By: Scott Van Vooren

This blog post is a part of Lane & Waterman’s M & A Blog Series.

1. Introduction

Purchase price adjustments reflect changes in the agreed purchase price of the target company that typically occur between the signing of the letter of intent or acquisition agreement and the closing date. These price adjustments occur post-closing when closing date numbers are finally determined. There can be delays from the initial determination of the purchase price until or after the closing for many reasons, such as Hart-Scott Rodino filing, other regulatory approvals, third-party consents, the buyer’s continuing due diligence, tax matters, litigation and changes in the business financial condition.

Common post-closing adjustments are based upon changes in working capital, net worth or net asset value of the target company.  A change in net working capital is a common basis for a purchase price adjustment and is the focus of this posting. The definition of working capital is current assets less current liabilities.  Working capital is a good measure of the target company’s requirements to operate its business as a going concern. Also, the accounting treatment of long term assets many times does not reflect fair value.

Purchase price adjustments for changes in working capital are true-ups of working capital accounts between what the parties know and estimate at closing and what becomes known after closing as the target company’s books are closed.

Disagreements over working capital adjustments are common. Many of the disagreements over working capital adjustments are due to imprecise language in the purchase agreement and the latitude in applying generally accepted accounting principles.

An example of a working capital clause in an acquisition agreement is as follows:

“Working capital shall be calculated as of the closing date in accordance with generally accepted accounting principles (‘GAAP’) consistently applied.  If working capital is greater than $    x            , then the purchase price shall be increased by the amount of such excess.  If working capital is less than $       x       , then the purchase price shall be decreased by the amount of such deficiency.”

2. Potential Issues/Negotiating Points Regarding Purchase Price Adjustment Provisions

(a) Although the definition of working capital is relatively straightforward (current assets less current liabilities), the application is sometimes not very clear.

(b) While GAAP is commonly used as the standard, it does not clearly set forth one definitive valuation for each particular component of working capital. GAAP recognizes many different accounting methods that are acceptable to account for the same item. It is helpful that the purchase price adjustment provisions above state that GAAP must be consistently applied. But still there is much latitude that accountants have, such as materiality standards relating to litigation, environmental issues, adjustments to a particular account that is part of working capital, or matters arising post-signing where the target company has no established past practice to apply on a consistent basis.

(c) The buyer may propose an adjustment to the closing date balance sheet based upon an accounting method different than applied by seller. For example, seller may have prepared the financial statements used to negotiate the purchase price, using one generally accepted principle of accounting and thereafter subtly switch its method of accounting to provide a more favorable result.

(d) Another issue that arises is where beginning working capital prepared by the seller is not done in accordance with GAAP.

(e) Be aware when the acquisition agreement mandates consistency between the pre-closing financial statement from which a purchase price was negotiated and the final closing statements. The interim statements may not have the rigorous cut-off procedures used in a closing statement.

(f) One item to negotiate is who will prepare the closing balance sheet, the buyer or the seller. The balance sheet of the target company could look very different as of the closing and the adjustment could be surprising. The seller will want to do the closing balance sheet because it has a better knowledge of the business and financials. The buyer will want to do the closing balance sheet because it is putting up the money to purchase the target company, will be running the target company post-closing and the closing balance sheet calculation will not be done until several weeks after the closing. The party that does the calculation has the advantage. More times than not, the buyer will prepare the closing balance sheet.

(g) Consideration should be given to what happens if the party charged with preparing the final purchase price calculation does not do so or is not timely in the preparation of such calculation. Should that party lose its right to seek an adjustment? Should the other party then be able to prepare the calculation? If the other party is the seller and the seller chooses to prepare the calculation, the seller will need access to the financial records of the target company which are in the control of the buyer.

(h) Consider including language to deal with the double counting such as, “In no event shall any component of working capital, indebtedness or indemnification be double counted as a component of any such categories.”

(i) Draft the purchase price adjustment language so that if an intervening event takes place between the beginning working capital date and the closing, it will not cause an unintended result because of a change in classification of a current asset to a non-current asset.  One technique to achieve the desired result is to attach an exhibit to the agreement that includes a company chart of accounts and defines the inclusions and exclusions to working capital by reference to specific account names and numbers. The exhibit should also include the specific accounting procedures and policies regarding allowance for bad debts, liability accruals, inventory obsolescence, sales cut-offs and the like. The more precise you can be, the less likely there will be surprises for the buyer and the seller.

(j) Consideration should be given to enumerating the generally accepted accounting principles used when calculating the purchase price adjustment. For example, accounts receivable collections applied to the invoice stated on the check and if no such invoice is stated on the check, then to the oldest accounts receivable; bad debt allowance; inventory obsolescence allowance. Do not rely on the statement that generally accepted accounting principles shall be consistently applied. Sometimes sellers are not consistent within their own practices.

3. Deferred Tax Assets and Liabilities

Deferred tax assets and liabilities reflect timing differences where certain revenue and expenses are recognized differently for income tax purposes and financial accounting reporting purposes under generally accepted accounting principles. The current portions of deferred tax assets and liabilities are within the traditional definition of working capital. Consider whether deferred tax assets and liabilities should be specifically excluded from the definition of working capital. If such items are not excluded from the working capital definition, then determine what the impact will be on including deferred tax assets and liabilities on the estimated balance sheet at closing and the actual closing balance sheet.

4. Dispute Process

A common dispute process as part of the purchase price adjustment provision is as follows:

–  The buyer or seller prepares the closing statement within a period of days after the closing (e.g. 90 days) and sends that statement with supporting documentation to the other party.

– The other party has a set period of time to review the closing statement and send to the party that proposed the closing statement a dispute notice within a period of time (e.g. 30 days).

–  If there is a dispute, the buyer and seller get together to try to resolve the dispute.

– If the dispute cannot be resolved, the parties submit the unresolved issues to an arbitrating accountant for final and binding resolution which arbitrator should be limited to what the parties have set forth in the closing statement and dispute notice with such dispute being decided within a stated period of time (e.g. 90 days).

5. Conclusion

Carefully consider working capital adjustments early in the negotiations. Consider the working capital components and accounting principles used by the seller when negotiating the letter of intent. Understand and document in the purchase agreement those assets and liabilities that are included in working capital. Determine whether any of the current assets and liabilities are addressed in other parts of the agreement, such as in the representations and warranties or indemnification sections. Put thought into customizing the purchase price adjustment provisions to fit your situation.

Scott is a senior partner in Lane & Waterman’s Mergers & Acquisitions practice group, helping clients with transactional and business matters including mergers and acquisitions, joint ventures, corporate and limited liability company formation and governance, commercial real estate transactions, and general corporate and contractual matters.