In locked‑box transactions, it is assumed that the economic value of the target is definitively fixed on the locked‑box date and, from that point onwards its full value accrues to the buyer. However, this assumption of stable value does not always hold true in practice. Subtle transfers of value, which are often difficult to detect — referred to as leakage — can gradually erode the agreed transaction value during the time prior to closing.
Definition and impact on transaction value
Leakage refers to all types of value transfer from the target to the vendor or parties affiliated with the vendor during the period between the locked‑box date and completion of the transaction. The basic principle of a locked‑box mechanism is that all financial benefits and costs from the locked-box date onwards accrue to the buyer. Any deviation from this, unless expressly permitted in the Share Purchase Agreement (SPA), is viewed as leakage and constitutes a breach of this fundamental principle.
Leakage can materially affect the transaction value because seemingly limited, fragmented transfers of value cumulatively result in a significant economic shift in favour of the seller. Furthermore, leakage increases the risk of post‑closing disputes and undermines the predictability of the agreed pricing mechanism.
Common types of leakage in practice
Although there is a wide range of different types of leakage depending on the transaction, in practice we see a number of recurring patterns.
Management fees and bonuses
Payments to management or shareholders that deviate from market levels or are not consistent with the target company’s normal business operations represent a classic source of leakage.
Intercompany transactions
Loans, cash pooling arrangements or internal settlements that are incorrectly priced, inadequately documented or suddenly adjusted after the locked‑box date can lead to hidden shifts in value.
Dividend and distribution-related payments
In addition to formal dividends, there are alternative structures that have the same economic effect but different legal structures.
Related-party transactions
Supplies of goods or services to shareholders or other related parties on terms that are not at arm’s length directly undermine the value of the target.
CapEx or OpEx outside the normal policy
Bringing forward investments or incurring exceptional costs prior to closing can be used to extract value from the company in a way that is outside the agreed framework.
Changes in working capital activity
Deliberate timing of payments or receipts in order to manage cash flows may be an indication of disguised leakage.
Transactions at below market prices
The sale of assets, internal offsetting or the provision of services at below-market prices result in a direct economic disadvantage for the purchaser.
Costs that should be borne by the seller
Costs that should really be borne by the seller but are nevertheless entered in the target’s accounts after the locked‑box date often pose a risk.
Contractual and financial protection for the buyer
A clear, detailed and exhaustive definition of leakage in the Share Purchase Agreement is essential for enforcing the locked‑box mechanism. At the same time, it is essential to strictly limit and precisely define permitted leakage. Exceptions that are insufficiently defined or worded too broadly undermine enforceability of the agreements and increase the likelihood of disputes after closing.
Vendor due diligence alone does not provide sufficient assurance of enforceable leakage agreements. Additional buy side financial due diligence is required to substantiate normalised results, working capital and historical transaction flows, and demonstrate potential breaches of the leakage provisions in the contract.
Finally, specifically worded leakage clauses, combined with clear recovery mechanisms, such as repayment obligations or price adjustments, provide additional protection for the agreed transaction value.
Key points
- Locked‑box structures are intended to ensure value stability, but leakage can undermine this in practice.
- Leakage refers to any unauthorised transfer of value between the locked‑box date and closing.
- Common leakage risks include payments to management that are not in line with market rates, intercompany transactions, disguised distributions, related‑party transactions and unusual management of working capital.
- Effective protection requires strictly and exhaustively defined leakage provisions in the SPA.
- Buy‑side financial due diligence and clear recovery mechanisms are crucial to achieve effective value protection.
