Purchase Price Adjustment
Category: Explaining the Deal; Risk Allocation
What is it?
A purchase price adjustment is a way of making sure that the Buyer gets what they bargained for and that the Seller is compensated appropriately. Generally based on working capital, it’s a protective measure that ensures the Seller continues to operate the business in the ordinary course. In theory, it should catch a business that is operating in a way that is different than it used to.
In almost every transaction, no matter the form of agreement, there’s going to be some type of working capital adjustment – and the permutations of these types of adjustments are endless. Ideally, this adjustment will be tailored to reflect the unique elements of any particular transaction and of the particular target company. The ways working capital ebbs and flows and the necessary adjustments to ensure that both parties are getting the benefit of the bargain are different for every business, and agreements will sometimes get creative to ensure that everyone involved agrees on what a fair snapshot of the business is and sees the same reality in terms of truing the business at close to the snapshot that drove the initial valuation.
When does it matter?
As you’re building the business deal, the seller is providing the buyer with a host of historical financial, operational, etc. information that paints a picture of the business and how it operates. Based on that, the buyer comes up with a price and valuation for that business. Working capital gives you a sense of what’s normal, average operational conditions of the business. Buyers want to make sure that the business they’re buying at closing is reflective of the snapshot they’ve seen. Essentially, will they be able to continue operating the business as it has been done?
So, looking at the current assets (cash and cash equivalents, accounts receivable, inventory, prepaids and deposits + anything that’s specific to your business or your business type), liabilities (those liabilities of the business that are payable within a year, like accrued payroll, accrued expenses, accounts payable, deferred revenue liabilities (particularly with service and software businesses), debt that is due and payable within a year (working capital lines of credit, etc.)), and working capital, the buyer and seller will come up with a working capital target based on the average. The purpose of the adjustment takes what it should be, what it actually is at the closing, and then takes the difference to adjust the price. More working capital than the business normally has? The buyer will pay the seller more money. Less working capital than the business normally has? The seller will receive less money because the buyer will have to put more assets into the business.
During the transaction, you agree on the working capital target and the working capital principles (methodology for calculating it). In the two-step adjustment (more common), the seller will deliver an estimated working capital. At the closing, you compare the estimation to the target and make an adjustment. Adjustments are made. 90-120 days after the closing, the buyer will do a calculation of what the working capital actually was. Then they compare that to the estimate and make a secondary adjustment. The two-step adjustment is there for security. The one-step adjustment all happens post-close.
What to look out for?
As you’re thinking about working capital and about what is fair, you’ll need to account for and give consideration to variances and how they might affect either party in connection with the transaction. It can be confusing and complicated, but these adjustments are simply trying to ensure that the buyer is getting the same business that they signed up for based on the way the valuation was done.
The most common snag in determining fair working capital adjustments is businesses that don’t have ordinary operating cycles: cyclical or seasonal businesses, etc. How do you have a target that appropriately reflects the business so that neither party is unjustly benefited or harmed by the fact that the transaction is being closed at any one particular moment in time – when the snapshot, the average, and the current situation may not match?
Another frequent point of contention is around how to treat different types of current liabilities and assets. For example, Buyers tend to think of deferred revenue liabilities as debt because they’re assuming a performance obligation for something the seller has already been paid for. Sellers tend to think that they’re giving AR, the buyer will collect on those, and that money will fund what needs to be done to meet performance obligations.
This is one of the most aggressively negotiated and high-potential for confrontation parts of a transaction. Understand your working capital early, get your accountants involved, and have a sense of what to present and expect before you get to the negotiation. Be as specific as possible both in the purchase agreement as well as in the working capital principles and procedures about what’s included, what’s excluded, and the process for calculating it. The point is to be able to understand and explain those elements of your business, and think about how you can adjust for and accommodate those parts of your business.