The Anatomy of a Deal Newsletter October 26, 2018
What is it?
Closing adjustments refer broadly to any number of potential adjustments to the purchase price in a transaction. These most commonly take the form of working capital adjustments; adjustments based on closing cash, indebtedness, and transaction expenses; accounts receivable adjustments and/or inventory adjustments. In most cases, the purchase price is adjusted, upward or downward, by the amount by which any of these balances at closing may differ from a pre-negotiated target balance.
What does it really mean?
These adjustments may take any number of forms as illustrated above, but they generally all are aimed at the same goal: ensuring that the Seller delivers to the Buyer a “turn-key” business that does not require immediate additional investment from the Buyer. The negotiated purchase price assumes that the Buyer can begin operating the business as normal on Day 1. These adjustments essentially protect against the Seller stripping out the financial lifeblood of the target company that the Buyer will need in order to operate the business post-closing.
While this theory seems pretty simple, there’s a lot more complication to it than appears on its face. For starters, which of these adjustments do you use in a given transaction? The answer depends on a number of factors, including the structure of the transaction (stock sale/merger vs. asset sale), the nature of the target’s business, and the target company’s system of accounting (cash basis vs. accrual basis). For discussion purposes, each of the adjustments can be summarized as follows:
- Working capital: The difference between the target company’s current assets other than cash (think inventory, receivables, prepaid expenses, etc., but not equipment, real estate, etc.) over its current liabilities (think accounts payable, accrued expenses, etc., but not debt).
- Cash/debt/transaction expenses: As most transactions are structured as “cash-free/debt-free” deals, this adjustment increases the purchase price for the amount of cash left in the target company at closing and decreases the purchase price for the amount of the target company’s debt and transaction expenses remaining unpaid as of closing.
- Accounts receivable and/or inventory: When a full-blown working capital adjustment isn’t necessary or appropriate, the purchase price may be adjusted instead based on the closing balance of accounts receivable and/or inventory being acquired.
A typical closing adjustment might work something like this:
- The Buyer and Seller will first negotiate an appropriate target. The target can be determined in any number of ways. For cash, debt and transaction expenses, the target is usually zero for each, meaning that the Buyer expects no cash, debt, or unpaid transaction expenses at closing. For working capital (and perhaps the other adjustments), you generally see a target that is equal to the average historical monthly working capital balance, usually over the preceding 12 months (commonly referred to as “TTM,” which is shorthand for “trailing twelve months”). But that doesn’t always work, particularly for seasonal businesses or businesses that have experienced a significant operational change during that period. So, great care should be taken in calculating a fair and appropriate target to avoid unexpected surprises.
- The Seller will usually (but not always) deliver its estimated balances at closing. The closing purchase price is then adjusted, upwards or downwards, by the difference between the estimated closing balance and the negotiated target balance. The Buyer usually wants some visibility into how the Seller made these estimates to avoid having a major swing at the true-up (as described below), but the Buyer has to rely largely on the Seller here because the Seller is the only one with adequate information about the business prior to closing.
- A few months after closing, the Buyer will provide its calculation of the actual closing balances. After the dust has settled and the actual figures are available, the Buyer (as the current owner of the business) then calculates what the actual closing balances were for purposes of the adjustment. To ensure an apples-to-apples comparison, the purchase agreement usually requires the Buyer to prepare these calculations using the same methods of accounting used by the Seller prior to closing, though even that leaves some room for interpretation or potential disagreement. The purchase price is then “trued-up” based on the actual figures. The agreement will usually specify a process for the Seller to review and dispute the Buyer’s calculations, if necessary. It may also specify how the Buyer recoups any adjustment owed to it, particularly because the Buyer has already paid over the purchase price to the Seller.
As you might guess, the devil is truly in the details here. Because there are so many possible permutations, uncertainty involving the Buyer’s application of the Seller’s accounting principles, and incentive for gamesmanship – after all, the adjustment directly impacts the dollars received by the Seller and paid by the Buyer – great care should be invested in making sure that the closing adjustments are constructed properly and with minimal room for maneuvering.
Why Should I Care?
Buyer: The Buyer needs assurance that it’s not closing into an immediate capital infusion. If the Seller runs down the inventory while running up the payables, the Buyer may find itself paying for the business and then immediately paying more to run the business. In addition, the Buyer needs to complete its due diligence as part of the closing adjustment exercise as a means to better understand the historical operating requirements of the business as well as the Seller’s method of accounting. All of these factors will have an impact on how the Buyer operates the business post-closing.
Seller: It’s all dollars to the Seller. And to the extent the Seller may have been overly-diligent about leaving extra working capital in the business, or if the timing of the closing results in an artificial blip in working capital, the Seller might actually find that it’s disadvantaged by the closing adjustment if not properly constructed. The Seller also needs to ensure appropriate visibility into the Buyer’s post-closing true-up calculation and have an adequate procedure to challenge the calculation.
Next Month: What Goes in a Letter of Intent
Read last month’s piece: Preparing to Sell Your Company