When Assumptions Meet Reality in M&A: Purchase Price Adjustments From the Buyer’s Perspective

When a buyer determines its valuation of a business it has targeted for acquisition, that valuation is based on a number of assumptions, such as continuing historical growth and retention of key customers, suppliers, and employees.  Other common assumptions are that the business will include sufficient working capital for the buyer to operate the business in the ordinary course of business immediately following the closing, and that the business will be “cash free, debt free” (other than what should be included in working capital) as of the closing.  Purchase price adjustments are used to square these assumptions with the reality of the acquisition target at the closing.

Initially, care should be taken at the LOI stage to identify the correct purchase price adjustment metrics.  An adjustment based upon working capital is extremely common, but will working capital include cash or will cash be broken out to its own adjustment?  If the sellers will be credited for all of the target’s cash on hand at the closing, the buyer should consider the practical impact; does the business collect accounts receivable quickly enough to build sufficient cash to pay bills, make payroll obligations, etc.?


Due Diligence

Following execution of the LOI, thorough due diligence will be required to set appropriate targets for the adjustments.  Quality of earnings reports are frequently relied upon to determine a correct working capital target.  If the buyer isn’t utilizing a third party to assist with this analysis, a common standard is to look to the target’s 12-month trailing average.  This calculation may not be sufficient on its own, however.  If the target’s business is subject to seasonal variance, is experiencing rapid growth requiring increasing amounts of working capital on hand, or is subject to other factors that may require less or more working capital on hand than a simple average, all such factors should be taken into account when determining the targets.  It is not unusual for purchase price adjustment targets to be heavily negotiated over the course of a transaction.

When drafting the purchase agreement, the buyer and its deal counsel should work closely to ensure that the financial metrics and calculations making up the purchase price adjustments are correct.  For example, bad debt should generally be excluded from the definition of accounts receivable, and unsalable and obsolete items should generally be excluded from the definition of inventory.


Prioritize Process

It is also important that the parties agree on the process for determining the values of the purchase price adjustment metrics, and for the flow of cash to one side or the other.  Typically, a purchase price adjustment will include an estimate of the adjustment metric as of the closing date, which then impacts the amount of cash paid to the sellers at the closing (e.g., a working capital target is agreed upon, and the cash at closing is adjusted upwards or downwards on a dollar-for-dollar basis depending on whether working capital is expected to be above or below the target).  Following the closing, there will be a look back to the closing date with the benefit of hindsight, and a true up occurs if the actual amount of the adjustment metric was greater or less than the estimated amount.  The process to arrive at a final determination can be quite detailed, and can take a number of months and include an independent accounting firm to act as a fact finder if the parties are unable to come to an agreement after the closing.  It is important to account for all realistic scenarios.

The buyer should also consider how it will be paid if there is a shortfall following the final determination of the purchase price adjustment.  In some instances, particularly where a working capital target is of significant size or there are a number of sellers (usually stock sales or mergers), the buyer should insist on a separate working capital escrow fund that is to be used to fund any shortfall.  These escrow funds are usually separate from a general post-closing indemnification escrow fund, and are released shortly after the final determination of closing working capital.  From the buyer’s perspective, it will want any working capital escrow to also be available to satisfy indemnification claims if a claim is discovered prior to the release of the working capital escrow.


Forming Your Deal Team

Purchase price adjustments play a key role in ensuring that a buyer is put in a position to succeed with its new acquisition.  As a buyer, it is important that your deal team has sufficient knowledge and experience to identify and solve for the issues that commonly arise in regards to purchase price adjustments.

If you’re forming your deal team, and need high-quality legal representation from attorneys that possess the knowledge and experience to guide you through these issues, give us a call at 720-306-1001 or email info@doidacrow.com.



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