In an M&A transaction, the purchase price is the consideration that the seller receives from the buyer in connection with the purchase and sale of the target business. The purchase price may be paid in cash, securities (typically capital stock of the buyer), or a combination of cash and securities. Furthermore, the purchase price may be paid in full at closing or partly at closing with the remainder being paid over a specified period of time following the closing, pursuant to a promissory note made payable to the seller by the buyer. Such a promissory note is typically secured by certain assets of the buyer (including the assets of the target business) and/or guaranteed by one or more affiliates of the buyer. The cash portion of the purchase price is generally paid by the buyer to the seller at the closing via a wire transfer of immediately available funds to one or more bank accounts specified by the seller.
According to a recent study performed by the American Bar Association, 82 percent of purchase agreements executed in 2010 contained a post-closing purchase price adjustment. Post-closing purchase price adjustments can vary greatly from transaction to transaction. For example, post-closing purchase price adjustments may be based on the target business’s net working capital, net worth, net assets, or another financial measure agreed to by the parties. Post-closing purchase price adjustments also can include adjustments that are contingent on the occurrence of future events, such as the performance of the target business after closing (i.e., an “earn-out”) and/or obtaining certain regulatory approval for one or more products of the target business, such as FDA approval of a drug or 510K clearance for a medical device (i.e., a “milestone payment”). Earn-outs and milestone payments will be the subject of a separate article in a subsequent edition of this publication. However, the most common type of post-closing purchase price adjustment is based on net working capital, which is the subject of the remainder of this article.
Purchase agreement provisions regarding a post-closing purchase price adjustment based on net working capital (a “Net Working Capital Adjustment”) are some of the most complicated terms in a purchase agreement, requiring extensive negotiations by the parties. These provisions require thoughtful and precise drafting in order to accomplish the objectives of the buyer and the seller and to avoid future disputes. This article highlights some of the essential elements of a well-drafted Net Working Capital Adjustment.
Net Working Capital Adjustment
The rationale for a Net Working Capital Adjustment is that the target business needs a minimum amount of net working capital in order for its operations to be continued by the buyer in the ordinary course after the closing. The minimum amount of net working capital, which is usually a specific dollar amount typically referred to as the “target amount,” is a negotiated amount agreed to by the parties that is often based on the historical operation of the target business. If, at the closing, the actual amount of net working capital of the target business is less than the target amount, the buyer will have to contribute more cash to operate the business in the ordinary course, thereby effectively increasing the purchase price that the buyer paid for the target business. However, if the actual amount of net working capital at closing exceeds the target amount, the buyer will have effectively underpaid for the target business as the seller transferred more net working capital than contemplated by the parties.
Depending on the objectives of the parties, a Net Working Capital Adjustment can either be upward-adjusting or downward-adjusting (i.e., a “one-way adjustment”), or can adjust both upward or downward (i.e., a “two-way adjustment”). It can also be dollar-for-dollar or subject to a deductible or cap. Purchase agreements usually call for an adjustment to the purchase price within 60 to 90 days after the closing since the accounting information needed to accurately calculate the actual amount of net working capital will most likely neither be available nor subject to verification by the parties on the closing date.
For example, in a two-way adjustment that is dollar-for-dollar, if the parties have agreed on a target amount of $1 million and, as of the closing date, it is determined that the actual net working capital is $800,000, the seller would be required to pay the buyer $200,000. However, if the actual net working capital as of the closing date is $1.2 million, the buyer would be required to pay the seller $200,000. If the actual net working capital at closing was $1 million, neither party would be required to make a payment as the actual amount of net working capital equals the target amount.
Aside from the target amount and whether the Net Working Capital Adjustment will be a one-way or two-way adjustment, the most important aspects of a Net Working Capital Adjustment provision are (1) the definition of “net working capital,” (2) the standards of accounting to be used in calculating net working capital, (3) which party initially determines the actual amount of net working capital as of the closing date and the access to relevant books and records by the non-preparing party, and (4) the dispute resolution process.
Definition of “Net Working Capital”
The purchase agreement should be as specific as possible regarding the accounts or financial line items that will be used to calculate net working capital. Attaching a list of the specific accounts or financial line items or a sample calculation as a schedule to the purchase agreement are ways to narrow the risk of a later misunderstanding. The calculation of the actual net working capital as of the closing should be consistent with the methodology used in setting the target amount so that any comparison to the target amount is not distorted and is on an “apples to apples” basis.
Standards of Accounting
Both the buyer and seller should specify precisely the standard of accounting that will be used in determining the actual amount of net working capital as of the closing. The two most common standards for calculating a Net Working Capital Adjustment are generally accepted accounting principles (GAAP) or GAAP applied consistently with historical financial statements of the target business. Even when GAAP is the selected standard of calculation for the Net Working Capital Adjustment, the parties must be careful to account for interpretations allowed within GAAP. This can require careful attention to the accounting methods underlying the target company’s financial statements and a separate schedule of acceptable accounting principles or assumptions attached to the purchase agreement. If GAAP applied consistently with historical financial statements of the target business is the selected standard of accounting, any modifications to such standards should be explicitly set forth in the purchase agreement in order to avoid any ambiguity.
Preparation of Actual Net Working Capital Amount
The parties must determine who will prepare the initial draft of the net working capital statement (the “Closing Statement”) showing the calculation of the actual amount of net working capital as of the closing so it can be compared to the target amount. Most commonly, the buyer prepares the initial draft of the Closing Statement since the buyer has possession of the books and records of the target business after the closing. However, the target may advocate that its accountants are best situated to prepare the Closing Statement due to their familiarity with the financial statements of the target business. Another aspect of Net Working Capital Adjustments that can be easily overlooked is timely access to books and records after the closing. Access to the relevant information is critical to reviewing and/or disputing the Net Working Capital Adjustment.
Following the preparation of the Closing Statement, the non-preparing party and its advisors should have the opportunity to review it in detail. In the event of a dispute, the purchase agreement typically requires the buyer and the seller to work together for a short period of time using good faith efforts to resolve any disputes prior to engaging an independent accountant.
In addition to mathematical mistakes, disputes related to purchase price adjustments may arise when the financial components of an adjustment are not properly defined, creating questions as to whether certain transactions should be included in the amount of net working capital at closing. It is customary that disputes related to Net Working Capital Adjustments be resolved by an independent accountant rather than a court, since these disputes relate to the proper interpretation of GAAP and its application to financial information.
The purchase agreement should (1) describe the process for appointing an independent accountant to resolve disputes, (2) define the scope of the independent accountant’s review, (3) allocate the independent accountant’s fees between the parties, and (4) state that the determination by the independent accountant shall be binding and conclusive on the parties absent manifest error or fraud.
The purchase agreement also should clearly state that a party may not recover for a matter both through the purchase price adjustment and the indemnification provisions in the purchase agreement (i.e., no “double dipping”).
Net Working Capital Adjustment provisions can be a minefield of problems for drafters who fail to appreciate the complexity and nuances involved in such adjustments. Through careful and thoughtful drafting, Net Working Capital Adjustments can be drafted to avoid disputes and, if disputes do arise, provide for their resolution in an independent manner by a qualified expert.