What is a Post-Closing Purchase Price Adjustment?
Post-closing purchase price adjustments are common provisions in middle market M&A transactions. Most purchase price adjustments act as a mechanism to address the potential shifts in “value” between the date a definitive agreement is signed and the date it closes, and ownership is officially transferred. Unfortunately, these two dates are rarely the same and often create economic risks for buyers (as well as sellers). In order to mitigate these risks, the transaction’s definitive agreement will routinely include a purchase price adjustment provision. These provisions attempt to resolve two primary areas of concern.
The first area of concern relates to the potential value created and/or destroyed after the buyer has agreed to purchase a company (but before control changes to the buyer). The second area relates to the company’s resources and its ability to effectively continue operations after the transaction is closed and ownership is transferred. During this period, the operational and financial controls remain with the seller, which, from the buyer’s perspective, creates concerns over the value it will receive at closing should the seller decide to reduce his or her involvement in the day to day management of the business. Generally, the buyer does not have any influence over the day to day management until the transaction is closed. As such, it will typically seek to protect its planned investment by requiring a purchase price adjustment.
While there are numerous methods to adjusting a transaction’s purchase price, the most common method is a Net Working Capital Adjustment, which will be the focus of the remainder of this article.
Mechanics of the Net Working Capital (NWC) Adjustment
Perhaps the most common approach for adjusting the purchase price in a middle market transaction is referred to as the “two-step” adjustment. This is a variant on another common approach, the “one-step” adjustment, both of which are described below.
STEP 1: Under the two-step method, the seller prepares an estimate of the NWC it expects to achieve at closing (sometimes called the required working capital). At closing, the seller will provide the actual NWC as of the closing date which is then compared to the original NWC estimate. While it is common for the seller to prepare both NWC calculations, the buyer will usually have some involvement in its development. If the actual NWC is less than the estimated NWC, the seller will owe the buyer the difference; if the actual NWC is higher that the estimated NWC, the buyer will owe the seller the difference (the “first” step of purchase price adjustment). For reference, this would be the same (and only) step under the “one-step” adjustment method.
STEP 2: After closing, the buyer will typically calculate a final NWC calculation as of a specific date, usually 30 to 90 days after the closing date. The purchase price is adjusted again by comparing the final NWC as of the specific date to the actual NWC as of the closing date (previously calculated in the first step). Similar to the first step, if the final NWC is less than the NWC that was calculated at closing, the seller will owe the buyer the difference; and vice versa (the “second” step of purchase price adjustment). While the seller may not be responsible for the final NWC calculation, the definitive agreement will usually afford the seller the option to review the details behind the calculation should there be any questions on its accuracy or method. Because these NWC calculations are a common topic of post transaction disputes, most definitive agreements will contain procedural language on how the dispute will be resolved.
The above methodology is a simple summary of the mechanics for adjusting the purchase price in a transaction. As you would expect, however, the specific details and terms of the purchase price adjustment provisions are far more important and are often a central focus of negotiations throughout a transaction. Unfortunately, they are also frequently the topics of post-closing disputes.
Negotiation Topics of NWC Adjustments
First and foremost, the purchase price adjustment mechanism should be used as a neutral tool to address both the increase/decrease in value and the maintenance of operational/growth working capital between the signing date and the closing date (recall the two primary areas of concern mentioned above). Unfortunately, it is also an opportunity for either party to create additional value or “make money” from the terms of the transaction agreement, particularly in instances where the buyer or seller is under-represented. As such, these provisions (among other terms and conditions within a transaction’s definitive agreement) serve as negotiation topics that should be understood and addressed well in advance of executing an agreement, preferably by “framing” the NWC expectations in the seller’s confidential information memorandum or in the buyer’s letter of intent.
The following concepts offer a high-level perspective on a few of the most common negotiation topics and provide some insight into the risks commonly associated with working capital adjustment throughout the transaction’s life cycle.
Defining the components of NWC: Net working capital, as determined by standard accounting definitions, is calculated as current assets minus current liabilities; however, NWC for middle market M&A transactions will typically include other adjustments, all of which should be clearly defined in the definitive agreement executed by the buyer and seller. Many middle market M&A transactions, for example, are structured on a “cash-free debt-free” basis. Under these conditions, adjustments will likely be made to remove cash and cash equivalents and any short-term debt from the NWC calculation.
Other target or deal specific adjustments may also be warranted. For example, parties concerned with questionable receivables may seek to adjust out certain aged receivables (presumably uncollectible). Similarly, parties concerned with stale or slow-moving inventory may seek to remove certain inventory products from the calculation of NWC. Related party receivables and/or payables may require adjustments as well.
Definitive agreements that identify the specific components and adjustments to NWC result in a consistent calculation between the required dates. Additionally, specifying the exact NWC components in the agreement is likely to minimize post-closing disputes, thereby preserving the relationship between the buyer and seller and is critical to maintaining effective post-closing integration efforts.
Estimating or pegging the NWC: Analysis of the monthly historical working capital is usually the first place to begin when attempting to estimate future NWC requirements. In fact, nothing supports future NWC requirements more than the company’s historical working capital levels, which provides direct evidence of the working capital a buyer potentially needs to sustain current operations.
One approach is to take a simple average of the adjusted NWC over the trailing twelve months (or some other period). While this may be appropriate for target companies with stable or highly predicable growth patterns, there are other considerations that must be taken into account. For example, recent improvements to a company’s working capital conversation cycle may be misrepresented in a simple average (see below for more on conversion cycle improvements). Seasonality can create unexpected variations in NWC levels if not properly considered in the estimate.
One-way versus two-way adjustment and adjustment limits: Most working capital adjustments allow for both a positive and negative adjustment; that is, an increase to the purchase price if NWC increases or a decrease to the purchase price if NWC decrease (i.e. a two-way adjustment). Occasionally, however, working capital provisions will be more favorable to one party. For instance, a working capital adjustment can be one-way and may prevent the seller from receiving the benefit of delivering an increased working capital amount (and vice versa). Similarly, limitations or thresholds can be placed on the size of a working capital adjustment.
The use of these adjustments is acceptable in certain situations; however, it is not uncommon to see these types of provisions work their way into a definitive agreement without a specific purpose. In these instances, the diminished party should request an adjustment to the one-sided provisions and/or seek favorable terms in another part of the agreement (i.e. the purchase price allocation or the earn-out for example).
Consistency of accounting principles: Most middle market M&A transactions will specify that the parties present the NWC calculations in accordance with U.S. Generally Accepted Accounting Principles (or some other accounting standard). Occasionally, the buyer and seller may agree to use other accounting policies for the calculation (i.e. cash basis, tax basis, current accounting policies etc.); however, this approach increases the risks of a post-closing dispute. While it may be the path of least resistance during the formation of the definitive agreement, using the target’s “current accounting policies” opens the doors to errors in the interpretation of how the accounting records were kept (or will be kept by the buyer), particularly with policies that substantially deviate from common accounting standards. If other accounting standards, other than U.S. GAAP, are used, the parties should clearly document those accounting policies to avoid any ambiguity or inconsistency between the dates the target’s NWC is calculated.
The consistent application of the NWC calculations allows for an apples-to-apples comparison and mitigates any chances to take advantage of uncertain accounting policies, particularly after ownership has transferred to the buyer. Generally, the best practice is to specify a recognized accounting standard, such as U.S. GAAP, which should be easier to apply consistently over the period of time it takes to close a deal. It further provides well documented accounting policies should they be needed as support in a working capital dispute.
Conversion cycle improvements: While it may not be considered a negotiation topic, it certainly is a tactic that, with adequate planning, could be used to influence a transaction’s working capital adjustment. Simply stated, the conversion cycle represents the company’s effectiveness of converting accounts receivable and inventory into cash and/or extending the terms at which it pays its accounts payable.
As the seller’s make improvements to its conversion cycle, net working capital is reduced. As such, sustainable improvements to the conversion cycle demonstrates to a buyer that lower levels of working capital can be achieved while maintaining current financial and operational growth. From a seller’s perspective, it is far better to achieve those improvements prior to setting the NWC estimate, which subsequently reduces the buyer’s ability to achieve a purchase price adjustment based on its ability to affect the conversion cycle. This is more of a concern in a “two-step” purchase price adjustment, which may take 30-90 days from the closing NWC adjustment (plenty of time for a new buyer to accelerate a target’s accounts receivable and/or delay accounts playable).
The above is intended to provide a few of the common negotiation topics, some of which create potential risks if not addressed appropriately during the transaction. Of course, there is more to negotiating a transaction than the definitive agreement’s working capital provisions. In many instances, one party may concede its position on a few of the above points in an effort to move the deal forward, particularly if it has gained ground on other terms of the deal. Regardless, understanding the purchase price provisions of a M&A transaction is critical to protecting both the buyer’s and the seller’s interest.