Presenting a live 90-minute webinar with interactive Q&A M&A Post-Closing Purchase Price Adjustments: Planning and Drafting Strategies Defining Working Capital, Setting Baseline Amount, Specifying Accounting Principles, Navigating Overlap With Indemnification Clauses THURSDAY, MAY 25, 2017 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: John J. McDonald, Partner, Troutman Sanders , New York Michael Weinsier , Partner, Troutman Sanders , New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 .
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CALIBRATING THE DEAL: PURCHASE PRICE ADJUSTMENTS IN M&A TRANSACTIONS May 25, 2017 John McDonald Michael Weinsier Partner Partner Troutman Sanders LLP Troutman Sanders LLP John.McDonald@ Michael.Weinsier@ TroutmanSanders.com TroutmanSanders.com
THE OBJECTIVE OF PURCHASE PRICE ADJUSTMENTS • Businesses being acquired are often priced based on multiple of revenues or earnings (EBITDA) . • However, the financial components underlying those metrics could change between negotiation of the deal (LOI signing) and closing. • To bridge the gap , the purchase price is specified in the purchase agreement, but is adjusted based on the amount of the applicable metric as of closing. • The most common adjustment is “net working capital” (“current assets” minus “current liabilities”, so only <1 year assets and liabilities), but there are many other possibilities , including the following: “Net worth” (i.e., “assets” minus “liabilities”, so include >1 year assets and liabilities). “Minimum cash at closing” (but be careful to avoid double counting with the NWC adjustment). 6
NUANCES RE: PURCHASE PRICE ADJUSTMENTS • NWC Adjustment or Accounts Receivable Guarantee? Most NWC adjustment are intended to address the issue that the exact NWC balance may not be known until the books are closed after closing of the acquisition, particularly for complex businesses. However, in some deals, the sellers will guarantee collection of A/R . Need to distinguish any such guarantee from the sellers’ financial statements reps re: calculation of A/R reserves in accordance with GAAP, which are not a guarantee that particular A/R items will be collected. If the sellers guarantee collection, any uncollected receivables are typically assigned to the sellers. • No Double-Counting . Need to confirm no overlap/double-counting of the purchase price adjustment with the sellers’ indemnification obligations to buyer. Important because the purchase price adjustment is usually not subject 7 to indemnity basket or cap.
WHAT IS INCLUDED IN NET WORKING CAPITAL? • Baseline is “current assets” (cash + A/R) minus “current liabilities” (A/P and other short-term liabilities), but there are many nuances. • Industry-specific items – e.g., earned but unbilled revenue, prepaid items, customer deposits. • Reserves on accounts receivable (a component of “current assets”) and accounts payable (a component of “current liabilities”) are often heavily contested issues. • Receivables outstanding >90 days are sometimes written down to zero as there is less likelihood of collection. Payables outstanding more than 90 days are cause for concern because seller may be “stretching out” payables due to cash flow issues . Receivables and payables may be reserved due to disputes with customers or suppliers. • How are inventories (a component of “current assets”) valued - LIFO, FIFO? Stale inventory not sold within 1 year of manufacture are sometimes written down to zero. 8
WHAT IS INCLUDED IN NET WORKING CAPITAL (cont.) • Need to specify treatment of other “current liabilities” – for example, accrued salaries, bonuses, vacation, sick pay and sales commissions. • In “asset purchase” deals , only include “current assets” to the extent included in the “purchased assets” and “current liabilities” to the extent included in the “assumed liabilities”. • In “cash free/debt - free” deals , exclude cash from “current assets” and borrowed money debt from “current liabilities” to avoid double-counting . • In “debt - free” deals , buyer often gets indemnification from sellers for any seller debt, in addition to NWC adjustment, since long-term debt (more than 1 year) would not be a “current liability” included in NWC. • Exclude from “current liabilities” the sellers’ “transaction expenses” (i.e., attorneys, accountants and investment banker fees and expenses, sale bonuses paid to employees and other deal-related expenses), since sellers will pay those, to avoid double-counting. 9
HOW IS NET WORKING CAPITAL DETERMINED? • “Bottoms - up” or “True - up” ? Parties can do a “bottoms - up” GAAP analysis and, if the seller’s historical accounting practices weren’t GAAP, then the adjustment process corrects the deviations - “buyer favorable” formulation. Alternatively, the parties can do an “apples to apples” true -up process in which GAAP is interpreted using same policies, practices, assumptions as company's historical/audited financial statements - “seller favorable” formulation. • Example NWC Statement or NWC Calculation Rules? Attach an “example NWC statement” (e.g., pro forma closing balance sheet) as an exhibit to the purchase agreement to minimize disputes later about the way in which the NWC calculation should be performed. Alternative is to attach “NWC calculation rules” (e.g., procedures for accruing and reserving against accounts receivable and accounts payable). 10
HOW IS NET WORKING CAPITAL DETERMINED (cont.)? • Objective is “normalized” level of NWC , so seller should benefit from increase over LOI NWC amount or be penalized for drop since LOI NWC amount, since LOI NWC amount was used to determine purchase price. • However, it is sometimes not advisable to use NWC from most recent balance sheet as target if working capital fluctuates over time due to: Seasonality. Intra-month variations as A/R is collected and A/P paid down. • Sometimes, the NWC target is set as an average amount of NWC , as reflected on the company’s balance sheets over several quarters during the year or over several years. • Sometimes, there are multiple NWC targets depending on when during a month or the year the closing occurs. • Sometimes a “buffer” (or “collar”) concept is used in which there is no adjustment if the final amount is within a defined band around the target amount . “ Caps” and “floors” are also used occasionally, but aren’t typical. 11
PURCHASE PRICE ADJUSTMENT PROCESS • Typically, the steps in the process are: (1) delivery of proposed closing balance sheet; (2) response/objection by the other party; (3) negotiation period; and (4) submission of disputed items to third party for resolution. • The purchase price adjustment can be “downward only” (buyer-favorable) or upward & downward (more “fair”, but buyer needs to be prepared to potentially pay more than the stated purchase price). • Typically, there are two adjustments - one at closing based on seller's estimate and another adjustment 60, 90 or 120 days post-closing based on buyer's determination. • If there is an “at - closing” adjustment, the estimated closing balance sheet is typically either "prepared in consultation with the buyer" or must be "reasonably acceptable" to the buyer. • Sometimes, the estimated closing balance sheet becomes final (i.e., no post-closing adjustment) if buyer fails to deliver its post-closing NWC statement by end of specified 60/90/120-day period post-closing. 12
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