A post-pandemic rise in private M&A transactions is in full-swing and working capital purchase price adjustments (PPAs) are typically a core element in most of these transactions. The purchase price adjustment mechanism provides for an adjustment to the purchase price (usually either up or down) based on whether the final amount of working capital in the seller company is higher or lower than that estimated shortly before closing.
Working Capital Purchase Price Adjustments (PPAs) Checklist
SRS Acquiom has been engaged on thousands of deals and handles a large volume of working capital adjustments. In our experience, a well-crafted purchase price adjustment section of the agreement in which the language and methods for adjustment are clear is critically important in avoiding disputes after the deal closes. Learn what to watch for in the PPA provisions in your next deal with this checklist.
1. Start Early in the M&A Process: Define Required Working Capital for “Normal” Operations
It is impossible to negotiate the agreement without taking the financial condition and operations of the seller company into account. It benefits both buyers and sellers to clearly identify the right level of working capital to sustain what the seller perceives as business continuity under normal conditions. This forms the basis for determining the baseline amount of working capital, or “peg,” that is usually hardwired into the agreement and often can be established by averaging the working capital of the business over a 12-month period. However, this may not work for many companies because of unique factors in the business that can influence this working capital average, such as one-time events, seasonality effects, or other periodic impacts to the seller company’s level of working capital. M&A deal parties need to overtly agree on a baseline working capital figure and the components and assumptions underlying that figure at the outset of the deal to help prevent disputes down the line.
2. Define Common Language and Terms for Merger Parties
The parties to the merger need to ensure there are no overlaps in commonly used terms in the agreement. While this may seem obvious, the team at SRS Acquiom has found mistakes and misunderstandings around working capital definitions are a common occurrence. Deal terms can often be nuanced, so rigorous and careful definition of terms are a critical step in finalizing the PPA provisions. A clear review of common terms—such as cash, working capital, net working capital, current assets, and current liabilities—are critical to effective deal documentation.
3. Determine Accounting Methodologies
The method by which the working capital statement is prepared and reviewed also needs to be expressly addressed by the M&A deal parties—whether it is GAAP, GAAP consistent with the seller company’s historical practices, or some other accounting principles. A sample working capital PPA calculation attached as an exhibit or a schedule to the agreement can also help avoid misunderstandings or misinterpretation. Working through a sample calculation can also highlight potential gaps in term definitions or misunderstandings between the buyer and seller.
One area that M&A deal parties should be sure to address is the seller company’s accounts receivable balance at the time of closing and how it will be treated.”
One area that M&A deal parties should be sure to address is the seller company’s accounts receivable balance at the time of closing and how it will be treated. Clear articulation of the accounting principles to be used in evaluating outstanding accounts receivable is a key aspect of the methodology definition. The team at SRS Acquiom has often seen that buyers seek to add a reserve for accounts receivable that were outstanding but not yet collected at closing, even though this may not be required by GAAP or the seller’s historical accounting policies. Depending on the circumstances, this can create a windfall effect for the buyer as those receivables are subsequently collected. This and similar provisions emphasize the importance of reaching agreement on the accounting methodology that the parties will use.
4. Determine the Purchase Price Adjustment Mechanism and Watch Out for Legal Issues
When an M&A deal closes, the buyer and seller typically conduct a review and assess whether an adjustment is due per their negotiated agreement. Deal parties need to determine what happens at that juncture: how the buyer communicates and requests an adjustment, the process by which the request will be reviewed, the timeframe for the seller to object and/or respond, and how disputes will be resolved (accounting arbitration or other). Potential conflicts of interest with any accounting firm selected to act as arbitrator should also be identified.
Sometimes, an accounting arbitrator is not the best way to resolve the issue at hand. Issues such as whether the parties maintained or provided adequate accounting records or other matters of legal interpretation may arise. Should such issues occur in a PPA negotiation, they can be problematic if the agreement limits resolution to accounting arbitration alone. One option for deal parties is to address these potential legal challenges through indemnification processes instead of PPAs, or to consider alternatives to accounting arbitration. The key is to ensure that the proper forum is available to resolve any disputes that come up, so accountants are not deciding issues best left to the courts, and vice versa.
5. Step Back and Assess the PPA in the Agreement Context
Once deal parties have conducted the comprehensive work of identifying the working capital targets, defining PPA terms, determining accounting methodologies and outlining the PPA procedure, it is time to review the PPA conditions in the context of the whole agreement. Specifically, both the PPA and indemnification provisions should be reviewed for their interactive dynamics and assessed for any overlap or ability to cause “double dipping” by the buyer for a single dispute. Likewise, significant disputes can occur if there is ambiguity as to whether the buyer can bring a claim for a certain matter under the PPA mechanism, the indemnification provisions, both or neither. The parties should do their best to close off any ambiguity as to whether and how any claims are to be addressed.
Specifically, both the PPA and indemnification provisions should be reviewed for their interactive dynamics and assessed for any overlap or ability to cause ‘double dipping’ by the buyer for a single dispute.”
Regardless of these preventive measures, deal parties often find themselves in disputes over PPA provisions once the deal is closed. The team at SRS Acquiom often helps M&A professionals review PPA provisions to minimize post-closing impacts as much as possible. This checklist is designed to provide you with a head start to negotiate the best possible working capital PPA provisions for your next M&A transaction.
Managing Director, Escrow & Payment Solutions and Deputy COO 303.957.2855
Chris is the managing director, escrow & payment solutions and deputy COO. In this capacity, Chris manages our relationship manager, relationship associate, and deal intake teams, and works to ensure that our clients are able to navigate the closing and post-closing escrow and payments process as easily as possible.
Chris also has deep expertise in shareholder representation. For over a decade, Chris worked in the SRS Acquiom Professional Services Group where he led the teams that handled post-closing escrow claims, earnouts, purchase price adjustments, distributions of shareholder proceeds and other activities related to serving as shareholder representative.
Before joining SRS Acquiom, Chris practiced corporate law in the Colorado office of Cooley LLP, where he focused on venture capital transactions and mergers and acquisitions. He began his legal career at Cravath, Swaine & Moore LLP in New York City. At Cravath, he primarily represented underwriters in initial public offerings and high-yield debt offerings and lenders in commercial banking transactions.
Chris is a frequent contributor to M&A thought leadership via work on SRS Acquiom’s data studies, articles and speaking presentations. Chris holds a J.D. from Harvard Law School and a B.A. from Rice University.