A purchase price adjustment is a mechanism included in most M&A agreements for private company acquisitions to modify the final price of a deal after it has been agreed upon, typically based on specific financial metrics or performance targets. These adjustments help ensure that the final transaction price reflects the true value of the business being acquired, accounting for variables such as changes in working capital, debt, or other financial conditions that may fluctuate between the time of agreement and the closing date.
These provisions can function in a variety of ways but generally seek to ensure that the purchase price accurately reflects the target company’s financial state at the time of closing. Purchase price adjustments can protect both the buyer and seller.
The most common type of purchase price adjustment is a working capital adjustment. This involves the buyer and seller agreeing on the initial or benchmark working capital, then agreeing on the mechanics of the purchase price adjustment. The adjustment could be move the price higher or lower and could take many forms like a dollar-for-dollar adjustment, a de minimis adjustment, or a capped adjustment.
Working capital needs to be clearly defined in the purchase agreement. This includes confirming which accounts and items will be included in the adjustment. The most common definition is the addition of accounts receivable, inventory, and prepaid expenses minus both accounts payable and liabilities. A good starting place for assets and liabilities is the target company’s balance sheet. It should be noted, however, that not everything will be included in working capital. Items such as long-term debt would be addressed separately.
The parties also need to agree on how to value the defined working capital. An M&A agreement should specifically define methodologies for calculating working capital to avoid problems down the line. Typically, the “Generally Accepted Accounting Principles” (“GAAP”) adopted by the U.S. Securities and Exchange Commission are used to determine the closing date working capital. Parties can agree on what figure will control if there are inconsistencies at the time of closing, or if seller’s past practices will be used if there are multiple acceptable methodologies according to GAAP.
In addition to the period between the initial valuation and the closing date, there is also time between the closing date and the actual payment. To accommodate this, some parties may agree that the adjustment amount be paid with interest.
After closing, the buyer usually gives the seller a closing date balance sheet and their calculation for closing date working capital using the agreed upon methodology. This is the buyer’s job because they own the accounting necessary to do the calculations. The parties can agree that the seller makes this calculation, but the agreement needs to make sure the buyer gives the seller the necessary records to do so. Either way, the agreement should have a deadline for delivery of the closing date balance sheet and initial determination of the closing date working capital – usually 60-90 days, depending on the size and type of the target company.
The seller typically has thirty days to review the calculation. If they don’t give the buyer notice, it becomes final and binding. If they give notice, it should include the amount in dispute, supported by documentation, to be resolved according to the agreement. The dispute resolution provision in the agreement should have instructions for selecting an independent accounting firm, the agreed-upon methodologies the firm should use when making their determination, and how the parties will pay the firm’s fees.
The agreement should designate how many days can pass after the adjustment amount is determined before it becomes due and payable – usually five to ten business days. The parties can agree that if there is a dispute, the undisputed portion becomes due and payable within such period. The agreement could also allow for certain mechanisms that serve to protect the parties, such as escrow accounts.
From a transactional level, this is a team effort that requires the involvement of the business’ financial and accounting personnel, the company’s attorneys, and its outside accounting or business brokers.
MLMW is a boutique business and real estate firm in Denver, Colorado (www.mlmw-law.com). MLMW regularly represents both buyers and sellers in connection with M&A transactions. Craig T. Watrous can be reached at 303-722-2165 and cwatrous@mlmw-law.com
