Our Business Transactions team has worked on a wide range of M&A deals. This is the third post in a series that discusses some key issues buyers and sellers will encounter during the M&A process, and some of the lessons we have learned along the way.
The most important term for a seller in most purchase agreements is the provision setting the amount and terms of payment of the purchase price. The purchase price may simply be a fixed cash amount payable on closing. But, it is frequently more complicated, involving pricing formulas or deferred or conditional payments. This article briefly summarizes items that can be subject to negotiations between a seller and buyer, including purchase price adjustments.
Forms of Payment
The consideration provided by the buyer to the seller may take a number of forms. For example, the purchase price may be paid:
- On closing in cash (usually the seller’s preferred option)
- By the issuance of shares of the buyer to the seller
- By a combination of cash and shares of the buyer
- On a partially deferred basis, often the buyer providing the seller with a promissory note or another form of debt instrument to evidence the remaining amount owing
In addition, in an asset sale the buyer typically assumes at least some of the seller’s liabilities in relation to the acquired business. In some cases additional value to the seller may be received by way of a post-closing employment, consulting or management contract with the buyer (or target company in the case of a share sale), where the seller is kept on a long term basis or to assist with the post-closing transition.
In some cases, such as when there is a valuation gap between the parties, agreements provide for an additional earn out purchase price to be paid if the acquired business achieves negotiated milestones post closing.
Security for Deferred Payment
If payment of the purchase price is partially deferred, the seller will usually require the buyer to provide some form of security to backstop payment. This can take the form of a general security interest in the purchaser’s personal property (or the personal property of the target company itself in the case of a share sale), a mortgage of real property, a pledge of shares (usually of the target company) or a guarantee from a corporate parent or principal, amongst others.
Escrows and Holdbacks
Buyers often seek to negotiate that some portion of the purchase price will be subject to a holdback and not paid to the seller at closing, and instead held in escrow to serve as a source of funds against which the buyer can claim in respect of claims for breaches of the seller’s representations and warranties. The amount ≈ of the holdback can be a key point for negotiation, usually at a letter of intent stage. For example, the holdback could be a percentage of the price or XYZ. Another point of negotiation may be whether the holdback amount is to be the sole source for indemnity or breach of representation and warranty claims.
Post-Closing Purchase Price Adjustment
It is quite common for there to be a post-closing purchase price adjustment. The most common form of post-closing purchase price adjustment is the net working capital adjustment, which is an adjustment based on the difference between current assets, such as accounts receivable, inventory and prepaid expenses, and current liabilities, such as accounts payable, taxes payable and other accrued expenses. However, there may also be adjustments based on other pre-determined financial metrics (e.g. net income) or that are contingent on future performance of the acquired business (earn outs) or the occurrence of specific events (e.g. obtaining regulatory approval for a product or operation post-closing).
Net Working Capital Adjustment
A net working capital adjustment corrects the purchase price either upwards or downwards for changes in net working capital from the time it is estimated -usually at the time the purchase agreement is signed – to the time of closing. If the net working capital amount at closing is higher than the estimated amount, the purchase price is commonly adjusted upward dollar for dollar, and vice-versa if the net working capital amount at closing is lower than the estimated amount. However, the parties may choose to do one of the following:
- Cap the net working capital adjustment at a certain amount, or
- Provide that no net working capital adjustment will be made unless the difference between the estimated and closing date net working capital amounts exceeds a de minimis amount
Typically the working capital at closing cannot be confirmed at the time of closing. The agreement usually provides for a period of time after closing for calculation of the final closing working capital. When the calculation is completed, payment is made. As a result, a working capital adjustment provision is common even in a “sign and close” situation where a purchase agreement is not signed until the time of closing.
Working Capital Calculation
While the basic net working capital formula of current assets less current liabilities is well known, the devil can be in the detail, and the parties are advised to define all accounting terms and clearly set out the manner in which working capital is to be calculated.
A common method of ensuring consistency in calculating the estimated and closing net working capital amount is to attach a reference balance sheet as a schedule to the purchase agreement, which should be used to calculate both the estimated and closing net working capital amount. If a reference balance sheet is used, it should set out all potential line items even if $0 at the time the estimated net working capital is set.
One issue that can be the subject of negotiation is who calculates the final closing working capital. Most typically the seller calculates the estimated working capital and the buyer calculates the final working capital. In some cases sellers negotiate for the right to calculate the final closing working capital. This is generally more typical in Canadian transactions than in U.S. deals.
Normalization of Net Working Capital
In certain cases, the parties may need to give consideration to the normalization of net working capital. This can be particularly important in cases where the target company:
- Is a party to any significant non-arm’s length contracts
- Operates in a cyclical industry where there may be significant fluctuations in net working capital from season to season, or
- Is a subsidiary of a larger company that absorbs the target’s administrative costs through its head office
It is important that a net working capital adjustment provision works in harmony with other provisions in the agreement to prevent any double counting. For example, if a seller has provided an indemnity against a potential short term liability, it should not also provide a reserve against the same liability in the balance sheet, otherwise the buyer may benefit from both a reduction in net working capital and an indemnity claim. From a buyer’s perspective, it is important to ensure that any short term liabilities it agrees to assume are included in the net working capital calculation so that the buyer receives credit for doing so.