The Anatomy of a Deal Newsletter June 25, 2021
- A deal’s purchase price can be adjusted post-closing based on a number of factors, at which point disputes often arise.
- Most adjustment disputes start when the buyer (now having operated the business for a few months) delivers its final calculation of the closing adjustments to the seller.
- Most purchase agreements leave all adjustment disputes to an independent accounting firm or valuation company to make the final determination.
- Setting a post-closing adjustment escrow amount can be difficult, and it’s not uncommon to see adjustment disputes in which the amount in controversy exceeds the adjustment escrow.
- Both parties should make the adjustments a priority and not wait until the last minute to prepare and test the working capital methodology.
Last month, we talked about indemnification claims , which are the scary ones because they can be really big, but they’re actually pretty infrequent.
On the other hand, adjustment disputes happen much more frequently. And while the dollars at issue may not be earth-shaking, they can still be pretty damn big. So this month, we’re going to take a closer look at these adjustment disputes.
We’ve also talked about closing adjustments previously, but as a quick refresher, we’re talking about adjustments that are made to the top-line purchase price to account for things such as working capital (i.e., current assets (except cash) over current liabilities (except debt)), cash, debt, inventory, or any other similar adjustment. The idea behind these adjustments is that the purchase price the buyer is paying is usually a cash-free/debt-free purchase price that assumes a normal level of working capital, inventory, or whatever the agreed-upon metrics might be. In other words, the buyer doesn’t want to pay the full purchase price only to find out that it has to inject a bunch of money in the business on day one just to ensure that it can run normally.
As an example, let’s say Globo Gym enters into a stock purchase agreement to acquire all of the outstanding stock of Average Joe’s. When we flip to the purchase price section, it might read something like this:
“At the Closing, Globo Gym shall pay to the Shareholder the sum of $1,000,000, plus the Closing Cash, minus the Closing Indebtedness, plus the Working Capital Adjustment Amount (if it is a positive number), minus the Working Capital Adjustment Amount (if it is a negative number, but expressed as a positive number for purposes of this calculation), minus the Stockholder Transaction Expenses.”
While in most cases the purchase price gets adjusted at the time of closing based on estimates of each of these values, let’s say for simplicity that there’s a single post-closing adjustment made 90 days after closing, once Globo Gym takes over and the dust settles. At that time, Globo Gym delivers Peter LaFleur (the sole shareholder of Average Joe’s) its final calculation of the purchase price, as follows:
|Base Purchase Price||$1,000,000|
|Plus Closing Cash||$1,000|
|Minus Closing Indebtedness||($85,000)|
|Plus/Minus Working Capital Adjustment||($145,000)|
|Minus Stockholder Transaction Expenses||($100,000)|
|Final Purchase Price:||$671,000|
Globo Gym’s lawyers include a long recitation of all the stuff that resulted in this big adjustment, including late fees for rented videos, stacks of unpaid bills owed to vendors, and uncollectible membership fees from Steve the Pirate.
Peter is stunned. He never thought that he’d be selling his baby for a little more than two-thirds of what he actually expected to take home.
What can Peter do? Sue Globo Gym? Try to undo the deal? Challenge Globo Gym to a winner-take-all dodgeball match?
Well, in most cases, the purchase agreement will be quite clear about the process for resolving adjustment disputes. But that doesn’t mean that there won’t be plenty of twists and turns along the way.
Do You Realize You Haven't Collected Any Membership Fees in 13 Months?
Most adjustment disputes start when the buyer (now having operated the business for a few months) delivers its final calculation of the closing adjustments to the seller. Even though the buyer is providing its calculations post-closing, it is still required to calculate each of these components as of the closing date. But, now that the dust has settled, it should be fairly clear what the numbers actually were as of the closing date, right?
Except things often aren’t as clear as you would hope. That’s because there are often judgments that get made whenever the buyer and seller calculate each of the components that make up the adjustment. And sometimes it’s hard to freeze the company’s balance sheet at a single moment in time in order to make a truly accurate determination.
For example, Average Joe’s hasn’t been collecting membership fees for 13 months, but they’re still including those old membership fees as receivables on the books as assets. And Peter feels pretty confident that they’ll get paid. After all, his members have always paid in the past…eventually. Plus he’s got a promise from Steve the Pirate that he’ll be sharing a portion of his buried treasure with him!
Globo Gym is much more skeptical that these old membership fees are going to be paid. So instead of treating these old receivables as an asset in the working capital adjustment, Globo Gym determines that they’re uncollectible and writes them down (or writes them off entirely). After all, why should Globo Gym pay for receivables that aren’t likely to be collected?
So who’s right? The purchase agreement will generally include some guidelines used in calculating the working capital and other adjustments. First and foremost is the system of accounting that’s used. Most buyers want to require a GAAP (generally accepted accounting principles) standard, but lots of privately held companies don’t use a GAAP system of accounting at all, or if they do, they use a modified version of GAAP. The working capital and other adjustments must properly compare apples-to-apples, so we need a standard that provides an accurate basis for comparison. Then we have to articulate that accounting standard in the agreement so that everyone can understand how the adjustments are computed, which can be a real challenge itself.
And even when we’ve agreed on the appropriate accounting standard, there are judgments and classifications that are made within that standard that may have a major impact. Given the somewhat subjective nature of these types of things, there’s only so much the purchase agreement can do to ward off disputes later.
So Peter and White Goodman (Globo Gym’s president) sit down and try to reach an agreement. But there’s too big a difference and too much emotion involved. So what next?
*Thank You,* Chuck Norris!
So now we have a real dispute on our hands. And unlike indemnification claims, which can in some cases be resolved before a judge, a jury, or an arbitrator, most purchase agreements leave all adjustment disputes to an independent accounting firm or valuation company to make the final determination.
The first question, then, is who decides the firm that serves in this role? In many cases, the parties will pre-agree on an independent firm in the purchase agreement. That way there’s no fight later about who makes the decision. However, sometimes that doesn’t happen in the agreement or the appointed firm can’t or won’t accept the engagement. In those cases, there’s a whole separate fight to be had about who serves in this role.
Then there’s a question about what the independent firm is being asked to do. In some cases, the agreement may give the independent firm broad latitude to make whatever determination it chooses and the parties simply agree to live with it. In other cases, the agreement may restrict the role of the independent firm significantly. For example, it’s common to provide that the independent firm will make its determination based solely on the presentations provided by the buyer and seller and without any independent review or investigation by the independent firm. Also, in many cases, the independent firm must pick a value that falls within the range established by the buyer’s and seller’s respective positions. Alternatively, the agreement could call for a “baseball arbitration” provision where the independent firm can only choose the buyer’s position or the seller’s position—no splitting the difference.
But it’s still important to note that the independent firm has broad latitude to determine the final adjustment computation. And in most cases, the firm’s determination will be final, binding, and not appealable (except in extreme cases, such as where there’s evidence of true fraud or a clear mathematical error). So the buyer and seller both enter into this process with some trepidation.
And then we still have the question of who pays for the independent firm. While many firms are happy to serve in this capacity, in my professional experience, most of them like to be paid for their services. Once again, the agreement usually provides a default rule, such as having both parties share equally or requiring the “loser” to pay. The latter option also raises some other unique issues because—except in baseball arbitration—the independent firm’s decision might fall somewhere between the buyer’s and the seller’s positions. In that case, it’s common to see a mechanism that requires the buyer and seller to pay a proportion of the independent firm’s fees based on the degree of that party’s success (or failure) in disputing the other party’s position. That mechanism alone may encourage buyers and sellers to be more reasonable in staking out their positions heading into a review by the independent firm because being too greedy might put them on the hook for more of the firm’s fees.
And so Globo Gym and Peter put their respective fates into the hands of Chuck Norris and his partners at Norris & Associates, with hundreds of thousands of dollars on the line.
Maybe We Could Pay It Off in Canadian Dollars and Save Ourselves Some Money!
This time, Globo Gym successfully convinces Chuck Norris and his partners that Globo Gym is owed at least a significant part of the adjustment. Now, how does Globo Gym get paid? After all, Peter is pretty irresponsible with money; how do we know he hasn’t already spent every dollar that Globo Gym paid at closing?
Similar to indemnification claims, most buyers are sensitive to this issue on the front end and plan accordingly. So, just like with indemnification claims, many buyers propose escrows or holdbacks to provide a source of money to satisfy the claim. In many cases, the buyer will want a separate escrow for adjustment claims rather than looking to the indemnification escrow to recover these amounts. Why? Because the buyer wants to be able to tap into the escrow to pay any adjustment owed to it without fear of eating away at dollars it wants to keep available in case of future indemnification claims. And sellers only want to put additional dollars in escrow for adjustment claims if they’re confident that those additional dollars won’t be tied up for 12-18 months as is the case with indemnification escrows. So buyers and sellers will often agree on a short-term adjustment escrow that is expected to be held for approximately 90-120 days after closing, though it could go longer in the event of a protracted adjustment dispute.
But there’s always some uncertainty as to how much of the purchase price to withhold for purposes of funding an adjustment escrow or holdback. Indemnification escrows often track the indemnification cap, and while there’s some theoretical risk that indemnification claims could exceed the cap, it’s generally unlikely. On the other hand, an adjustment could theoretically be almost any amount. It’s not uncommon to see adjustment disputes where the amount in controversy exceeds the adjustment escrow. In those cases, the buyer still has to figure out how to get paid the difference.
And, because the adjustment should go both ways in most deals, sellers have to think about how they get paid if the adjustment turns out in their favor. Buyers usually say this isn’t an issue because the buyer now owns the business and can simply use the business to generate the cash needed to pay the seller. But in some cases, that’s not enough, particularly when the seller is rolling over equity in the deal. The seller doesn’t want to be using dollars from the business it partially owns to pay the seller’s adjustment; doing so effectively means that the seller is paying a portion of its own adjustment.
It's a Bold Strategy, Cotton. Let's See If It Pays Off for Them.
As if all of that wasn’t enough, there are often fights about things that weren’t even contemplated at the time of closing. What if, after the closing, Average Joe’s unexpectedly receives a life insurance payment relating to the tragic death of dodgeball coach Patches O'Houlihan, even though Patches died before closing? What happens then?
Sometimes the closing adjustments become a de facto battleground for a whole host of other stuff that would have been addressed prior to closing, if only we had known about them. Those types of claims become particularly difficult because there’s nothing tangible that we can point to other than some vague sense of “fairness.” While most business people believe in doing what’s fair and right, there can often be differences in opinion as to what those mean in a specific situation.
But, you don’t get what you don’t ask for. So sometimes, the strategy is to throw all of these items into the mix and see how everything ultimately shakes out.
While the theory of purchase price adjustments is usually pretty straightforward, disagreements often arise because you’re trying to capture individual components of a living, breathing business at a single moment in time. That’s hard enough on its own, but it becomes even harder when you add the buyer’s and seller’s respective expectations and biases into the equation.
So, what’s the moral of the story? Make the adjustments a priority. Don’t wait until the last minute—as is often the case—to prepare and test the working capital methodology, and each of the underlying components. Make sure it captures the right operating drivers and excludes things that improperly skew the calculation. Then, expend the effort to negotiate procedures in the agreement that will provide for a “fair fight” in the event of a dispute. Finally, hope like hell that everything works out just fine.
Or, you can just be like Peter and not have any expectations about how much you ultimately get to keep from selling your business. After all, if you don’t have any goals, you’re never disappointed. I’m told that’s a phenomenal feeling.
Next Month: Post-Closing Integration in a Mad (Men) World
Read last month’s piece: Oh, Sh*t! Anatomy of an Indemnity Claim