Private target M&A agreements often provide for one or more post-closing purchase-price adjustment mechanisms, which may have a material effect on the value of the transaction to a buyer and seller. Indeed, 86 percent of the sampled transactions used in the ABA’s own Private Target Deal Points Study (transactions from 2016 and H1 2017) incorporate post-closing purchase-price adjustments. The most common purchase-price adjustment mechanism is to adjust the purchase price for the target company’s working capital at closing, which we address in this article.
Stepping back to establish a basis for more in-depth discussion, a company’s working capital consists of its current assets, such as accounts receivable and inventory, minus its current liabilities, such as accounts payable. The composition and the amount of working capital is subject to near-continuous change during the course of a company’s operating cycle, and its measurement generally involves many accounting methodology determinations, estimations, and judgments.
In a nutshell, working capital adjustment mechanisms in an M&A transaction work as follows. After the transaction closes, the parties painstakingly determine the amount of working capital, however defined by the parties, that was transferred with the business at the closing. That final working capital amount is then compared to the target working capital agreed to be delivered by the seller to the buyer with the target company. The contractual amount of target working capital is customarily based on the target company’s (normalized) historical working capital needs or reflective of anticipated future needs, but is ultimately a negotiated amount and can be determined however the parties mutually agree for the transaction at hand. Ultimately, the purchase price is adjusted upward or downward to reflect the surplus or shortage of actual working capital at closing relative to the target working capital, and a corresponding true-up payment is made between the parties (net of any preliminary working capital adjustments made at closing).
Defining Working Capital; Establishing the Target Working Capital
Not surprisingly, working capital provisions are often heavily negotiated, beginning with the contractual definition of working capital, closely followed by the determination of the amount of target working capital. Possibly the most significant negotiation point between a buyer and seller is the methodology that is to be used by the parties to measure the amount of working capital at the closing. The parties commonly agree to rely on (i) generally accepted accounting principles (GAAP), (ii) the target company’s historical accounting practices, or (iii) a combination of the foregoing.
When negotiating the measurement of working capital, sellers favor the target company’s historical accounting practices, and buyers prefer to prioritize GAAP. The parties’ respective preferences correspond with their disparate desires to avoid unfavorable post-closing surprises. A seller wants to ensure that the comparison between target working capital and closing working capital is made on an “apples-to-apples” basis in reliance on the target company’s historical accounting practices. A buyer, on the other hand, wants to be able to rely on GAAP to safeguard against non-GAAP errors in the target company’s historical accounting practices, which could otherwise result in overstated working capital. Compare the following examples:
- Example of Seller Preferred Language: “Closing working capital shall be determined in accordance with the target company’s historical accounting practices, including any exclusions or deviations from GAAP incorporated therein, ….”
- Example of Buyer Preferred Language: “Closing working capital shall be determined in accordance with GAAP applied on a basis consistent with the target company’s historical accounting practices. If there is a conflict between GAAP and the target company’s historical accounting practices, GAAP shall prevail….”
In the remainder of this article, we discuss a more customized mechanism for selected working capital accounts in order to minimize undesirable adjustment surprises and post-closing disputes. We specifically highlight revenue recognition issues and the allowance for doubtful accounts, which are commonly disputed and may be ripe for customized solutions. For both items, we provide more seller-friendly and more buyer-friendly approaches, each of which potentially adds to comparability and mitigates uncertainty that can be associated with ambiguous documentation of accounting practices and the existence of multiple GAAP-compliant accounting outcomes. Notably, these discussed approaches in some circumstances may be analogously customized to apply to other potentially problematic elements of working capital. Of course, in discussing a more customized mechanism for selected working capital accounts, we assume that the parties are willing—and the deal circumstances reasonably permit the opportunity—to consider and negotiate the working capital adjustment mechanism on a more granular, tailored basis.
Repeated Errors—Revenue Recognition
Although revenue is reflected on a company’s income statement, the application of accrual accounting and the associated matching of sales to the appropriate accounting period is realized by using balance sheet accounts. For example, a cash receipt for services that have not yet been performed can be booked as a deferred revenue liability on the balance sheet until the service is performed. The balance sheet then also appropriately reflects the company’s obligation to perform the service.
As a result, perhaps counterintuitively, flaws in revenue recognition accounting (i.e., errors in determining what revenue should be included on the current period income statement as opposed to being deferred to a later period) can result in balance sheet errors. These errors may in turn impact the amount of working capital at the closing. In practice, a company may have relied on its original revenue recognition approach through years of growth, overhauls of its products and services mix, and other changes in facts and circumstances, such as technical developments. Combined with complex and changing GAAP guidance, revenue recognition mistakes can result, and the impact of correcting revenue recognition errors may be significant.
A seller’s and buyer’s respective views of revenue recognition flaws, of course, diverge. A buyer desires to avoid owing post-closing performance obligations that it perceives as uncompensated due to past errors in revenue recognition. Accordingly, buyers generally prefer contractually mandated GAAP compliance for purposes of revenue recognition accounting when determining closing working capital. A seller, however, perceives a significant risk of a distinction without a difference that drives a wedge between the target working capital and the closing working capital in the event of GAAP-driven adjustments, i.e. from a seller’s perspective, two wrongs can make a right. Although that seller’s perspective may be directionally true in certain instances, the net effect is uncertain at best, and absent specific circumstances, two wrongs are unlikely to cancel each other.
A possible customized solution would be to provide for true parallel adjustments between the target working capital and closing working capital if revenue recognition errors are discovered. For example, a business that sells annual service contracts may have recognized quarterly revenue in violation of GAAP by accruing revenue for each contract entered into during a quarter from the start of that quarter, effectively recognizing revenue early across its service contracts. As a result of this error, the target company may understate the deferred revenue as of the closing date. Utilizing a parallel adjustment methodology after the transaction closes, the deferred revenue liability included in closing working capital and also included in the target working capital would be recalculated by prorating revenues from service contracts in accordance with GAAP. This approach would prevent both the “apples-to-oranges” comparison dreaded by sellers and the existence of an understated deferred revenue obligation in violation of GAAP, to a buyer’s dismay. Importantly, the parallel adjustment could still result in a purchase price adjustment as a result of changes in the ordinary course of business.
Customized contractual language to implement an agreed upon parallel adjustment approach for revenue recognition can vary, either being more seller or buyer friendly:
- Example—Seller Friendly: “If the target company’s revenue recognition accounting principles are not in accordance with GAAP, those accounting principles shall be modified to comply with GAAP for purposes of calculating both the closing working capital and also the target working capital in a manner that results in the smallest absolute difference between the outcomes of two calculations: (i) the so-adjusted closing working capital minus the so-adjusted target working capital and (ii) the unadjusted closing working capital minus the unadjusted target working capital.”
- Example—Buyer Friendly: “If the application of the company’s revenue recognition accounting principles as of the closing date would result in the recognition of revenue prior to the closing for which not all of the GAAP recognition criteria were met at that time, the buyer may adjust those accounting principles to be in compliance with GAAP and may determine the closing working capital using the adjusted accounting principles; provided, however, that if the buyer elects to make such adjustments to the accounting principles for purposes of determining the closing working capital, it shall also adjust the target working capital calculation using the same adjusted accounting principles to the extent necessary to bring revenue recognition into compliance with GAAP as of the date on which target working capital is determined.”
Both illustrative provisions implement a parallel adjustment methodology, but with potentially significant differences in outcome. The seller-friendly approach minimizes the impact of any GAAP required adjustments to the purchase price adjustment, and the GAAP adjustment could even be in seller’s favor. The buyer-friendly approach is permissive in the discretion of the buyer and allows the buyer to select the GAAP compliant approach to be used in the event of accounting errors (from among the acceptable GAAP compliant accounting treatments, which may vary significantly in outcome), meaning that the seller is highly unlikely to benefit from past revenue recognition errors.
Of course, when implementing parallel adjustments for one or more components of working capital, counsel should carefully consider whether parallel adjustment is practicable for the account at issue. The implementation of a parallel adjustment mechanism assumes that an underlying, granular calculation of the target working capital exists. That may not be the case if it is a negotiated amount or is based on, for example, averages. In addition, a parallel adjustment mechanism is not particularly suitable for accounts that are estimates as of the balance sheet date based on the facts and circumstances at the time, such as the allowance for doubtful accounts, which we discuss next.
Estimations and Judgments—Accounts Receivable and the Allowance for Doubtful Accounts
Companies that sell products or services on credit record an allowance for doubtful accounts for the potentially uncollectable portion of their outstanding accounts receivable as of a balance sheet date. Deriving the appropriate amount for the allowance for doubtful accounts in accordance with GAAP requires estimations and judgments as to collectability. Reasonable minds may differ, and post-closing a buyer’s and seller’s respective estimations and judgments may well diverge, easily escalating into formal disputes.
Buyers don’t want to pay dollar-for-dollar for uncollectable accounts receivable balances. Accordingly, a buyer will likely be reluctant to rely solely on the target company’s historical accounting practices because (i) a seller is incentivized to be unrealistic about the collectability of its accounts receivable in general (resulting in a lower allowance for doubtful accounts and a higher working capital balance in favor of the seller), and (ii) a seller is incentivized to use less stringent credit standards during the period prior to the closing date (also resulting in a higher working capital balance). Further, a target company’s historical estimation and judgment practices may be vague and poorly documented. Accordingly, buyers prefer to rely on the GAAP safeguard for accounts receivable and the corresponding allowance for doubtful accounts.
All else being equal, however, a seller will be concerned that its estimations and judgments may be supplanted after the fact by a buyer’s estimations and judgments based on the buyer’s perceived GAAP noncompliance of the target company’s preclosing accounting practices. Even if facts and circumstances have changed as of the closing date in a manner that requires a change in accounting relative to the target company’s historical estimations, a seller will not want open-ended exposure to a buyer’s potentially very conservative allowance estimate (GAAP allows a range of possible outcomes). A seller will be concerned about comparing apples to oranges at its expense.
A possible customized solution is to retreat from the judgments and estimations involved when applying either GAAP or the target company’s historical accounting practices in favor of a contractually agreed-upon mechanical calculation. For example, the parties may include a provision (and example calculation) that mandates the quantification of the allowance for doubtful accounts based on increasing percentages across accounts receivable aging brackets.
- Example: “The allowance for doubtful accounts shall be calculated as the sum of (i) 25 percent multiplied by the part of the gross accounts receivable balance that is older than 30 days but not older than 60 days, (ii) 50 percent multiplied by the part of the gross accounts receivable balance that is older than 60 days but not older than 90 days, (iii) 75 percent multiplied by the part of the gross accounts receivable balance that is older than 90 days but not older than 120 days, and (iv) 100 percent multiplied by the part of the gross accounts receivable balance that is older than 120 days.”
Of course, a broad range of potential customizations and negotiation points exists when electing this solution. For example, the parties likely will negotiate the allowance percentages for each aging bracket as well as the aging brackets themselves. The parties may also want to customize the provision by including, for example, a cap on the allowance for doubtful accounts and by specifying how write-offs factor into the calculation.
An analogous approach—utilizing an agreed-upon mechanical calculation—may also be negotiated for other accounts that exhibit similar point-in-time estimation issues, such as the inventory allowance. The inventory allowance is used to record the estimated portion of the cost of inventory that exceeds the net realizable value or market value of the inventory reflected on the balance sheet of the target company.
A myriad of other solutions occurs in practice. For example, the allowance for doubtful accounts amount may be frozen (without increase or decrease, or one direction only) for purposes of calculating closing working capital at the amount included in the latest balance sheet that is included in the target company’s financial statement representations and warranties, except for adjustments for actual collections and write-offs following the date of the latest balance sheet. This approach provides rough justice to both a buyer and a seller by not accounting for the passage of time and changes in collectability of accounts receivable from the date of the latest balance sheet to the closing date, but is easily applied and assumes that the allowance for doubtful accounts and accounts receivable remain relatively stable over time. Assuming that post-closing events are an acceptable basis for consideration, the parties also may agree that, utilizing actual post-closing experience, the buyer would receive a repayment from the seller for any accounts receivable that remain outstanding after, for example, the 120th day following the closing date (assuming that the parties can agree on the collection efforts required by the buyer during the post-closing period), and the seller then may be entitled to seek to collect such stale accounts receivable for the seller’s benefit (assuming that the buyer does not mind the seller pursuing collection from the buyer’s continuing customers).
Notably, questions regarding the impact of post-closing events on the determination of the closing working capital—as provided for explicitly in the example in the preceding paragraph—exist more broadly for accounting estimates that are not replaced by another arrangement. This issue of determining the extent to which post-closing events may be considered when performing accounting estimates is an issue with which the parties commonly grapple. For example, should post-closing, actual collection information impact the allowance for doubtful accounts as of the closing date in the absence of a specific provision? If so, through which date should those collections be considered?
GAAP includes guidance on the consideration of subsequent events for purposes of preparing financial statements and distinguishes between types of events. That guidance, however, is tied to the date the financial statements are available to be issued (for non-SEC filers). Assuming the parties are willing to rely on GAAP for purposes of its subsequent event guidance, they could contractually agree to an equivalent date to mitigate post-closing disagreements.
Additional Mitigation Options and Overriding Provisions
In addition to the above approaches, there are a variety of other options to deal with potentially problematic working capital accounts. The parties may afford special treatment to specific items, either excluding particularly problematic items from the transaction economics altogether or excluding items from working capital and relying on other provisions, such as representations and warranties and indemnification rights for breaches thereof, or covenants among the parties (e.g., the tax and indemnification provisions addressing the allocation of pre- and post-closing taxes between the buyer and the seller, rather than addressing taxes in part via the working capital adjustment).
In doing so, the parties should of course be mindful of contractual gaps and overlap, differences between provisions, and potential unintended consequences, avoiding the over- or under-inclusion of the effects of working capital accounts in the determination of the purchase price and components thereof, and in the determination of indemnified losses. Importantly, any departures from the overall working capital adjustment mechanism for specific working capital accounts also should be considered when negotiating the target working capital.
In addition to addressing specific accounts, the parties may also use overriding provisions to mitigate potential working capital issues, including the following:
- The parties may define global working capital terms such as GAAP, which is not static and may change between the date on which target working capital is determined and the closing date, to be as of a specific date so that the same GAAP applies to the determination of target working capital and closing working capital.
- The parties may establish a post-closing true-up process in the purchase agreement that can be objectively applied and that cannot be unduly sabotaged or delayed by one of the parties through, for example, one party’s refusal to agree to and retain a neutral accountant or meet a specified milestone date (e.g., the date on which a buyer is required to deliver its post-closing working capital analysis). This issue could arise if the purchase agreement simply leaves it to the parties to mutually agree (without an objective process for doing so) to a neutral accountant if and when actually needed during the post-closing working capital true-up process, often at a time when the relationship has soured. In addition, in respect of the failure of a party to meet an agreed milestone, this issue could arise if the parties remain silent as to the effect of such a breach of contract (which is commonly the case for a buyer’s failure to timely transmit its proposed final closing working capital statement following the closing), the amount of contractual damages potentially being difficult to determine, and the cost of enforcement being potentially prohibitive.
- The parties may agree to a contractual cap on the post-closing adjustment or utilize a working capital range to only adjust the purchase price for working capital if closing working capital exceeds or falls below target working capital by a specified percentage.
We have highlighted some commonly encountered, often complex problems with working capital true-ups and possible strategies that parties to a purchase agreement may consider to mitigate potential post-closing working capital disputes. In evaluating the options that may be implemented, if any, the parties should of course consider the facts and circumstances of the transaction at issue. In some instances, the working capital and related exposure can be a large component of purchase price, and the additional effort and expense associated with negotiating and incorporating customized solutions in the purchase agreement via the coordinated efforts of the parties and their respective accountants and legal counsel may well be worth it.
The views expressed herein are the authors’ own and are not attributable to their firms, those firms’ members/partners, or their clients. We utilize sample agreement language in this article to highlight some of the issues. Such agreement language is, of course, necessarily abbreviated, incomplete, lacking in defined terms, and for illustrative purposes only.