This is the second article in Fortis Advisors' After Closing Series highlighting frequently occurring post-closing issues that should be considered before signing an M&A agreement. The series focuses on helping selling shareholders avoid common pitfalls in the post-closing period.
In private M&A transactions with working capital adjustment provisions, the purchase price paid at closing is normally based on the seller's pre-closing estimate of what its working capital will be at the time of closing. That's because the actual closing-date working capital cannot be determined until after the closing.Purchase price, or "working capital" adjustment provisions in the agreement are then applied to "true up" the difference between the estimated and the actual or "final" working capital amounts. Money flows to the buyer if the actual amount is less than the estimate, and to the seller if it is more than the estimate. This article highlights two of the most common areas of post-closing working capital disputes and provides practical suggestions on how they can be avoided.
Specific working capital adjustment mechanisms differ in each deal, but most provisions provide as follows:
- The seller prepares and delivers the closing working capital estimate within days before the closing.
- Next, after closing, the buyer has a specified amount of time (customarily 60-90 days) to determine how much working capital the seller actually had at closing and deliver its working capital calculation to the selling shareholders' representative.
- Subsequently, upon receipt of the buyer's calculation, the shareholder representative has a period of time (usually 30 days) to review the buyer's working capital amount. In order to evaluate the buyer's calculation, the shareholder representative will require access to the company's books and records, as well as the opportunity to speak to the appropriate accounting personnel.
- Finally, upon conclusion of its review, the shareholder representative will notify the buyer whether or not it is in agreement with the buyer's calculation. Although the buyer and the shareholder representative are reviewing the same data, their conclusions can differ for a variety of reasons.
Given the complex nature of these provisions, and the fact that the working capital amount is separately calculated by parties with diametrically opposed positions, it is not surprising that purchase price adjustments are the most common source of post-closing disputes in private M&A transactions. Fortis has extensive exposure to the latest trends in purchase price adjustments and constantly addresses post-closing issues that arise from these provisions.This unique perspective enables us to identify the sources of post-closing conflicts that can potentially be avoided if certain issues are addressed during the drafting stage. Here are two of the most common areas of disputes, along with suggestions on how they can be avoided:
Definition of Working Capital: The most frequent disputes arise from the definition of working capital (or lack thereof) and guidance on how the final working capital amount should be calculated. For example, the merger agreement may contain language stating that the standard for the calculation is determined in accordance with the seller's historic accounting practices that are in accordance with GAAP. However, the buyer may take the position, for its own purposes on a go-forward basis, that the seller's accounting policies were improper or otherwise flawed and should not apply.In our experience, the best way to avoid these accounting arguments is to attach a schedule to the merger agreement setting forth the specific accounting policies and procedures used to prepare the working capital estimate. The schedule should set forth the definitions of working capital as well as the components thereof (i.e. assets and liabilities), if applicable. It is much more difficult to dispute the accuracy of the policies and procedures and meaning of definitions when they are specifically addressed in the agreement itself.
Indemnification Claims: Since both the purchase price adjustment and indemnification provisions of an agreement could apply to a claim, a common dispute arises as to which remedy the buyer should be able to pursue. For example, if there is a disputed accounting issue that resulted in a decrease in working capital, the buyer could claim that either it is entitled to a negative purchase price adjustment or it can seek indemnification for a breach of a financial statement representation. The distinction is important since an adjustment claim would generally not be subject to the negotiated indemnity basket, cap, and other limitations applicable to indemnification claims.An effective way to prevent indemnification claims being brought as improper purchase price adjustments is to stipulate in the closing agreement that adjustment claims are limited to changes in working capital amounts by applying consistent accounting principles. All other claims (i.e. that the historic practices are improper) must go through the indemnification claim procedures.
Conclusion: Post-closing purchase price adjustments are more than an accounting exercise. Adjustment disputes can and often do arise, particularly when significant value is at stake. To minimize these potential disputes, the purchase price adjustment provisions should be drafted as precisely as possible and include schedules setting forth specific definitions, accounting practices, and policies.Regardless of how well these provisions are crafted, however, it is important that both sides are represented after closing by people with the requisite experience in legal and accounting issues. This is particularly true on the seller's side.Unfortunately, individuals who serve as the shareholder representative after closing often lack the necessary expertise. This significantly impairs the seller's ability to effectively defend against the buyer's arguments.As a result, sellers are increasingly turning to professional firms with substantive legal and accounting expertise to serve as the shareholder representative. Consequently, sellers are increasingly able to effectively dispute buyer working capital calculations and preserve or recover amounts rightfully owed to the selling shareholders.