What Is a Purchase Price Adjustment Mechanism and Why Are They Used?
Transactions between private companies (and in some contexts where public companies are involved as well) very often include an “adjustment” to the purchase price paid by the buyer of the business. While the components of a purchase price adjustment can take many forms depending on the deal structure and the valuation method that the parties have agreed upon, the general goal of such adjustments is to ensure that the purchase price for the deal reflects the target company’s financial condition at closing.
A typical buyer will spend a great deal of time and effort valuing an acquisition target based on prior financials and operating history, but unfortunately, businesses are not static creatures. The target company’s financial condition will change between when the work was done to arrive at an agreed-upon valuation and the day that the transaction finally closes. If upon receiving the keys to the business, the buyer discovers that additional cash investments are needed just to keep the lights on and continue business as usual, then in effect such investments constitute an additional purchase price for the buyer.
For the seller, the business delivered at closing may now include certain assets (such as important inventory or accounts receivable) that were not included in the business at the time the valuation was finalized, and naturally, the seller will want to be compensated for such assets. A purchase price adjustment mechanism protects the parties from changes in the financial condition through the closing date by adjusting the purchase price paid for the target company up or down against a pre-determined target(s) agreed between the parties.
The Most Common Adjustment Mechanism: Working Capital
As I noted previously, purchase price adjustments come in many shapes and sizes. By far the most common adjustment mechanism in private company M&A is a working capital adjustment. A company's working capital signals the near-term financial health of the business – the money available to meet the current, short-term obligations of the company. Working capital is calculated as the difference between the target company’s current assets and current liabilities.
In a transaction utilizing a working capital adjustment, the buyer and the seller work together to negotiate a “target” working capital amount based on the target company’s past financials, often using a trailing 12-month average of the target company’s working capital balance. The categories of current assets and current liabilities included in the working capital calculation are also subject to negotiation and typically exclude items like cash and debt (which are sometimes covered in separate adjustment mechanisms – see below).
The parties must also consider the effect on the working capital of certain non-recurring items or trends unique to the business, such as seasonality. At the closing of the transaction, the company's working capital is compared to the working capital target, and the purchase price is adjusted up or down depending on how much working capital is delivered.
Adjustment Mechanisms Combining Other Financial Metrics
Most private company M&A transactions are structured on a “debt-free”/ “cash-free” basis, which means that the seller is expected to (1) settle the outstanding debts of the business at closing, and (2) extract any excess cash from the business prior to closing. To help accomplish that structure, purchase price adjustment mechanisms for debt and for cash are often included in conjunction with working capital. The purchase price paid by the buyer is decreased by the amount of the target company’s debt and increased by the amount of cash left on its balance sheet.
Other Forms of Adjustment
In some situations, such as deals structured as the sale of specific assets, the parties might decide to base a purchase price adjustment on financial metrics other than working capital, such as inventory or accounts receivable. Particularly where inventory makes up a considerable portion of the value of the target business, a buyer might consider an inventory adjustment to ensure that the actual value of the inventory delivered at closing closely tracks the buyer’s expectation as to the value of the inventory based on financial due diligence.
How Do They Work?
First, the buyer and the seller agree upon a benchmark target for the metric being used for the purchase price adjustment. As noted for working capital, this is typically the target company’s trailing 12-month average working capital. For debt/cash, parties usually set the target at zero, which would reflect the intent of the parties for the target company to be sold on a "debt free"/"cash free" basis. For inventory or accounts receivable, the target is the amount the parties expect to be delivered at closing based on their diligence of such assets.
In most cases, the seller will prepare and deliver to the buyer an estimate of the relevant adjustment metric at the closing. The rationale for the seller delivering the closing estimate is that the seller is closest to the target company’s numbers and in the best position to prepare such an estimate, but the buyer is often involved in reviewing and confirming the estimated number. The estimate is then compared against the established target to adjust the purchase price paid at closing.
After closing, typically within 60-90 days, the buyer is required to submit their calculation of the adjustment metric based on their review of the target company’s books and records at closing. The seller often has the right to review and approve or dispute the buyer’s calculation and to require a review by an independent third party if the parties cannot agree on the adjustment calculations. Once the purchase price adjustment calculation is finalized, it is compared to the target benchmark again and the purchase price is adjusted as necessary based on the difference between the estimate delivered at closing and the final agreed-upon adjustment calculation, resulting in the “final” purchase price for purposes of the deal.
For the buyer, a purchase price adjustment mechanism can be a key component to ensure the buyer receives the value it bargained for. No buyer wants to be in the position of discovering that their newly acquired investment needs additional cash in order to keep operating immediately after closing.
For the seller, the adjustment mechanism is critical protection against fluctuations in the financial condition of the business prior to closing. The gap in time between the agreement on valuation and the closing presents a risk that the seller might not be fully compensated for the actual business they deliver on the closing date.
Unfortunately, purchase price adjustments can be a potential area of dispute. It is critical for the parties and their counsel, accountants, and financial advisors to thoughtfully craft these provisions to avoid disagreements in hindsight and the potential for manipulation.
Both sides to a deal should carefully consider the target being set for the purchase price adjustment mechanism. It can be burdensome to negotiate and prepare detailed procedures for preparing the purchase price adjustment calculations, but greater detail helps lower the chance that the parties end up in disagreement once the final adjustment calculations are completed. The use of a sample calculation as an exhibit of the purchase agreement to document the specific applications of the relevant accounting principles and components of the adjustment calculation can be particularly helpful in eliminating ambiguity and room for maneuvering.
While purchase price adjustment mechanisms can sometimes be complex and often cause confusion in an M&A deal, with the right input and teamwork from the parties and advisors on both sides, the purchase price adjustment can be a critical component to ensure that everyone gets exactly what they bargained for.
The Middle Market Deal Corner is a recurring blog series of practical and easily digestible articles intended to help private business owners better understand the terms and strategies relevant to buying or selling a company.
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