SPA mechanics explained for sellers: locked box, completion accounts, escrow, earnouts and W&I

How the findings of due diligence turn into contract terms — the two price mechanisms, warranties and indemnities, the limits on seller liability, escrow, earnouts, W&I insurance and MAC clauses — and what a seller should have ready before the first SPA draft arrives.

How diligence findings become SPA terms

The share purchase agreement (SPA) is where the diligence report is turned into money. Every material finding ends up in one of a small number of places: it reduces the price, it is carved out into a separate protection, it is disclosed against the warranties, or it becomes a condition to completion. Which of these happens depends less on the finding itself than on how early it was found, how well it is quantified, and who quantified it.

That is the seller’s strongest argument for doing the work first. A finding the buyer discovers late arrives with the buyer’s number and the buyer’s proposed remedy attached. The same finding disclosed by the seller, quantified in a vendor due diligence report and explained, is usually settled with a narrower and cheaper tool. The rest of this guide walks through those tools from the seller’s side of the table.

Locked box versus completion accounts

On a cash-free, debt-free basis the buyer agrees an enterprise value, and the equity price is that value less net debt, adjusted for working capital. There are two ways to fix those numbers.

Locked box

The price is fixed by reference to a balance sheet at an agreed date before signing — the locked box date — ideally an audited or reviewed one. There is no adjustment after completion. Economic risk and reward pass to the buyer from the locked box date, so the buyer protects itself with a no-leakage covenant: no dividends, fees, bonuses, asset transfers or other value may flow to the seller or its related parties after that date, and any leakage is repaid to the buyer in full. Payments that are known and agreed — normal salary to an owner-manager, an agreed rent — are listed as permitted leakage. Sellers often negotiate a ticker: a daily amount added to the price from the locked box date to completion, reflecting the cash the business generates in the buyer’s period.

Completion accounts

The price is estimated at signing and trued up after completion on the basis of a balance sheet drawn up at the completion date. Actual net debt is compared with the estimate and actual working capital with the agreed peg; the difference is paid one way or the other. The agreement has to define the accounting policies for the completion balance sheet precisely, set a timetable for the buyer to prepare it and the seller to object, and name an independent expert — typically an accountant acting as expert, not arbitrator — to resolve disputes.

Which suits a seller

A locked box is generally the more seller-friendly mechanism, but it only works if the buyer trusts the balance sheet it is locking. Clean, reconciled accounts and a credible quality of earnings analysis are what make it possible to ask for one.

Warranties, indemnities and the disclosure letter

Warranties are statements of fact about the business — the accounts are accurate, taxes have been paid, there is no undisclosed litigation. If a warranty proves untrue, the buyer can claim, but generally has to show that the breach reduced the value of what it bought. Lawyers distinguish fundamental warranties (title to the shares, capacity to sell) from business warranties (financial, tax, commercial, employment); the former carry higher caps and longer time limits.

Indemnities are promises to reimburse a specified loss in full, without the buyer having to prove a reduction in value. A tax indemnity covering pre-completion tax is common and usually runs for the period in which the tax authority can reassess. A specific indemnity covers a known, identified matter — a dispute, a potential claw-back, an environmental issue — that the buyer will not accept as a general risk.

The disclosure letter is the seller’s principal defence. Matters fairly disclosed against the warranties cannot ordinarily found a claim. Buyers respond by asking for specific indemnities for known, quantified matters rather than letting them fall under disclosure. A seller is better placed to resist that when the matter is already fully described, quantified and, ideally, resolved in the diligence materials.

De minimis, basket, caps and time limits

Warranty liability is limited by a set of standard thresholds, each of which is negotiated:

• De minimis. Individual claims below a set amount are ignored altogether, so the seller is not pursued for trivia.
• Basket. Claims above the de minimis accumulate, and the seller pays nothing until the total passes the basket. In a first-dollar (tipping) basket the seller then pays the whole amount, not just the excess; in a deductible basket it pays only the excess. A deductible is the more seller-friendly of the two.
• Cap. An overall maximum on warranty claims, usually expressed as a proportion of the price, with a higher cap (often the full price) for fundamental warranties and tax.
• Time limits. Claims must be notified within a set period: business warranties typically long enough to cover at least one full audit cycle after completion, tax warranties aligned with the reassessment period, and fundamental warranties for considerably longer.

Specific indemnities usually sit outside the de minimis and basket and have their own cap and duration. Fraud is normally excluded from all limitations.

Escrow versus retention

A buyer that worries about recovering a claim from the seller after completion asks for part of the price to be held back. In an escrow the amount is deposited with a bank or escrow agent under a three-party agreement and released on agreed dates or against agreed claims. In a retention the buyer simply keeps the money until the release date. For a seller, escrow is safer — the funds are ring-fenced and the release mechanics are independent of the buyer — while retention is cheaper and simpler. Release is often staged, for example in two tranches over the warranty period. Where a specific indemnity covers a material known issue, its security should be a separate bucket, not mixed with the general warranty escrow.

Earnouts

An earnout pays part of the price later, if the business hits agreed targets. It bridges a gap in valuation — the seller believes in a forecast the buyer will not pay for up front — and, where the owner stays on, ties management to the result. Earnouts are also the most disputed term in practice, so the drafting matters:

• Metric. Revenue is easiest to measure and hardest for the buyer to manipulate; EBITDA or EBIT aligns better with value but is exposed to the buyer’s cost allocation. Define the accounting policies, exclusions and treatment of integration costs.
• Formula. State it as arithmetic, for example a multiple of the excess of actual EBITDA over a target, with a floor and a cap. Avoid “all or nothing” cliffs, which invite disputes at the margin.
• Period. Short enough that the business is still recognisably the one sold; one to three years is common.
• Conduct of business. Covenants on how the buyer runs the business during the earnout period, and what happens on a resale or integration.
• Disputes. The same expert-determination route as completion accounts, with a clear timetable.

Warranty and indemnity insurance

W&I insurance replaces (or sits on top of) the seller’s liability for warranty breaches with an insurance policy, usually bought by the buyer. For a seller it offers a clean exit: the warranty cap can fall to a nominal amount, and less of the price needs to be held in escrow — particularly valuable at a generational handover or for a seller who wants to distribute the proceeds. Three limitations matter. The insurer underwrites on the strength of the diligence, so a thin data room produces a thin policy. Known matters identified in diligence are excluded and still need specific indemnities. And certain risks are commonly excluded altogether, such as forward-looking statements and known underfunding. The cost of the premium is frequently shared or reflected in the price.

MAC and walk-away rights

Where there is a gap between signing and completion, the buyer may ask for a material adverse change (MAC) condition, allowing it to walk away if the business deteriorates materially before completion. Sellers should resist a MAC where completion follows shortly after signing, and where one is agreed, insist on a precise definition with the usual carve-outs: general market and economic conditions, changes in law, events affecting the industry as a whole, and consequences of the buyer’s own actions. A related request is a walk-away right if confirmatory diligence reveals an issue above an agreed threshold; the seller’s protection is a clear threshold and a requirement that the issue be evidenced rather than asserted.

From finding to remedy: a mapping table

The table below shows the remedy a buyer will typically propose for common diligence findings. It is a starting point for negotiation, not a rule.

What a seller should prepare

• A reconciled balance sheet at a recent date that can serve as a locked box date — and the numbers to argue for one.
• A defensible EBITDA bridge, built on the full adjustment bank, including the adjustments that reduce EBITDA.
• A net debt schedule that addresses every debt-like category, with “not applicable” recorded where it applies, and the list of permitted leakage.
• At least 24 months of monthly balance sheets to support the working capital peg.
• A draft disclosure letter started early, built from the data room, so that every known matter is fairly disclosed.
• A position on each known issue: the amount, the evidence, and the narrowest remedy the seller is willing to offer.
• A view on W&I insurance before the buyer raises it, and a data room complete enough to underwrite against — see our guide to choosing a data room for sell-side M&A.

In SellSide DD each red flag in the draft report already carries a recommended remedy — price adjustment, specific indemnity, escrow or condition — so the seller and its advisors can see the SPA consequences of every finding before the buyer does, and decide which to fix, which to disclose and which to price.