An estimated 95% of M&A deals, usually privately held but sometimes public, include a purchase price adjustment. This mechanism confirms the actual value of the target company at or after closing. These adjustments put the buyer and seller on equal footing and considered neutral. They also allow the two sides to proceed confidently, even when issues involve compliance with laws or regulations, employee benefits or contracts, labor or employment issues, and other matters like title or the ordinary course of business.
Why are they necessary?
The letter of intent purchase offer considers the most recent financial statements (either from quarterly or the fiscal year), but a target business’ value is often fluid, and circumstances change. Considering the amount of money changing hands, buyers and sellers want to protect themselves against such shifts. At the same time, they do not want to open themselves up to opportunistic behavior after striking a deal. Agreeing upon a purchase price adjustment (PPA) mechanism provides peace of mind and may even be the final hurdle for closing the deal.
It generally memorializes:
- The financial metric of the purchase price
- The benchmark amount of working capital that the metric uses to measure the adjusted price
- The specific procedures for the adjustments
- Procedures for handling disputes of the calculation or other details
Determining the adjustment
The most common adjustment mechanism involves working capital, which is the difference between the company’s current assets and liabilities. Working capital signals the company’s short-term health. If the buyer needs additional money to operate the target business and meet its obligations, a PPA can address it. The two sides can negotiate a working capital target using the average over the previous year or business cycle.
M&A deals may be structured to be debt-free or cash-free, which means it pays debts and drains excess cash. The price adjustment mechanism can address both this and working capital simultaneously.
Depending upon the company, other adjustment mechanisms can involve accounts receivable and inventory, especially if this significantly impacts the business’ value. The buyer can further protect themselves by having an inventory target as part of the closing. An adjustment can help ensure that inventory and receivables track closely to expectations.
Protection for the buyer
There are many issues to look at as the buyer does their due diligence. The buyer almost always prepares the PPAs, using them to address issues it wishes to flag. Common examples include:
- There may be a depletion of working capital, assets, or other value decreases between the time of the purchaser’s valuation and closing.
- Upon closing the deal and taking control, the buyer may find that an additional infusion of capital is necessary for regular operation.
- There may be regulatory issues that negatively impact the price, such as an interest hike.
The buyer expects these adjustments to address the stated concern. However, even though they have these protections, the buyer usually must go along with the prearranged adjustment provision rather than approve them at closing.
Protection for the seller
Purchase price adjustments can also work in the seller’s favor. The seller may deliver the company with a higher value than previously thought, and the buyer must pay (often dollar for dollar) for the increased measurable value. The reasons for the change include:
- There may be a significant new deal or new assets not accounted for during the final valuation.
- There may be an upturn in business or other good news for the target company or industry that markedly increases the company’s value.
Naturally, the seller wants compensation for turning over the company in even better condition than previously thought.
Negotiation is essential
M&A deals are incredibly complex, with an average middle market price between $30 million and $700 million. The right business attorney works alongside the client to determine priorities, areas of common ground, and low-priority issues. Using a PPA mechanism and other strategies, each side can move forward knowing they have protected their best interests.