Post-Closing Purchase Price Adjustments in Mergers and Acquisitions
Here's how both sides to a business acquisition can protect the value of their deal against pre-closing working capital fluctuations
Most U.S. private-company M&A deals feature some mechanism to adjust the price following closing to reflect more precisely the agreed value of the acquired business on the closing date. Buyers, sellers, their counsel and other advisers need to give careful attention to post-closing adjustment provisions and related procedures in the purchase agreement to make sure those terms express the parties’ intentions, that language and calculation methods are clear, and that they do not open the door to disagreement and opportunistic behavior after the closing. Getting these matters right requires a team effort and careful attention to detail by all participants.
What is a Post-Closing Adjustment?
Typical post-closing adjustment provisions focus on liabilities and assets of the target company that fluctuate as a result of business operations between the time the parties agree on a purchase price and the actual closing of the transaction, which could be months after the initial agreement on price. The most common adjustments are based on the difference between the target’s actual net working capital (NWC) at closing compared with an agreed target NWC amount expected at closing.
For example, if the target NWC is $1,000,000 but actual working capital at closing is just $700,000, the seller would pay or credit the buyer an additional $300,000 in adjusted purchase price. Most (but not all) adjustments are “two-way” and adjust in the seller’s favor if actual NWC exceeds the NWC target. For instance, in the previous example, if closing NWC were $1,300,000, the buyer would pay the seller the $300,000 excess as an adjustment to the purchase price to account for this difference. Post-closing purchase price adjustments are sometimes based on income, expense, asset and liability items in addition to, or instead of, the standard NWC components, such as net assets. Some adjustments reward the seller with additional payments contingent on future performance of the acquired business. The following discussion focuses mainly on NWC adjustments to the purchase price.
Why Have a Post-Closing Adjustment?
The main purpose of an NWC adjustment is to protect the buyer from working capital fluctuations between the time a purchase price for the target business is agreed upon and the closing. The buyer typically wants to be sure it gets an agreed- upon minimum level of operating capital in exchange for the purchase price to avoid having to increase its investment to fund post-closing working capital needs.
The NWC adjustment also reduces the seller’s incentive to manipulate working capital by accelerating collection of receivables, delaying payables and taking other actions to maximize cash distributable to the seller prior to closing.
Finally, since most (but not all) NWC adjustment formulas require payment to the seller if closing NWC exceeds the target, the NWC adjustment protects the seller from unusually positive NWC fluctuations that would otherwise give the buyer a windfall in the form of excess working capital. This preserves the underlying assumption in most U.S. M&A deals that the business is operated for the seller’s economic benefit (and at the seller’s risk) until the closing.
Negotiating the Post-Closing Adjustment Provisions
Setting the right NWC adjustment target is important for buyers and sellers, but reaching agreement on the target can be difficult. Often, the basic idea is to determine a “normal” level of NWC, which can be more difficult and subjective than it might seem. Sometimes the parties simply start with average monthly NWC for the last 12 months or some other relevant period. However, this may not yield a true picture of the current working capital needs for the company’s normal operations.
The parties need to take into account, among other considerations, seasonal fluctuations, unusual or nonrecurring events and recent growth in the business requiring higher levels of “normal” working capital. The parties should involve their accountants and financial advisers in the discussions of the NWC target amount and should be prepared with persuasive arguments as to what the target level of NWC should be.
Another important and sometimes contentious issue is defining the items included and excluded in the adjustment, along with the accounting policies and procedures to be applied in calculating those items. This is a critical step. Inattention to these details and mistakes can lead to expensive post-closing disputes and substantial economic loss. It is critical for the parties’ counsel, management, accountants and financial advisers to work closely as a team to draft and negotiate these provisions, with careful attention being given to items that might be manipulated, misinterpreted or disputed in hindsight.
The NWC calculation should exclude assets and liabilities that are not being transferred in the sale or that will have no economic value post-closing (certain tax items, for example). It is best to agree upon a detailed schedule of accounting policies and procedures for line items especially prone to disagreement, such as inventory, reserves for uncollected accounts, reserves for contingent liabilities, accruals for paid time off and bonuses, prorated expenses and other problematic items unique to the target company’s industry.
Attaching a sample NWC calculation as a schedule to the purchase agreement can also be very helpful in minimizing disputes.
The parties should avoid language that simply says items shall be “determined in accordance with GAAP” (generally accepted accounting principles), since GAAP often permits a range of accounting policies to be used. It is important for the seller to ensure that the adjustment items are calculated consistent with the seller’s past accounting practices for those items. The seller wants an “apples to apples” comparison of closing NWC and does not want the buyer to get a more favorable adjustment by changing the accounting rules.
The seller and its counsel also need to review the language carefully to close off any opportunities for the buyer to “double dip.” Double-dipping might occur, for example, when the buyer claims the same items in both the post-closing adjustment and under the indemnity provisions of the agreement, or includes the same adjustment item in more than one adjustment category.
The Mechanics of the Post-Closing Adjustment
Most M&A transactions with post-closing purchase price adjustment provisions require the seller to calculate an estimated adjustment immediately prior to closing. This estimate is used to determine closing payments. In most adjustments, the buyer and its accountants prepare a detailed calculation of the post-closing adjustment and deliver it to the seller within a specified time after closing.
After the buyer delivers its calculation of the adjustment, the seller and its accountants normally have a specified time period to review the buyer’s calculation, request and review supporting records and make written objections to the buyer’s calculation. If the seller does not send written objections by a specified date, the buyer’s calculation becomes final. On the other hand, if the seller submits objections, there is usually a period for the parties to negotiate and try to resolve the seller’s objections. If all objections are not resolved, most agreements provide for binding private arbitration, usually by a mutually agreed-upon public accounting firm.
If an arbitrating accounting firm is engaged, the parties should consider any potential conflicts of interest and whether the designated firm’s fees would be proportionate to the anticipated amount of any disputed adjustment. The designated accounting firm’s authority should be limited only to the items in dispute and to resolving the disputed items within the range of values claimed by the parties. The arbitrating accountant’s decision on the disputed items and the amount of the adjustment normally is final and binding. Typically, the fees of the arbitrating accountant are allocated in proportion to the amount of the disputed adjustment that is resolved for and against each party.
Payment of the adjustment amount is due once the adjustment amount is agreed upon or is finally determined by the arbitrating accountant. In some transactions a portion of the purchase price is escrowed to secure payment of any adjustment due from the seller. Sometimes the agreement also will provide for interest to begin accruing on any unpaid adjustment amounts, to discourage delayed payment.
THE KEY TAKEAWAYS
- Post-closing adjustment provisions require close attention. Disputes are common and mistakes can be very costly.
- A team approach to negotiating these provisions is critical – the parties’ internal personnel and their respective counsel, accountants and financial advisers should all be involved.
- Ensure that the target net working capital amount is appropriate.
- Define the key terms carefully, and include a schedule of accounting policies and procedures, along with sample calculations.
- Make the closing estimate as accurate as possible to avoid big adjustment swings in the post-closing process.