentioned that was a big leverage point. Lucas: Yeah, that's a hidden trap. You don't want to agree to a clause that says the seller pays the buyer's legal fees if the seller loses. That's a huge disincentive to fight even a weak claim. You want a neutral process, and you want to make sure that the burden of proof is on the buyer to show leakage, not on you to prove you didn't. Luna: So the locked box isn't necessarily bad, it's just a different animal. Lucas: Right. It's used all the time in the UK, and it can work well for both sides if it's negotiated properly. But it's not something you should agree to just because it sounds cleaner. You have to go in with your eyes open. Luna: And honestly, if you're a seller, this is the kind of thing where you really need an advisor who's seen a few of these. Because the optics are so different from a us style deal. Lucas: Absolutely. I mean, think about it — in a working capital deal, you're fighting over a few million in a true-up. In a locked box, you're fighting over the entire purchase price. It's a much bigger battlefield. Luna: And that's why we do this show, right? To help you spot these landmines before you step on them. If you've gotten something out of these conversations, maybe consider supporting the show. It's the same as buying a coffee for us, and it keeps the podcast ad-free. You can do that at buy me a coffee dot com slash fexingo. Lucas: Yeah, that's a nice way to put it. And every little bit genuinely helps us keep digging into these deal structures. But back to the locked box — one more thing I want to mention. Luna: What's that? Lucas: The best way to protect yourself is to insist on a 'no leakage' certificate at closing. That's a document where the buyer confirms they haven't found any leakage, and once they sign it, they can't come back later and claim something. It shifts the burden back to them — they have to do their due diligence before closing, not after. Luna: So you're making the buyer commit to their knowledge at that point. That's smart. Lucas: Exactly. And if the buyer refuses to give you that certificate, that's a red flag. It means they want to keep the door open for post-closing claims. You should walk away from that deal or demand a significant price increase to compensate for that risk. Luna: So the locked box can be a great tool, but only if you understand the game you're playing. Lucas: Yeah. It's all about the definition of leakage, the length of the gap, and who bears the burden of proof. Get those three right, and you might actually prefer it to a working capital fight. Get them wrong, and you could be the next cautionary tale.