Buyers and sellers of companies usually put a great deal of effort into determining the appropriate purchase price for a transaction by analyzing such factors as earnings multiples, book values and / or growth projections. While both parties might agree on a base price for the deal, an often underappreciated aspect of these negotiations is the effect that post-closing purchase price adjustments may have on the overall amount the buyer must pay for the company. If buyers and sellers do not fully understand how these adjustments affect the total price, or if the purchase agreement is drafted with vague or ambiguous language, significant post-closing issues may arise. This article offers some reasons why such issues arise and how both parties may be able to mitigate the risk of costly disputes.
A purchase agreement will often provide one or more mechanisms through which the transaction price is adjusted after the closing date. These may include: working capital (current assets minus current liabilities) adjustments, net book value (total assets minus total liabilities) adjustments, and earn-out provisions.
Earn-out provisions typically measure the performance of the acquired company following the deal’s closing and — if the acquired business reaches or exceeds particular benchmarks — require the buyer to make additional post-closing payments to the seller. These provisions contain many unique risks and benefits to all parties involved. For additional information, refer to the April 1, 2010 edition ofRaising the Bar titled: Strategic Considerations of Earn-out Provisions. This edition will focus on other post-closing purchase price adjustment mechanisms.
As opposed to earn-out provisions, which measure the performance of the acquired company subsequent to the closing date, other purchase price adjustments measure the financial condition of the company as of the closing date and compare it to a financial target within the purchase agreement (often referred to as a “peg”). To the extent that the company’s financial condition at closing is greater than the peg, the buyer is required to pay a higher purchase price to the seller, and vice versa.
Rationales for Adjustments
Purchase price adjustments based on closing-date financial condition are often used for one or both of the following rationales:
Rationale 1: The purchase price adjustment accounts for changes in the company’s financial condition after the purchase agreement is signed, but prior to closing.
The deal’s base price is typically negotiated at (or prior to) the date the purchase agreement is signed. However, there can be a significant amount of time between the date the agreement is signed and the closing date. During this period, the seller remains in control of the company and is responsible for its operations. The adjustment provides a mechanism to modify the purchase price for changes in the company’s financial condition occurring from the execution date through the closing date. This mechanism provides an incentive for the seller to continue to conscientiously operate the business prior to closing, so that its financial condition at closing is maximized for the purchase price adjustment calculation.
Rationale 2: The purchase price adjustment guarantees the financial condition of the company at closing.
The buyer seeks assurance that it will receive a company in a certain financial condition (e.g., a business with at least a specified dollar amount of working capital at closing). If the buyer does not receive a company in that condition (e.g., working capital at closing is less than the peg), the buyer is compensated via a reduction in the price paid to the seller (or a refund from the seller, if the buyer already paid the seller). Similarly, the seller seeks assurance that it will be compensated if it delivers a company in a financial condition greater than the amounts specified in the purchase agreement. The seller is compensated with a purchase price adjustment payment in its favor if the financial condition is greater than the peg in the purchase agreement.
As discussed below, if buyers and sellers disagree as to the underlying rationale for the purchase price adjustment, disputes may arise. Both rationales require a way to measure the financial condition of the business at closing (e.g., the amount of working capital or net book value at closing), and such a calculation is an accounting measurement.
As with most accounting measurements, the calculation of the financial condition at closing typically involves some degree of subjective professional judgment. For purchase price adjustment calculations, it is important to remember that changes in accounting measurements will result in a direct payment from one party to another party. Not surprisingly, the application of subjective accounting principles to calculate such a payment frequently results in disputes between buyers and sellers. Below are descriptions of some conflicts that frequently arise with respect to purchase price adjustments.
Potential Conflict – Consistency versus GAAP
Parties that view the purchase price adjustment as a way to account for changes in the company’s financial condition occurring between the execution of the purchase agreement and the closing date (see Rationale 1 above) typically believe the closing balances should be calculated in a manner consistent with the company’s historical methodologies or the methods used to calculate the peg. By maintaining consistency with the historical methodologies, the purchase price adjustment should only result in a payment for economic changes — not for any changes in accounting practices.
Conversely, parties that view the adjustment as a way to guarantee the buyer receives a business in a certain financial condition (see Rationale 2 above) typically believe that the financial condition should be measured in accordance with generally accepted accounting principles (GAAP) or other accounting principles mutually agreed to by the parties. By strictly adhering to GAAP in the calculation, the buyer and seller will be assured that the purchase price is adjusted for the absolute difference between the company’s financial condition at closing and the stated peg amount.
Therefore, if historical accounting methodologies are not in accordance with GAAP, an obvious conflict arises: should the company’s financial condition at closing be measured consistently with its historical methodologies or should it be measured using GAAP? Further, what methodology should be used if multiple methodologies each conform to GAAP? These questions frequently lead to disputes, because purchase agreements often fail to address any potential conflict. For example, common language in purchase agreements states that the financial condition (e.g., working capital) shall be calculated “in accordance with GAAP, applied in a manner consistent with the company’s historical financial statements.” When drafting purchase agreements, buyers and sellers should determine the rationale for any purchase price adjustment mechanism they are including in the deal and explicitly state whether GAAP or consistency shall prevail in the event they conflict.
Potential Conflict – Consideration of Subsequent Events
Calculating the financial condition as of closing may include an evaluation of events after closing that provides information on the company’s condition as of closing. Parties in a dispute typically argue that such an evaluation is in accordance with GAAP1. Subsequent events sometimes give specific, credible information regarding closing date accounting measurements. For example, subsequent collections from customers may provide information on the collectability of receivables as of the closing date and the appropriate balance for net accounts receivable.
However, the adjustment process creates a new question that may result in additional disputes: How long after closing should new subsequent events be reflected in the parties’ respective calculations? It is impractical to consider subsequent events indefinitely. Further, such a process might unfairly favor the buyer, which typically has more access and information regarding events affecting the company after closing than the seller.
GAAP requires that subsequent events be reviewed until financial statements are issued or available to be issued — but this requirement is unclear with respect to post-closing purchase price disputes. Some parties believe financial statements are “issued” when a party (usually the buyer) delivers the original closing statement, while others believe the statements are not “issued” until all disputes are resolved (either by mutual agreement of the parties or through arbitration or litigation). The former alternative requires a cut off date on or before the due date of the first party’s submission of its calculation to the other party. The latter alternative may extend years after the closing date. Either way, both alternatives may lead to vastly different balances for various assets and liabilities, particularly those requiring a judgment in calculation.
When drafting purchase agreements, buyers and sellers should specify the date through which the parties shall evaluate subsequent events. Both parties should also consider to what extent subsequent events were considered in preparing the company’s historical financial statements or in creating peg amounts (particularly if they rely on Rationale 1). Furthermore, parties should understand the impact that reviewing subsequent events may have on the duration of potential purchase price adjustment disputes.
Potential Conflict – Items Included in Financial Condition Calculation
The purchase agreement should specify what is to be included in the measurement of the company’s financial condition at closing. For example, if the agreement contains a working capital adjustment, the parties should define current assets and current liabilities to be included in the calculation. However, these definitions can frequently cause disagreements. For example, in a working capital dispute, which typically includes only current (i.e., short-term) assets and liabilities, the parties may differ on the classification of certain accounts or amounts as current or noncurrent (i.e., long-term). A party may argue that an item historically accounted for by the company as current is actually noncurrent and, therefore, must be excluded from the calculation of closing working capital. Such an argument may have a basis in GAAP (as in Rationale 2), but runs contrary to the principle of consistency (as in Rationale 1).
When drafting purchase agreements, the parties should consider including a schedule that explicitly identifies the accounts to be included in the measurement of the company’s financial condition. The agreement language should be written to convey the intent of the parties and prevent future attempts by either party to modify the accounts to be included in the purchase price adjustment calculation. Notwithstanding the foregoing, buyers must be very cautious in drafting such language and schedules, because the language may unintentionally exclude liabilities that the buyer is unaware of prior to closing. If such conditions exist, the buyer may be unable to subtract the value of the previously unknown liabilities when calculating the financial condition of the business at closing for the purchase price adjustment.
This article includes just a few examples of common disputes that arise regarding purchase price adjustments. Buyers and sellers should work together with their legal and accounting advisers when drafting purchase agreements to mitigate the risk of such disputes. Although disagreements frequently occur, a limited number of attorneys and accountants actually specialize in these matters. Buyers and sellers routinely engage accounting experts in purchase price adjustment matters; however, such experts are often retained only after a post-closing dispute arises. Retaining an expert prior to executing a purchase agreement may prove valuable in mitigating risks inherent in ambiguous or unfavorable purchase agreement language. This enables the expert to add value throughout the complete adjustment process: drafting purchase agreement language, preparing closing date calculations, negotiating differences, selecting an arbitrator and participating in arbitration or litigation.
1 As of the date of this article, guidance for subsequent events is contained in Accounting Standards Codification Topic 855.