In the dynamic world of mergers and acquisitions (M&A), business leaders recognize that the road from purchase agreement to final integration is fraught with complexities. One crucial aspect often underestimated during this process is the intricacies tied to working capital regarding post-close purchase price adjustments. For both buyers and sellers, navigating this domain effectively can spell the difference between financial success and unanticipated liabilities.
Avoid uncertainty with these pre-close considerations
Understanding and addressing key factors before closing a deal can mitigate post-close complications and financial uncertainty. Here’s how to approach the pre-close stage.
1. Understand the impact of historical accounting
The cornerstone of any M&A deal rests on the integrity of financial data. One common pitfall is the divergence between a company’s historical accounting practices and the methodologies defined in the purchase agreement. Consider a scenario where a target company historically deviated from GAAP standards while the purchase agreement mandates GAAP compliance; such discrepancies can lead to significant variances in the actual working capital value at closing compared to seller expectations. In order to circumvent these problems, it’s critical for both parties to scrutinize past accounting practices thoroughly. Consistency and alignment in expectations can reduce the risk of disputes regarding accounts receivable, inventory, and accrued expenses.
2. Maintain consistency in the purchase agreement
A purchase agreement is a complex document with various components impacting the computation of working capital. From the terms and definitions to specific accounting appendices, any inconsistency can lead to conflicting interpretations and produce disputes over the proposed working capital value. The parties should ensure every aspect of the agreement aligns to foster clarity and mutual understanding. This should include comprehensive language specific to accounting policies and illustrative examples to help clarify calculations and expectations where appropriate.
3. Determine how the target working capital figure was established
The target working capital figure is a pivotal component of the purchase agreement. Although it’s a defined, fixed figure in the purchase agreement, understanding how and when it was calculated is essential.
Often disputes occur because the parties (particularly the seller) think that the manner in which the post-closing working capital figure is calculated should be consistent with the manner in which the target working capital figure was calculated. However, unless the purchase agreement states specifically that this should be the case, how the target was calculated and how the post-closing working capital value is calculated are often different. For example, the target may be established based on a 12- or six-month trailing average working capital value, but the company’s value for these historical periods may not be accounted for in accordance with GAAP. Yet the purchase agreement may require the post-closing working capital value calculated by the parties to be presented in accordance with GAAP. This difference in approach can result in material differences between the target working capital figure and the actual post-closing working capital value calculated by the parties.
Timing, too, plays a role. If the target working capital is a trailing average that concludes before the actual closing date, financial activities in the interim could result in material deviations. For example, the target working capital figure could be established by calculating an average value for the 12 or six trailing months, but the end period of this range could be a period end, which is 15, 30, or 45 days prior to the closing date. In this scenario, transactions that occur in this stub period can impact the calculation. Planning for this in advance will ensure a smoother transition from the agreed target to the calculated post-closing value.
4. Consider the use of collars
Collars — a strategy that limits potential outcomes to an agreed acceptable range — can be a strategic buffer against unpredictable fluctuations in the post-closing working capital value. By setting acceptable deviation limits around the target figure, both parties can protect themselves from drastic financial adjustments and ensuing disputes. Choosing the right collar hinges on risk tolerance and negotiation skill, but when executed effectively, it provides peace of mind for both sides.
Avoid pitfalls with these post-close considerations
Even with diligent pre-close planning, unforeseen post-close issues can arise. Here’s how to navigate these challenges.
1. Understand the timelines and provisions set out in the purchase agreement
Timeliness and precision in post-close actions is crucial, and often sellers fail to understand the implications of failing to respond in a manner consistent with the purchase agreement. For example, the seller typically must respond to the buyer’s proposed closing working capital value within a stipulated period. Failure to adhere to the agreed timeline — whether through oversight or miscalculation — could result in unfavorable, binding outcomes. Key actions around objections to the buyer’s proposed working capital value include:
- Understanding specific time frames for issuing a dispute notice and adherence to these deadlines. If the seller needs an extension, this is typically an option, but it must be requested in writing to the buyer’s representatives with confirmation of buyer’s approval and the specifics of any revised deadlines.
- Ensuring any dispute or objection notice complies with stipulated methods of communication, often involving certified mail or other formal means.
- Exercising the right to request necessary information from the buyer when appropriate. Typically, a purchase agreement allows the seller to make reasonable requests of the buyer for information post-closing in order to review and analyze buyer’s proposed closing balance sheet and corresponding working capital adjustment. If the buyer resists, it’s important to include all questionable items in the dispute notice. After the issuance of a dispute/objection notice, the parties can continue to negotiate in good faith, which may result in seller obtaining additional information to resolve some of these items. Failure to include these items in a dispute/objection notice means they are final and binding on the parties and not subject to resolution by an independent third party if the dispute goes to arbitration.
- The seller needs to be specific and explicitly state what items they’re disputing in the dispute notice and provide a reasonable basis for the disputed items and for what amount. Simply stating that the seller objects to the buyer’s adjustments in an email may not be sufficient to comply with the terms and provisions of a purchase agreement. Failure to adhere to the terms and provide the required level of detail could result in the buyer’s proposed values and adjustments being final and binding on the seller.
2. Utilize third-party expertise in the post-close adjustment process
Third-party expertise is often underutilized, yet it can provide invaluable insight into the nuances of post-closing adjustments. Experienced advisors bring profound knowledge, especially for parties unfamiliar with the rigors of this process. Their contributions include:
- Assisting in drafting buyer closing balance sheets and working capital adjustments.
- Helping the seller analyze and vet the proposed figures and ensure requests are reasonable and responses are aligned with agreement terms.
- Facilitating negotiations between parties to resolve disputes amicably.
- Preparing for potential third-party dispute resolution, should it become necessary.
Engaging the right professionals can be a positive influence on negotiation and ensure that potential adversarial encounters become collaborative problem-solving exercises.
3. Evaluate the costs and benefits of dispute resolution
Dispute resolution, while sometimes necessary, can be complicated and expensive. From legal fees to the cost of hiring an independent accountant to resolve the dispute, expenses can soar quickly. The key is weighing these costs against the adjustment value and potential benefits gained from a resolution in your favor. For instance, reconciling a $3,000,000 dispute might justify higher costs than a $500,000 disagreement. Making thoughtful decisions on whether or not to proceed with dispute resolution is essential to avoid unnecessary economic erosion.
4. Engage a firm with proven dispute resolution experience
Oftentimes, a third-party accounting or consulting firm will be named in a purchase agreement as the firm both parties agree to engage to resolve any post-close working capital dispute. However, even if the agreement indicates a preferred firm, a conflict of interest or lack of necessary industry insights can necessitate looking beyond the stated choice. It’s important to select a knowledgeable and neutral firm that will ensure an equitable process.
Shaping your M&A outcomes
Navigating the rocky terrain of purchase price adjustments regarding working capital requires vigilance, strategic foresight, and adeptness at negotiation. By mastering pre-close and post-close considerations, optimizing contractual consistency, and leveraging third-party advisory services, you can minimize risk and drive a better outcome for your transaction.
