After the deal closes
After weeks or months of burning the midnight oil, the M&A deal has finally closed. The closing dinner comes and goes as buyers and sellers alike breathe a collective sigh of relief. The heavy lifting is behind them. Or is it? Given the increasing frequency of post-closing purchase price adjustments, often times the heavy lifting begins only after the deal closes.
Purchase Price Adjustments
Purchase price adjustments, such as working capital adjustments, earn-outs and indemnification provisions, are used frequently in M&A transactions as tools to mitigate financial risks to buyers while ensuring fair compensation to sellers. In recent years, purchase price adjustments have become routine in M&A transactions as economic uncertainty has decreased the reliability of traditional valuation metrics, such as historical financials and performance measures. While these tools are useful to bridge purchase price gaps and address certain “unknowns” of a business, careful drafting and thoughtful analysis must be part of any purchase price adjustment mechanism.
Working Capital Adjustments
A working capital adjustment, which is typically used to compensate or penalize a seller for an increase or decrease in the estimated working capital at closing, is the most common form of post-closing purchase price adjustment. In its simplest form, the seller estimates its working capital (typically, current liabilities minus current assets) prior to closing, and the buyer conducts a “true-up” audit of those numbers after the closing.
This “basic” net working capital formulation is often inadequate to address business-specific matters unique to a transaction-there is no “one size fits all” working capital adjustment calculation. As a result, it is imperative to understand the client’s goals and to use clear and descriptive drafting to carefully tailor a working capital adjustment that achieves those goals. In fact, for many deals, working capital may be an inappropriate or inadequate adjustment. Closing date revenues, shareholders’ equity, and other financial metrics may all provide stronger measurements for a post-closing true-up.
When drafting, the parties should consider:
The use of generally accepted accounting principles (GAAP) as a financial measure (including whether the seller currently uses GAAP or some other methodology), and, if GAAP is used, specific principles of GAAP to apply for your deal (e.g., types of inventory accounting or revenue recognition);
Whether the buyer’s or seller’s historical accounting treatment should be used to determine working capital;
Specific inclusions and exclusions from working capital;
Firm deadlines by which such adjustments must take place;
Conflicts with indemnification provisions, i.e., avoiding a “double dip”;
A range for an acceptable working capital target rather than a sum certain; and
A working capital model (using the agreed to format and principles) as an exhibit to the purchase agreement.
Above all, good communication between legal and business teams is critical to carefully drafted working capital provisions that should help avoid post-closing disagreements. Counsel must understand precisely what the client intends to achieve by using a working capital adjustment and must ensure that the client understands exactly how the provision will operate in practice. Good communication and careful drafting will help avoid post-closing surprises regarding any working capital adjustment.
An earn-out provision is a form of purchase price adjustment that conditions a portion of the purchase price upon the target’s achievement of specified operational or financial milestones. These provisions are often used to (i) bridge purchase price gaps, (ii) incentivize the target’s post-closing operational performance, and (iii) align the strategic goals of the target with its financial performance. Because these provisions are highly-litigated, it’s important to put in the effort up front to avoid post-closing disputes.
Take the time to define the rules. Simple metrics are best and leave little room for ambiguity. As a seller, you should insist on metrics that are within your control. For example, you should never agree to an operations-based earn-out if you are not going to have any operational oversight or control post-close. For a seller, consider covenants regarding future operations of the company to maximize earn-out potential. A buyer will want to limit those same types of covenants to the extent they interfere with the buyer’s ability to conduct its business.
Defining with specificity the up-front expectations regarding performance goals is also an integral part of putting together an earn-out package. Most earn-outs are based on post-closing earnings before interest, taxes, depreciation, and amortization (EBITDA) targets, but even each element of an EBITDA target has to be considered. For example, are changes in profitability unrelated to the operational performance of the seller’s business included in any earn-out calculations? Simple and clear earn-out objectives will eliminate many post-closing disputes relating to earn-outs.
Indemnity claims are used primarily for breaches of representations and warranties by the seller(s) or for third party claims brought against the buyer relating to the seller’s past operations. While historical indemnity claims have been relatively infrequent, the current economic climate appears to have prompted an increase in such claims.
It is impossible to prevent all indemnification claims, which makes it important for the parties to prepare for such claims. First and foremost, sellers can avoid having claims brought against them, or can limit potential damages, by careful drafting of the purchase agreement, and specifically by:
Limiting the duration of any survival period for representations and indemnity obligations;
Limiting the dollar amount of total indemnity obligations, and creating baskets (or a deductible) and de minimus claim amounts to prevent “nickel and dime” claims by the buyer;
Setting aside a fund out of deal proceeds that the seller or seller’s representative can use to pay costs incurred in defending against indemnity claims;
Avoiding joint and several liability among several sellers; and
Requiring a buyer to represent that it is not aware of existing issues that could give rise to a claim (or including a clause that prevents the buyer from raising indemnity claims for something that it knew about at closing).
In addition to thoughtful negotiation of the above provisions prior to signing the purchase agreement, a buyer, when considering whether to bring a claim post-closing, should evaluate:
Whether the sellers are key employees of the buyer post-closing (and thus whether the buyer risks damaging those relationships by raising a claim);
Time and effort involved in pursuing a claim versus the likely payout; and
Availability of an escrow fund (or the credit-worthiness of sellers, if not).
After the deal closes, the parties should focus on the integration of the two businesses rather than worrying about potential or actual post-closing disputes. While it remains likely that disputes will arise, clear drafting and thoughtful negotiation will help avoid many post-closing disputes relating to purchase price adjustments and allow the parties to focus their attention on moving the business forward, not on dispute resolution.