Purchase price adjustments in merger and acquisition (“M&A”) transactions are important tools for buyers trying to ensure that they “get what they pay for.” Likewise, targets are not fond of leaving money on the table. A well-drafted purchase price adjustment provision can satisfy all parties’ needs and reassure both the buyer and the target that they each received the benefit of the bargain. However, price adjustments are oftentimes the subject of hotly contested post-closing disputes between a buyer and a target, especially when the adjustment amount is significant. This article will focus on the most widely used form of a post-closing price adjustment, the working capital adjustment (“WCA”), and how the parties to the transaction can avoid common disputes.
It is the exception today to enter into an M&A transaction without some form of purchase price adjustment (“Closing Adjustment”). According to the American Bar Association’s 2013 Private Target Mergers & Acquisitions Deal Points Study1:
- 85 percent of the subject deals contained some form of purchase price adjustment
- The WCA is the most common form of purchase price adjustment (in 91 percent of relevant deals)
- 91 percent of the subject deals mandated a purchase price adjustment of any given amount, bucking the trend of requiring that the amount exceed some minimum threshold before an adjustment is triggered
In most private company M&A transactions, the buyer and the target will negotiate the purchase price months in advance of the closing, well before the buyer has completed its due diligence or determined how much working capital will be needed to effectively run the business. Unless the transaction is a “sign and close” transaction, it’s not unusual to have a 60-90 day period in between signing the definitive purchase or merger agreement (the “Agreement”) and the closing. Closing Adjustments are negotiated to reflect changes in the target’s financial condition between a certain pre-closing date and the closing date. More particularly, the WCA will provide for an adjustment to the purchase price to reflect changes (usually both increases and decreases) from (a) a predetermined baseline working capital amount (“Baseline Working Capital”) to (b) the working capital amount present at closing (“Closing Working Capital”). By implementing a WCA, buyers get peace of mind knowing that:
- A sufficient amount of working capital will be available at closing to aid in a smooth transition
- The target is incented to act rationally and to conduct business in the ordinary course prior to closing
- Any needed capital infusion after closing may be offset by a reduction in the purchase price, thereby not upsetting any financial covenants the buyer may have with its lender
Because WCAs are usually drafted to also account for increases in working capital, targets benefit from WCAs as well. Save… any breach of a covenant in the letter of intent (“LOI”) or the Agreement, the target is not penalized for pre-closing activity that affects the Closing Working Capital amount.
When Agreements include some form of Closing Adjustment, more often than not, a purchase price adjustment is ultimately made. According to a study of 720 private-target deals from Q1 2010 through Q4 2014, 65 percent of transactions with a Closing Adjustment mechanism actually made an adjustment.2 That same study reveals that, among transactions where a Closing Adjustment is made, 48 percent of the time the buyer is the party receiving the benefit of the adjustment, compared to 17 percent for the target. To put an average claim into perspective, the average Closing Adjustment claim equaled 1.3 percent of the deal’s overall transaction value.
Typically, the LOI will be the first meaningful place that the purchase price reveals itself. If the parties agree to employ a WCA, a well-drafted LOI will detail the adjustment mechanism and process. Or at the very least, the LOI should state that the Agreement will include an adjustment mechanism and process. Waiting to introduce the concept of a WCAuntil the parties begin to negotiate the Agreement may prove challenging. Begin the discussions surrounding a Closing Adjustment as early possible and prior to executing the LOI (even if the purchase price provisions of the LOI are non-binding, as the expectations of the parties will nonetheless be established).
Defining “Working Capital”
Whether in the LOI and/or the Agreement, the parties need to first define “working capital.” In its most generic sense, working capital is the minimum capital needed by the enterprise to maintain current operations in its current business cycle. Net working capital is the difference between current assets and current liabilities. But it is never quite that simple. Ideally, in conjunction with the client, the client’s lawyers, the client’s financial advisor, and the client’s accountant, a determination will be made as to which assets and which liabilities should be included in the calculation. The target’s balance sheet will be the starting point for determining the current asset and current liability accounts.
Current assets typically include cash, cash equivalents, accounts receivable, inventory, and prepaid expenses. But depending on the industry and the nature of target’s business, additional assets may be appropriate. Current assets typically do not include certain prepaid expenses that will not benefit buyer post-closing, doubtful receivables, receivables (note payments) from related parties, and deferred tax assets.
Current liabilities typically include accounts payable, accrued expenses, and accrued taxes. But like current assets, additional liabilities may factor into a particular target’s balance sheet. Current liabilities typically do not include payables to related parties, disputed accounts payable, and deferred tax liabilities.
The Methodology to Determine if an Adjustment Is Warranted
The calculation to determine whether an adjustment is required is typically straightforward. The WCA amount will be equal to the amount determined by subtracting the Closing Working Capital from the Baseline Working Capital. If the adjustment amount is positive (working capital decreased), the delta (subject to any limitations, as discussed below) is paid to the buyer. And if the adjustment amount is negative (working capital increased), the delta (again, subject to any limitations) is paid to the target. The more challenging questions in drafting the terms of the methodology are typically focused on the factors to consider when calculating Closing Working Capital, where the parties often engage in contentious negotiations, including:
- Are generally accepted accounting principles (“GAAP”) to be followed? Or is GAAP applied on a consistent basis with target’s past practices? Or is GAAP applied consistently with how the Baseline Working Capital was determined?
- In lieu of GAAP, is it based on some other or modified accounting standard?
- What if there is inconsistency between GAAP and target’s past practices?
- Which party will prepare the financial statements?
- Do the financial statements need to be audited?
Common practice is to permit the buyer to make the initial determination of whether or not an adjustment amount is due under the terms of the Agreement. The Agreement should be clear about when the buyer has to make such determination and how such determination is communicated to the target (and perhaps to its advisors). Likewise, the Agreement must contain provisions concerning what the target must do upon receipt of buyer’s determination. Typically, target will have a limited
amount of time (30 days would be market) to either accept or reject buyer’s calculation. If target disputes the calculation and rejects buyer’s determination, unless buyer’s calculation is “final and binding” pursuant to the Agreement, the parties will look to the dispute resolution mechanisms in the Agreement (discussed further below).
Adjusting the Purchase Price
If an adjustment is in fact mandated under the terms of the Agreement, the parties have some options when deciding how to implement the adjustment. Most deals favor a dollar-for-dollar adjustment. It’s simple and both buyer and target are equally protected. Depending on the relative bargaining position of the parties, they may however elect to place certain limits on the amount of the purchase price adjustment. First, similar to an indemnification basket, the parties may implement a de minimis threshold; i.e., a range within which neither party pays a purchase price adjustment. Second, the parties may elect to cap their exposure to an adjustment by establishing a “ceiling” (or a “cap”) and/or a “floor.” The ceiling represents an upper limit to any adjustment amount the buyer will be obligated to pay the target. On the flip side, the floor represents a limitation on the amount that a target would pay or give back to the buyer, establishing in effect a “floor” for the purchase price. The use of both a ceiling and a floor is commonly referred to as a “collar.” Best practices suggest that the parties include in the Agreement two or three sample calculations detailing hypothetical purchase price adjustments. This is especially useful when the adjustment involves de minimis thresholds, ceilings, and/or floors. As discussed further in this article, it is imperative that the parties to the transaction understand clearly what limitations (baskets, caps, etc.) apply to what kinds of post-closing claims — most often, parties will get vastly different economic results if a claim is brought under the WCA terms of the Agreement compared to a claim brought under the indemnification terms of the Agreement.
Another consideration to address is the payment of interest. If an adjustment amount is mandated under the terms of the Agreement, the parties need to state whether or not the payment of the adjustment amount will include any amount of interest. Typically, interest will begin accruing on the closing date and paid through the date that the payment is made.
A note to those representing sell side investment banks — pay close attention to the definition of “contingent consideration” (or a similar definition) in the engagement letter with the target. Depending on how the definition is crafted, the WCA amount that gets paid (to either buyer or target) will likely affect the amount of contingent consideration that may be due to the investment banking firm. The engagement letter with the target should clearly spell out how any such Closing Adjustment affects the fees paid to the investment banker.
Interaction Between the WCA and Other Provisions of the Agreement
The parties will need to understand the relationship the WCA provisions have with 1) the representations and warranties, and 2) the covenants (including indemnification covenants) in the Agreement. A good example highlighting the interplay comes in the OSI Systems case3. In OSI Systems, the plaintiff buyer claimed it was owed a significant WCA amount under the purchase price adjustment terms of the purchase agreement. The Delaware court, however, ruled that the nature of the claim (which focused on the accounting principles used in the preparation of the estimated closing balance sheet) was more appropriately addressed by certain seller representations and warranties. As a result, buyer’s remedies were limited to its indemnification rights. Under only slightly different facts, the Delaware court in Alliant Techsystems4 ruled differently. The lesson to be learned is that the parties drafting WCA provisions must expressly state which claims may be brought as WCA claims, and which claims may be brought as breaches of representations, warranties or covenants (and therefore subject to any applicable indemnification limitations). The parties in Matria Healthcare, Inc.5 managed to successfully craft such language, having included a provision that stated that the accountant would be the default arbitrator if the dispute could qualify as both a post-closing adjustment claim and an indemnity claim.
Dispute Resolution Mechanisms
Some form of formal arbitration is the most common mechanism to address WCA disputes. Independent accounting firms usually serve as the arbiters of WCA disputes. As in most any arbitration provision, the Agreement must include all material terms of the arbitration claim, including: the forum, the number of arbitrators, the qualifications of the arbitrators (unless the parties identify by name one or more particular individuals (and if so, be certain to identify alternates if the original party(ies) is unable or unwilling to participate)), the documentation to be made available to the arbitrators, and the binding nature of such arbitration. One of the most important considerations is identifying what, exactly, is subject to review by the arbitrator. The parties can agree to limit the arbitrator’s scope of review to only the “items in dispute” (which should be a defined term), or the parties can allow the arbitrator to examine all aspects of the WCA. The latter is more commonly permitted when the calculations of the parties are markedly different. Best practices would have the parties include an exhibit to the Agreement detailing the principles, policies, and practices to be followed by the arbitrator. The parties will also want to agree upon who is responsible for the fees and costs associated with any arbitration. As most Agreements with Closing Adjustments contemplate an escrow agreement to fund any WCA obligation, the parties not only need to pay careful attention to the terms and conditions of the Agreement, but also the terms and conditions of the escrow agreement and the escrow agent’s obligations with respect to any arbitration proceedings.
If a WCA makes sense for your transaction, all stakeholders will benefit by involving the appropriate advisors early in the deal process. Your particular WCA should be uniquely and carefully prepared to help ensure a successful M&A transaction.
Contact the author:
Kevin M. DiDio, Esq. - Varnum LLP - firstname.lastname@example.org
1 American Bar Association’s 2013 Private Target Mergers & Acquisitions Deal Points Study.
2 2015 SRS Acquiom M&A Claims Study.
3 OSI Systems, Inc. v. Instrumentarium Corporation, No. 1374-N, 2006 WL 656993 (Del. Ch. March 14, 2006).
4 Alliant Techsystems, Inc. v. MidOcean Bushnell Holdings, L.P., No. 9813-CB (Del. Ch. April 24, 2015, rev. April 27, 2015).
5 Matria Healthcare, Inc. v. Coral SR LLC, No. 2513-N, 2007 WL 763303 (Del. Ch. March 1, 2007).