In our March M&A Newsletter, we provided a broad overview of various price adjustment mechanisms which can be included in share purchase agreements. In this newsletter, Barton Hoggard considers, in greater detail, the purpose and potential pitfalls of the main price adjustment provisions currently being used in the market.
The price of a target company is at the heart of any transaction and can be based on a number of factors including net asset value, a multiple of earnings, revenue and/or comparative prices for similar companies. Furthermore, a purchase price is usually based on the target company’s balance sheet as at a date shortly before the execution of the acquisition agreement. Purchase price adjustments are mainly used by parties to:
(i) underpin or verify the assumptions on which the purchase price was based;
(ii) bridge the gap between the respective valuations of sellers and buyers; and
(iii) allocate amongst the parties any increase or decrease in the value of the target company from the date on which the acquisition agreement is signed until completion of the acquisition.
There is significant potential for disputes to arise between the parties in connection with post-completion price adjustments. A badly drafted price adjustment clause can result in one party obtaining an unintended windfall at the expense of the other party (for example, where the buyer is effectively compensated twice for the same loss). Furthermore, ambiguous price adjustment provisions may allow the seller to take certain action to artificially increase the purchase price (for example, by manipulating the level of the target company’s working capital and/or debt). Protracted and costly disputes between the parties are likely to arise where these clauses are open to interpretation. Therefore, it is essential that the relevant price adjustment provisions (in particular, the definitions of the items being valued and the valuation methodology) are clear and precise to avoid the pitfalls referred to above.
The buyer’s financial advisers should be consulted in connection with drafting price adjustment clauses because such clauses relate to matters that fall within their expertise and such advisers will be best placed to confirm the accounting methodology used by the target company in preparing its financial accounts as well as the basis on which the buyer reached its valuation of the target company.
Set out below is an extract from a typical consideration clause which includes the baseline price plus adjustments based on the target company’s debt and working capital as well as an earn out provision under which the balance of the consideration will be paid to the seller (provided certain prescribed targets are met).
1.1 The Consideration for the Sale Shares shall be an amount, in cash, equal to the sum of:
1.1.1 AED [ ], which shall be satisfied by the delivery of a managers cheque for such amount to the Seller upon Completion;
(a) plus the sum of the amount by which the Company’s Actual Debt is less than the Company’s Estimated Debt (“Debt Shortfall Amount”), such sum being payable by the Buyer to the Seller in accordance with clause 1.2.1; or
(b) less the sum of the amount by which the Company’s Actual Debt exceeds the Company’s Estimated Debt (“Excess Debt Amount”), such sum being payable by the Seller to the Buyer in accordance with clause 1.2.2.
(a) plus the sum of the amount by which the Company’s Actual Working Capital exceeds the Company’s Base Working Capital (“Excess Working Capital Amount”), such sum being payable by the Buyer to the Seller in accordance with clause 1.2.1; or
(b) less the sum of the amount by which Company’s Actual Working Capital is less than the Company’s Base Working Capital (“Working Capital Deficit Amount”), such sum being payable by the Seller to the Buyer in accordance with clause 1.2.2;
1.1.4 plus the 2012 Earn Out Amount (if applicable), such sum being payable by the Buyer to the Seller in accordance with clause [ ];
1.1.5 the 2013 Earn Out Amount (if applicable), such sum being payable by the Buyer to the Seller in accordance with clause [ ].
1.2 On the date being ten (10) Business Days after the date on which the Completion Accounts are agreed or determined in accordance with Schedule [ ]:
1.2.1 the Buyer shall pay to the Seller the Debt Shortfall Amount and/or the Excess Working Capital Amount (as applicable); and
1.2.2 the Seller shall pay to the Buyer the Excess Debt Amount and/or the Working Capital Deficit Amount (as applicable),
provided that if the Buyer is required to pay an amount under clause 1.2.1 and the Seller is required to pay an amount under clause 1.2.2, the net sum (as a result of offsetting the two amounts) shall be paid by the Seller or the Buyer (as applicable).
The above clauses are the starting point for purchase price adjustments in an acquisition agreement and should not be contentious. However, the real negotiations between the parties usually relate to:
(i) the defined terms (e.g. what constitutes working capital and debt);
(ii) the methodology for calculating the target company’s working capital and debt;
(iii) the interaction between the price adjustment mechanisms (to avoid double counting items);
(iv) the conduct of the business between signing and closing to prevent the seller manipulating the target company’s working capital and/or debt to increase the purchase price; and
(v) the procedure for calculating the earn out amounts and the parties’ respective rights in relation to such amounts (e.g. set-off and claw back rights).
Below, we assess the purpose of the price adjustments in the sample clause set out above and describe the main issues that should be considered in respect of such adjustments.
In our experience, a working capital adjustment is the most commonly used price adjustment under acquisition agreements as buyers often want comfort that the target company will have a normal level of working capital at closing to allow the target company to maintain its business and revenue without requiring further funding from the buyer.
The baseline working capital amount is usually negotiated between the parties and the parties endeavour to include appropriate adjustments for seasonal businesses or particular events (e.g. the holy month of Ramadan). An inappropriate baseline working capital amount can have significant financial consequences so this risk is sometimes mitigated by including a cap on the working capital adjustment.
There is a natural connection between working capital, cash and debt because the main components of working capital (inventory and trade receivables) convert into cash in the short term which then reduces the target company’s debt. In the event that the purchase price is based on a certain level of debt, a seller could manipulate the target company’s working capital by delaying the payment of its creditors which would reduce the target company’s normal overdraft level (i.e. its debt) and increase the price.
On the other hand, if a price adjustment is based solely on a certain level of working capital and the acquisition agreement does not include appropriate protections against manipulation, a seller could artificially increase the price by selling fixed assets, deferring capital expenditure or reducing P&L expenditure such as marketing costs (thereby increasing the cash in the target company’s working capital).
Therefore, it is important that the acquisition agreement includes protections against such manipulations.
As noted above, the methodology for calculating the target company’s working capital should be clearly set out in the acquisition agreement to: (i) minimise the potential for disputes that can arise from an ambiguously drafted valuation procedure; and (ii) ensure that the methodology used for preparing and finalising the completion accounts is consistent with the methodology used in agreeing upon the balance sheet of the target company immediately prior to signing (i.e. the parties are comparing like for like).
A commonly used example of issues that can arise from ambiguously drafted valuation procedures is where an agreement simply refers to the use of GAAP to calculate working capital. Such a provision is likely to create significant uncertainty because it is possible to use several different accounting methods for the same line item. For example, the value of a target company’s inventory can be materially different depending on whether a “Last In First Out” or “First In First Out” valuation method is used. Both methodologies are acceptable under GAAP.
Where an acquisition agreement includes both a working capital adjustment and a debt adjustment, care should be taken to ensure that the definitions of working capital and debt do not overlap resulting in one party being affected by the same item twice. A good example is the part of a long term loan that is a current liability (which could potentially fall within both definitions). If the definitions of working capital and debt are not drafted precisely, a seller could be subject to a double reduction of the purchase price.
The enterprise value of a target company is generally the price that the buyer attributes to the target company on a “debt free, cash free” basis. In practice, companies are rarely free of debt, so the purpose of the “debt” price adjustment is to ensure that the debt free assumption is reflected in the final purchase price.
Once again, it is important that the definition of debt in the acquisition agreement is clear and unambiguous. From a buyer’s perspective, it should include debts shown in the target company’s balance sheet as well as off-balance sheet debt (e.g. performance bonds, receivables discounted on a recourse basis, and finance lease liabilities).
Interaction of Price Adjustments and Indemnities
It is also important to fully understand the interaction between the price adjustment mechanisms and the seller’s potential liability under the warranties and indemnities in the acquisition agreement.
Firstly, the acquisition agreement should ensure that there is no inadvertent double dipping which allows a buyer to be compensated for the same loss twice.
The parties could consider carving out certain indemnified items from the working capital/debt adjustment, however, this could disadvantage the buyer because:
(i) the buyer may be required to go through a longer and more expensive process (e.g. arbitration or court hearings) to obtain payment of the indemnified amount than if the relevant item was simply included in the post completion price adjustment; and
(ii) the relevant indemnities can be subject to limitations (e.g. deminimis, threshold, cap and claim period) which are hurdles that the buyer would not normally have to overcome under a normal price adjustment mechanism.
If the indemnification provisions exclude items in the working capital/debt adjustment, the buyer could unwittingly be left out of pocket because the price adjustment only relates to the difference between an estimated valuation and an actual valuation as opposed to full compensation for the relevant liability.
All of these potential issues can be overcome through appropriate protections and precise drafting in the acquisition agreement.
Earn out provisions can be used where the seller and the buyer disagree on the value of the target company. In such circumstances, part of the purchase price can be contingent on the company’s performance after the acquisition. Normally the benchmarks are financial targets (e.g. revenue or earnings), however, in certain circumstances non financial conditions could be appropriate (e.g. obtaining the approval of the Supreme Petroleum Council to carry out oil and gas activities). Sellers will prefer revenue based benchmarks so their payments are not affected by operating expenses, however, buyers will prefer net profit targets to incentivise the former owner to manage costs and expenses appropriately.
As part of the negotiation of earn out provisions, there is usually a discussion between the seller and the buyer with regard to the conduct and control of the business during the earn out period. The seller wants control of the business to maximise its chance of reaching the earn out targets and to ensure that the buyer does not transfer assets and/or revenue out of the target company. The buyer normally wants to have the flexibility to manage the company as it sees fit to maximise any potential synergies with other businesses owned by the buyer and to ensure that the buyer does not maximise short term gains/profits to the detriment of the long term prospects of the target company.
Other benefits to the buyer that arise from earn out provisions are as follows:
(i) Defers part of the buyer’s funding obligations and reduces the cost of raising such funds.
(ii) Incentivises the former owner to increase the revenue and profitability of the target company after the acquisition.
(iii) Gives the buyer a potential source of funds against which the buyer could offset warranty claims or indemnities provided by the seller under the acquisition agreement.
The seller benefits from the earn-out arrangements in the event that its projections are accurate.
Well drafted price adjustment clauses in an acquisition agreement can be very useful in:
(i) underpinning and verifying the assumptions on which the purchase price has been based;
(ii) bridging the gap between the respective valuations of the seller and the buyer; and
(iii) allocating amongst the parties any increase or decrease in the value of the target company from the date of the acquisition agreement to closing.
The interaction between each price adjustment mechanism and the warranty/indemnification provisions in the acquisition agreement should be carefully considered to ensure that:
(i) the seller is not permitted to manipulate the financial position of the company to artificially increase the purchase price; and
(ii) the seller is not penalised for the same loss/liability twice.
A badly drafted or ambiguous price adjustment clause can result in one party obtaining an unintended windfall at the expense of the other party and/or cause a protracted and costly dispute between the parties. Therefore, all of the potential consequences of the price adjustment provisions in an acquisition agreement should be considered by the parties’ legal and financial advisers to avoid potential pitfalls.
Author: Barton Hoggard
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