Private M&A transactions frequently provide for post-closing purchase price adjustments. These provisions are designed to ensure that the value exchanged at closing reflects the bargain struck when the parties signed the purchase agreement. When they are appropriately tailored to the transaction, post-closing purchase price adjustments are valuable tools for reducing the risk that the buyer has overpaid or that the seller has received too little consideration. But when ill-considered and not carefully drafted, they can become a source of significant dispute and financial loss.
There are two general categories of purchase price adjustments: earn-outs and balance sheet adjustments. Earn-outs tie a portion of the seller’s compensation to the performance of the target business after closing. A closing balance sheet adjustment accounts for fluctuations in the value of the target business between the signing of the purchase agreement and the closing of the deal.
In theory, both earn-outs and balance sheet adjustments should be objective mechanisms that guarantee that the parties receive the value that they bargained for. In practice, however, the calculations of post-closing income or working capital can be complex and subjective, and when disputes arise, they tend to lead to significant economic loss, for example, by consuming resources that should otherwise be focused on integrating the target business into the buyer’s existing operations.
Accordingly, the parties and their counsel should consider using strategies to reduce the likelihood of costly purchase price adjustment disputes, such as:
- Specifying Accounting Principles - Accounting principles are by far the biggest source of conflict over purchase price adjustments. The purchase agreement should be explicit as to (1) whether the parties will use generally accepted accounting principles (GAAP) or some variation on GAAP that is consistent with the seller’s historical practices, and (2) how those accounting principles should be applied. GAAP often allows a range of approaches to be used on matters such as revenue recognition, A/R aging reserves, and inventory policies. Precision is essential, as courts have interpreted “in accordance with GAAP applied on a basis consistent with past practice” to have a different meaning than “in accordance with GAAP and applied on a basis consistent with past practice.”
- Including an Example - Attaching a sample calculation as an exhibit to the purchase agreement can force the parties to consider the application of accounting principles on a line-item level of detail and minimize future disputes.
- Using Escrows - Some portion of the consideration should be placed in escrow at closing in order to cover any purchase price adjustments. This protects the buyer from having to pursue collection from the seller. Sellers can also seek to limit remedies to the recovery of the escrow funds, thereby capping their exposure.
- Addressing Related Party Transactions - Transactions with the affiliates and related parties should be carved out of post-closing payables and receivables when calculating purchase price adjustments.
- Accruing Interest - Providing that interest will accrue during the dispute resolution process can help incentivize the parties to reach an agreement quickly.
- Ensuring Access to Records - Sellers should confirm that they will have access to the records of the target business after closing so that they can effectively review the buyer’s earn-out or final working capital calculations.
If you would like any additional information about navigating the use of post-closing purchase price adjustments, please contact the attorneys in Parker McCay’s corporate department at any time.
The content of this post is for informational purposes only and should not be construed as legal advice or legal opinion. You should consult a lawyer concerning your specific situation and any specific legal question you may have.