This is the fourth installment in a series of articles providing practical information about all things business.
Imagine you are selling your business and negotiating the purchase price. You’ve either had a valuation prepared or are using your last set of financial statements to come up with a purchase price.
As a vendor, you’re looking for as much cash as possible on closing, asking the purchaser to take on the risk of your business from the date the purchase price is determined. On the flip side, the purchaser wants to protect him- or herself from any negative changes to the purchase price between the date that the price is determined and the closing date.
This negotiation of risk is often resolved by the use of a price adjustment clause (PAC) in a purchase agreement. This is a mechanism used by the parties to confirm the value of the target company or business at closing.
The following are key components of a PAC:
• identification of the metrics on which the adjustment is to be based; • determining whether there will be any money held in escrow as security; • identification of who will prepare the financial information and within what time frame; • detailing a review process for the financial information once produced; • the process for dispute resolution; • allocation of the burden of costs of preparing the financial information; and • the formula by which the purchase price will be adjusted.
And what does this formula really involve? Most often in a private purchase and sale transaction, a working capital adjustment is used which, very generally, is current assets less current liabilities.
However, every business is different, with its own nuances, and the definition of “working capital” is almost always more complex, typically relying on the business’s financial statements or EBITDA (earnings before interest, taxes, depreciation and amortization). Depending on the nature of the business, normalization of the working capital may also be an important aspect to negotiate.
It is, therefore, very important that the purchase agreement contain clear, detailed definitions. These include definitions of working capital, current assets and current liabilities as well as specifics such as cash on hand, excluded assets, etc.
When it comes to how the adjustment is made, often the PAC is a dollar-for-dollar adjustment or possibly a ratio, but it can also include specifications such as a cap on the total adjustment permissible; that funds be held in escrow; or that the PAC only kicks in when certain events do or don’t happen.
In negotiating your agreement, you ultimately need to understand financial statements and have a good team of advisors who understand your business, whether as a vendor or purchaser, as well as what’s required for any adjustment.
A PAC can provide flexibility and fairness in the allocation of risk; however, it needs to be prepared with knowledge and specificity. It can be used with some creativity, and highlights the value of having a good team around you from the beginning when you’re thinking about selling—or buying—a business.