9 Keys To Successfully Using Working Capital Adjustments

In the world of mergers and acquisitions (M&A), the post-closing price adjustment aka working capital adjustment (PPA) mechanism plays an important role in determining the final purchase price.?

According to deal studies from SRS Acquiom, from 2020 through 2023, approximately 90% of private deals included a PPA.?

A PPA allows for adjustments to the purchase price based on the working capital of the target company at the time of closing.

However, negotiating a PPA can be complex and challenging, often leading to disputes between buyer and seller and in some instance the loss of the deal.

Understanding the Post-Closing Price Adjustment Process

First, we need to examine the components of a closing accounts pricing mechanism and how it affects the purchase price.

The closing statement, prepared in accordance with the terms of the purchase agreement, outlines the balances required to calculate the final purchase price. These balances typically may include working capital, cash, indebtedness, and seller transaction expenses, or a combination of two or more metrics.

There are two working capital closing statements: the first one is called the estimated closing statement is prepared in advance of the closing, and the second one is the final closing statement is prepared sometime after the closing which in practice means approximately 90 days after closing.

To be clear the closing statement is not a Generally Accepted Accounting Principles (GAAP) based audited statement, or the buyer's opening balance sheet. Rather it is an artificial construct based on the terms of the purchase agreement.

Following the legal closing, a purchase price true-up occurs, which is the difference between the estimated closing statement and the final closing statement.

This true-up reflects any adjustments to the purchase price based on the final working capital of the seller company. The true-up process is crucial for ensuring a fair and accurate determination of the purchase price, and it requires careful preparation and review by both buyers and sellers.

If the final closing statement reflects a surplus compared to the estimated closing statement, then the seller should receive more money.? If the final closing statement reflects a deficit compared to the estimated closing statement, then the buyer should be entitled to a price reduction.? If the final closing statement balance is equal to the estimated closing statement, then neither party would benefit.

In Practice Who Wins in the True-Up?

Roughly 50% of the time there is a deficit which favors the seller according to SRS Acquiom.

The remaining 50% is split between surplus 38% of time which favors the seller and no adjustment approximately 11% of the time.

Key Considerations for Effective Negotiations

To maximize deal value and minimize the risk of disputes, parties involved in M&A transactions should follow these key considerations during the negotiation of PPAs:

1. Start Early and Define Required Working Capital

?Early engagement is critical for successful negotiations. Parties should define the required working capital necessary for the seller company to sustain normal operations.

This baseline working capital figure serves as the reference point for determining adjustments to the purchase price. It's important to consider business specific factors that may impact working capital, such as capital expenditures, one-time events, or seasonality effects, to ensure an accurate baseline figure.

2. Establish Common Language and Terms

In order to avoid misunderstandings and disputes, parties should establish clear definitions of commonly used terms related to working capital, such as cash, net working capital, current assets, and current liabilities.

Rigorous definition of terms is essential for effective deal documentation and alignment between the buyer and seller.

3. Determine Accounting Methodologies

Parties must agree on the accounting methodologies to be used in preparing and reviewing the working capital statement.

This may involve deciding whether to follow GAAP, seller company's historical practices, or a custom approach based on an exhibit to the purchase agreement.

Either way a sample working capital calculation attached as an exhibit can help clarify expectations and identify any gaps in term definitions or misunderstandings.

Parties should also consider the treatment of the accounts receivable balance and any potential windfall effects for the buyer.

4. Select the Right Purchase Price Adjustment Mechanism

Seller and buyer must determine the mechanism for requesting and reviewing adjustments to the purchase price. This includes establishing the process for communication, reviewing, and resolving disputes.

Potential conflicts of interest with accounting firms acting as arbitrators should be identified and addressed. It's essential to ensure that the chosen mechanism provides a fair and efficient resolution of disputes.

5. Assess the Overall Agreement Context

Before finalizing the post-closing price adjustment provisions, it's crucial to review the agreement as a whole, considering interactions with indemnification provisions to avoid double dipping or ambiguity.

Both parties should have a clear understanding of the claims process and how different provisions may impact the resolution of disputes.

Strategies for Effective Negotiations

Parties should employ the following strategies to facilitate effective negotiations of PPAs:

1. Open and Transparent Communication

Maintaining open and transparent communication throughout the negotiation process is essential. Both parties should share relevant information and concerns to foster a collaborative approach.

Regular updates and discussions can help prevent misunderstandings and promote a mutually beneficial resolution.

2. Focus on Interests, Not Positions

Parties should focus on understanding each other's underlying interests rather than fixating on specific positions.

By identifying and addressing the underlying concerns, it becomes easier to find creative solutions that meet the needs of both parties.

3. Seek Professional Mediation if Needed

In cases where negotiations reach an impasse or become contentious, seeking the assistance of professional mediators can help facilitate productive discussions.

Mediators can provide an unbiased perspective, guide the negotiation process, and help parties find common ground.

4. Consider Alternative Dispute Resolution Methods

Parties may also explore alternative dispute resolution methods, such as arbitration or expert determination, to resolve any disputes that arise during the negotiation process.

These methods provide a structured and objective approach to dispute resolution, potentially reducing the time and cost associated with traditional litigation.

Conclusion

Effective negotiations of PPAs are crucial for protecting and enhancing deal value in M&A transactions.

By following key considerations and employing effective negotiation strategies, parties can avoid disputes and ensure a fair determination of the purchase price.

Open communication, focus on interests, and consideration of alternative dispute resolution methods can contribute to successful negotiations that ultimately benefit all parties involved.

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The information provided is intended for general informational purposes only and should not be construed as legal, tax, or financial advice.

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For more information, please contact:

Kresimir Peharda

[email protected]