Nearly all M&A merger agreements contain a working capital or purchase price adjustment. Ensure your next M&A agreement considers these nuanced aspects of working capital to navigate post-closing challenges as efficiently as possible.
M&A deal parties know that net working capital is defined as a company’s current assets (subtracting cash) minus current liabilities (subtracting debt).
It measures the liquidity available to a company to operate its business effectively. However, getting the details right for this simple equation is considerably more complicated than it may seem.
Engaged on more than 6,000 M&A deals to date, the team at SRS Acquiom has seen firsthand the myriad of ways that net working capital is defined, and the pitfalls to avoiding many post-closing issues. Below, our team offers tips and perspectives to keep your next M&A deal moving forward hassle-free.
Watch Out for Legal Issues in Purchase Price Adjustments
Purchase price adjustments sometimes require legal determinations rather than accounting analysis. For example, the issue might be whether the target company’s tax practices followed applicable law or whether a threat of litigation is sufficient to mandate reserves.
When these issues come up in purchase price adjustments, it can create a problem if the merger agreement says that they are to be resolved by accounting arbitrators who may not be as well suited to conduct the underlying legal analysis on which the accounting determination depends.
Accounts Receivable in Purchase Price Adjustments
SRS Acquiom has often seen that buyers will look to adjust the calculation downward based on accounts receivable that were outstanding at closing and have not yet been collected post-closing. While that may or may not be the correct conclusion based on the terms of a particular deal, if the shareholder representative does ultimately determine to accept the adjustment, a question remains as to what should happen if those receivables are later collected. The buyer receives a windfall if the buyer gets the benefit of a downward adjustment in the purchase price while collecting the cash later.
To account for this disparity, the parties may agree to extend the working capital adjustment period for a reasonable period in which they believe the applicable receivables will be collected, if at all. Alternatively, they may resolve the working capital adjustment but agree that if any receivables are subsequently collected, that amount could be added to a future distribution to shareholders (for example, to proceeds from an earnout).
Review the Buyer’s Obligation to Provide Access to Books and Records
Working capital adjustments can be complicated. The buyer has information and resource advantages because it controls the books and records, typically has large internal and external accounting teams, and typically has 60 to 90 days following closing to prepare its report. In contrast, the shareholder representative usually has 30 days to answer, does not have control of the applicable files, and has less target-specific institutional knowledge. Therefore, the agreements must set forth terms that will work for both sides in a way that does not prolong the process unnecessarily but provides sufficient time to complete the applicable tasks. Since the shareholder representative generally has fewer resources and limited access to materials, the process must contemplate cooperation between the parties.
Two critical additions are included in the language below to try to address this:
The representative shall be granted access during business hours to the books, records, and accounting work papers of the Company to conduct its review, and the Buyer shall use commercially reasonable efforts to respond promptly, in good faith, and as fully and accurately as is reasonably possible to inquiries from the representative related to such review. Buyer (i) will use reasonable efforts to provide access to the books and records of the Company electronically and (ii) shall transmit financial statements, general journals, and trial balances of the Company and its subsidiaries in formats such as Excel spreadsheets or searchable Word or PDF documents.
If the underlined portions are omitted, a shareholder representative could find itself unnecessarily burdened in attempting to prepare a response. A buyer could respond to a representative’s request for additional information by saying, “You can have access to the files if you’d like, but we’re not going to have our people spend any time on this. Oh, and by the way, the files are in 17 different countries. Please let us know what you’d like to see.” While that may sound outrageous, it is an answer that SRS Acquiom has received. This can lead to disputes that should have been avoided.
It is helpful if the buyer has an obligation to make its people and former employees available to answer questions. For instance, if the files are hundreds of pages of paper, the representative will want to be able to ask the buyer to point to specific calculations or data rather than searching for a needle in a haystack.
Consider the Consequences of the Buyer Not Delivering Adjusted Statements
A typical working capital section contains language along the lines of the following:
- At closing, Seller shall deliver its working capital statement.
- As soon as possible following closing, but within 90 days thereof, Buyer shall deliver notice of any adjustments to that statement.
- The shareholder representative shall then have 30 days to dispute any adjustments. If the shareholder representative fails to respond within such time period, it shall be deemed to have accepted the Buyer’s calculations.
- Once there is a final agreed-upon figure, fair purchase price or escrow adjustments will be made.
One related detail often left unclear is what happens if the buyer fails to deliver the notice of adjustments within the required time frame? Has it forfeited its right to do so? If so, does that mean that the working capital statement delivered by the seller at closing is the final statement and that the buyer has no right to object to it?
Most buyers will object to that conclusion. Their position will be that if they deliver their calculations late, the selling shareholders are only entitled to any damages resulting from the late delivery. This rarely would result in any identifiable damages. This could give buyers the right to deliver their calculations within any reasonable timeframe.
The parties should consider what outcome they desire. There is an argument (and limited case law) that both parties should be obligated to meet a timeframe, rather than consequences if one side misses the deadline but no consequences if the other side does so.
To avoid this issue, consider adding a sentence to the merger agreement that specifically says something like this:
If the Buyer fails to deliver notice of any adjustments within such day period, the shareholder representative shall have the right, at its election, to either (i) determine that the Working Capital Statement delivered by the Seller at Closing shall be deemed for all purposes hereunder to be the final statement for purposes of calculating the [Closing Working Capital Balance], and such determination shall be binding on the Buyer with the Buyer having no further rights to object or require adjustments thereto or (ii) require the Buyer to deliver such Working Capital Statement within ten (10) days of the shareholder representative’s demand therefor.
Whichever option the shareholder representative chooses will likely depend on whether the price adjustment is one-way or two-way (meaning whether it is an adjustment that can only decrease the purchase price or an adjustment that can increase or decrease the purchase price). If it is a two-way adjustment mechanism, the shareholder representative may demand that the buyer deliver the statement if it thinks a positive price adjustment will result.
Avoiding a Second Bite at the Apple
Purchase Price Adjustments are meant to be straightforward accounting “true-up” mechanisms, and M&A parties should generally avoid using the adjustment mechanism to address breaches of representations and warranties or other indemnified losses through specific, careful drafting. However, without limiting language, buyers may attempt to incorporate broader claims or concepts in their proposed adjustment calculations. What happens if buyer-proposed adjustments are determined through the dispute process to be invalid adjustments, and the dispute resolver (e.g., independent accounting firm, mediator, or an arbitrator) rules in favor of the selling shareholders? Should the buyer then be able to revisit the issue as a breach of a representation or warranty?
A buyer may argue that a “second bite at the apple” is allowable because there could be claims knocked out of the working capital calculation that still constitute a breach of a representation or warranty. For instance, an independent accountant may have determined that a liability should not be included in working capital because it is a long-term rather than a short-term liability. It could, however, still be a breach of a representation if it is a liability that was not adequately disclosed. In this case, the accountant’s determination may not preclude the buyer from bringing an indemnification claim.
On the other hand, if it is determined in the working capital dispute process that the buyer’s position is factually invalid, the buyer might nevertheless bring, or threaten to bring, the same issue as an indemnification claim. This is a way to get a free appeal on the accountant’s ruling. It is challenging for the shareholders to do the same thing when they lose on a working capital issue because there typically is no second venue to have the matter reviewed again under the merger agreement.
To address this issue in merger agreements with working capital adjustments, consider adding language that the purchase price adjustment mechanism is the exclusive remedy for any disputes relating to the calculations and underlying facts and circumstances included in the buyer’s proposed adjustment.
Counsel especially familiar with accounting issues should help define the circumstances in which a claim may be denied under the working capital provisions but might be adequately indemnifiable. While many auditors are unfamiliar with these issues, accounting firms often have specialized technical groups to handle such problems. When drafting a provision along these lines, SRS Acquiom suggests seeking specialized expertise, which is usually beyond a discussion with the individual who manages the company’s audits.
Review Contingent, Unknown and Unquantifiable Liabilities—Working Capital Adjustment or Indemnification Claim?
Contingent, unknown, and unquantifiable liabilities are problematic in the post-closing purchase price adjustment process. Target companies will probably see these liabilities in the best possible light and exclude them from the estimated balance sheet. When buyers prepare the final closing balance sheet, they will often quantify contingent, unknown, and unquantifiable liabilities using a conservative, worst-case analysis. Regardless of which might be the better way to reflect the intentions of the merger parties, buyers typically have the protection of having the opportunity to make an indemnification claim if the contingent liability is incurred, when an unknown liability arises or when a previously unquantifiable liability is finally determined. On the other hand, sellers cannot usually receive any benefit after the working capital adjustment process is completed if the liability is lower than the buyer’s estimate. A typical example is accruing for sales tax liabilities where the target company historically did not believe sufficient nexus exists to collect or remit the tax.
To address this, sellers have a couple of options:
- First, contingent, unknown, and unquantifiable liabilities can be explicitly excluded from the definition of working capital and be prosecuted by the buyer solely as an indemnification claim. Since indemnification periods are typically substantially longer than working capital periods, this allows a more extended period for the actual amount of the applicable liability to be determined.
- Second, as described above, the parties might consider assigning the sellers the right to either collect or receive any contingent, unknown, and unquantifiable amounts that result in a downward purchase price adjustment but are later collected or reversed. As another example, if there is a downward working capital adjustment for payment of a tax liability that may ultimately be determined not to be owed, the parties may agree that the sellers shall be assigned any future refunds related to that liability that might be received.
The one exception to this strategy is the parties may wish to estimate the tax liabilities and potential tax refunds the Company will receive for the stub period tax returns. Since the transaction costs can be used to reduce taxable income, the parties may wish to quantify the tax impact of the acquisition on stub period taxes and include provisions as to who is to pay additional tax liabilities and receive tax refunds, if any.
Armed with nuanced knowledge of the challenges associated with working capital, M&A deal parties can more effectively negotiate the obstacles that can hinder a smooth post-closing process. Taking the time to assess and define buyer obligations, working capital definitions, and potential scenarios for the unique aspects of your next deal can save time and reduce friction after the close. The team at SRS Acquiom often assists M&A professionals with reviewing working capital provisions to help minimize post-closing risks. These tips can help your next M&A deal move toward a smooth conclusion.
Senior Finance Director, Shareholder Advisory 720.799.8604
Paul is a senior finance director in the Shareholder Advisory group at SRS Acquiom, specializing in finance and accounting. He manages post-closing matters and disputes related to purchase price adjustments, earn-outs, and indemnification claims.
Before joining SRS Acquiom, Paul worked at Alvarez & Marsal in Chicago and AlixPartners in London, advising multinationals and private companies on high-value purchase price disputes, commercial litigation, financial damages, and forensic accounting.
Paul holds an MA in Economic History from the University of Glasgow in the UK, and is a Fellow of the Institute of Chartered Accountants in England & Wales (ICAEW).