In addition to setting forth the principal financial terms of a transaction, the agreement (the “Agreement”) for the acquisition of a private company (the “Company”) also allocates the risks associated with the Company’s business among the parties to the Agreement.
Such allocation is accomplished through the representations and warranties, covenants, conditions, indemnification provisions, and purchase price adjustments (“PPAs”) contained in the Agreement.
Although the parties would usually prefer to sign the Agreement and immediately close the transaction, there are often long delays between the signing of the Agreement and the closing of the transaction (the “Closing”) for reasons such as the need for:
antitrust and other regulatory approvals,
continuing due diligence,
shareholder approval, and
The purpose of a PPA is to protect the parties to the transaction against fluctuations in the Company’s business during the period between the signing of the Agreement and the Closing (the “Interim Period”). A PPA achieves this purpose by allocating the risks and rewards of the business between the buyer of the Company (the “Buyer”) and the seller (the “Seller”) during the Interim Period.
In its simplest form, a PPA compares a specified Company financial metric as of the Closing against a negotiated target level of the same financial metric as set forth in the Agreement. If that metric at Closing is higher or lower than the negotiated target metric amount, the purchase price is adjusted up or down accordingly.
A significant majority of Agreements involving a private company target contain a post-closing PPA. According to the American Bar Association’s Private Target Mergers & Acquisitions Deal Points Study (the “ABA Study”), 93% of the Agreements executed and/or transactions completed between 2020 and 1Q2021 included a PPA. Similarly, in the SRS Acquiom 2021 M&A Deal Terms Study (the “SRS Study”), 90% of the 2020 vintage transactions reviewed included a PPA.
PPAs are not intended to be neutral between the parties. The Buyer is protected by ensuring that the level of assets required to run the Company’s business (as represented by the Seller in the Agreement) is delivered at Closing and is not appropriated by the Seller through out-of-the-ordinary course actions, such as, e.g:
aggressively pursuing accounts receivable or offering discounts for quick payment so as to collect more cash prior to Closing;
failing to make needed capital expenditures; or
failing to pay creditors on a timely basis (thereby running the risk of damaging supplier relationships).
Alternatively, a PPA enables the Seller to capture any additional value created by the Company during the Interim Period and protects the Seller if, e.g., additional capital is needed in the business due to unforeseen circumstances arising during the Interim Period, or there are slower customer payments during the Interim Period (which would result in a windfall for the Buyer).
Despite their intended neutrality, PPAs are fertile ground for disagreement at the negotiation and enforcement phases of an acquisition because they involve complex legal and accounting concepts. Disagreements over PPAs often arise from imprecise or vague language in the Agreement and the latitude afforded by generally accepted accounting principles (“GAAP”).
PPAs can be complex and may require intricate drafting. In that regard, attorneys need to memorialize three aspects of a PPA:
the particular financial metric to be used in the adjustment;
the target metric against which the corresponding Closing amount is to be measured; and
the specific procedures by which the adjustment is to be determined (whether before and/or after Closing) and enforced.
Working Capital and the Purchase Price
Although other financial metrics (e.g., sales, book value, stockholders’ equity) are sometimes used, the most common PPA metric is changes in net working capital.
Working capital was the chosen PPA metric in 87% of the transactions reviewed in the ABA Study. Similarly, working capital was the chosen metric in 90% of the PPAs reviewed in the SRS Study. Given its ubiquity, this guide focuses upon working capital as the relevant PPA metric.
In practical terms, working capital is the minimum capital needed by the Company to maintain its current day-to-day operations through activities such as revenue collection, accounts receivable, and inventory management. Working capital accounts are the balance sheet items that are most likely to change over the Interim Period. They may fluctuate daily as the Company purchases/sells inventory, creates/collects receivables, and pays employees and vendors. Working capital–based PPAs do not consider long-term balance sheet accounts such as Property, Plant & Equipment, or Intangible Assets, as these are unlikely to fluctuate significantly during the Interim Period.
The purchase price the Buyer is willing to pay to acquire the Company takes into account both the Company’s future cash flows and a measure of the working capital required to generate those cash flows. Therefore, the Buyer typically bases its offer price on the enterprise value of the Company “on a cash-free, debt-free basis, assuming a normal level of working capital.”
The amount of cash the Seller receives at closing is determined by deducting from the purchase price the debt that must be repaid by the Seller, offset by the cash the Seller retains. Accordingly, in a “cash-free, debt-free transaction,” the definition of working capital typically excludes cash, cash equivalents, and debt.
The “normal” level of working capital is the average working capital required to generate the level of earnings before interest, taxes, and depreciation, and amortization (“EBITDA”) that was the basis of the enterprise value reflected in the Buyer’s offer to purchase. The amount determined to be “normal” is the amount described in the Agreement as the “Target Working Capital.”
The Target Working Capital should approximate the expected level of working capital that will be reflected on the Company’s balance sheet as of the Closing (the “Closing Balance Sheet”). If the Company’s working capital on the Closing Balance Sheet is less than the Target Working Capital, then the Buyer has effectively paid for a level of working capital it did not receive.
Setting the Target Working Capital
The purchase price for the Company is likely to be based on the Company’s enterprise value expressed as a multiple of its EBITDA. Although not a term recognized under GAAP, EBITDA is a commonly used measurement of a company’s basic cash profitability and ability to service debt.
Inasmuch as the level of EBITDA underlying the Buyer’s offer price is frequently measured over the most recent twelve months (“LTM”), the parties will often set a level of Target Working Capital based on the Company’s average working capital over the LTM period.
The use of an LTM average helps to mitigate the typical effects of any seasonality in the Company’s business. However, if the Company is growing rapidly and the Buyer’s offer price was based on the business’s forecasted EBITDA, then the Target Working Capital should ideally be based on the forecasted average working capital over the same period. Conversely, the parties might agree on a short average period (e.g., the latest six months) if these periods are believed to better represent the current or even short-term future state of the Company’s business.
A PPA is typically based on a comparison of (i) the amount of the net working capital on the Company’s balance sheet at Closing (the “Closing Working Capital”) to (ii) the Target Working Capital specified in the Agreement. The purchase price will be reduced if the Closing Working Capital is less than the Target Working Capital, and the Buyer will pay the Seller additional consideration to the extent Closing Working Capital exceeds the Target Working Capital.
From an accounting point of view, net working capital is the difference between the Company’s current assets and current liabilities.
Current assets generally represent assets that can be converted into cash within one year, and typically include:
cash and cash equivalents,
Current liabilities represent all liabilities that are due within one year, and typically include:
trade notes payable,
dividends payable, and
current portion of long-term debt.
Importantly, using the simplistic definition of working capital in drafting the PPA may import into it certain asset or liability balances that are already otherwise addressed in the Agreement, potentially resulting in a “double count” of the same item.
To ensure an “apples-to-apples” comparison, such items should be excluded in calculating the Target Working Capital. Examples include, among other things:
Cash or debt (which may be the subject of a separate adjustment if the acquisition is structured on a “cash-free, debt-free” basis);
income tax assets or liabilities (which are often allocated to the parties on a pre-Closing/post-Closing basis);
litigation and other reserves (the liability for which is often addressed in the Agreement’s indemnification provisions); and
assets and liabilities not assumed in an asset purchase.
In analyzing the Company’s balance sheet, the parties need to understand that individual account balances are not one homogeneous item. There may be individual components that need to be considered separately.
In lieu of a generic definition, the definition of Target Working Capital should specify the particular accounts (including accounting general ledger references) that are included in current assets and current liabilities and should specify accounts that are excluded. Attaching a sample calculation as a schedule to the Agreement is a helpful means of narrowing the range of any misunderstanding. The example of how working capital should be calculated should go to the trial balance account level of detail to show which accounts should be included.
Another factor that the parties need to understand and address is the interrelationship between the nature of the Company’s business and its working capital needs.
Seasonal business: Working capital may vary significantly over the course of the year. At Closing, working capital may be very different than it was when the Agreement was signed.
Growth businesses: A growing business often has increasing needs for working capital as sales grow. With growth, receivables and inventories may increase each month, requiring working capital to grow as well.
Subscription business: If the Company receives payment before a product or service is delivered (e.g., as in the software business), the Company may operate with negative working capital. As the business grows, it generates working capital. In a cash-free, debt-free transaction, the Buyer will have the obligation to provide services to customers post-transaction while the related cash remains with the Seller.
Volatile business: Working capital can be erratic when customers payments are large and infrequent, or in a commodity driven business where commodity valuations may be subject to unpredictable swings.
Before setting the Target Working Capital, the Buyer should engage in due diligence to understand the accounting policies, judgments, and estimates that are implicit in the Company’s financial statements. The focus should be on those areas most likely to create an unanticipated result. If the Buyer disagrees with the Company, the disagreement should be resolved and addressed in the Agreement.
Things to consider in establishing the Target Working Capital include:
What is normal for the industry?
What is working capital as a percentage of sales?
What special terms cause the Company’s working capital to vary?
How significantly does inventory vary on a month-to-month basis?
Do seasonal sales affect working capital?
Are the business and its working capital needs growing?
The Adjustment Process
A gating issue in the adjustment process is agreeing upon which party will prepare the Closing Statement (defined below).
The Seller argues that it has better knowledge of the Company’s business and financials and, therefore, should calculate the Closing Working Capital. The Buyer will want to do the calculation because it is buying the Company and will be running it post-Closing.
Typically, the Buyer (which, post-Closing, will have access to the Company’s books and records) wins the negotiation and prepares a closing statement within a set time frame (e.g., sixty or ninety days after Closing) (the “Closing Statement”). The timing for the preparation of the Closing Statement should accommodate the need for physical inventories and the challenges and time required to coordinate multi-location businesses or warehouse sites.
In 94% of the transactions reviewed in the ABA Study, the Buyer prepared the Closing Statement.