Mergers and acquisitions (M&A) take place when businesses combine to achieve common corporate objectives. In an acquisition, a company purchases another company’s assets, identifiable business segments, or subsidiaries. In a merger, a company purchases another company in its entirety. In either situation, there is a union of businesses. Along with mergers and acquisitions come special price adjustments tools and principles.
Purchase Price Adjustments (PPAs) are common in merger agreements. Frequently, some financial elements of the deal must be estimated prior to the closing, and the PPA provisions are used to assess the values based on a post-closing accounting. For example, at the time of closing, the target company may not be aware of its sales a few days before the closing date because the employees may have submitted the expense reports late, or the vendors may have submitted their final bills for pre-closing expenses subsequent to the closing date. In such a situation the buyer has time to review these items and make closing date adjustments, subject to the rules and procedures specified in the merger agreement.
The PPA provisions define a process by which the company management prepares estimates of these financial items prior to closing. After the closing, the buyer performs a final accounting for the target company and determines the actual accounting results for these items. The provisions typically provide that the buyer must submit its accounting within a stipulated time frame and the shareholder representative then has a set amount of time within which s/he has to review the buyer’s submission and deliver any objections. The parties are then typically given a time frame within which they are supposed to resolve the disputes. The disputes may be referred to arbitration or litigation if the disputes are not resolved within the stipulated period of time.
Purchase price adjustments are designed to ensure that the parties receive the full benefit of the bargain that was agreed to at signing. For example, if on January 1, a transaction is valued, or priced, at $10,000,000 when the target has an inventory worth $100,000, and if, when the transaction closes (all other financial metrics being equal), the seller delivers the target with $500,000 of inventory, the seller will expect to be paid for the additional $400,000 of added, measurable value. Alternatively, if at closing the target’s inventory is valued at $50,000, the buyer would expect a $50,000 reduction in the purchase price due to the depleted inventory value. Thus, purchase price adjustments are intended to put the parties on an equal footing, as on the closing date. Once the parties have agreed upon a purchase price (often subject to the buyer’s satisfactory completion of its due diligence or other conditions) and to include a purchase price adjustment, the three aspects regarding the purchase price adjustment which has to be taken in to consideration are:
(1) The particular financial metrics to be used;
(2) Setting the benchmark amount against which the corresponding closing amount is to be measured; and
(3) The specific procedures for calculating the adjustment (before and/or after closing).
(4) In addition to these aspects, buyers and sellers are increasingly considering establishing a separate escrow to secure payments due as a result of a purchase price adjustment.
Purchase price adjustments in merger and acquisition (“M&A”) transactions are important tools for buyers trying to ensure that they “get what they pay for.” A well-drafted purchase price adjustment provision can satisfy all parties’ needs and reassure both the buyer and the target that they each received the benefit of the bargain. However, price adjustments often become a subject of hotly negotiated post-closing disputes between a buyer and the target, especially where the adjustment amount is significantly high.
In today’s scenario parties entering into an M&A transaction essentially adopt some form of purchase price adjustment (“Closing Adjustment”). In most private company M&A transactions, the buyer and the target will negotiate the purchase price months in advance of the closing, well before the buyer has completed its due diligence or determined how much working capital will be needed to effectively run the business. Unless the transaction is a “sign and close” transaction, it is not unusual to have a 60-90-day period in between signing the definitive purchase or merger agreement (the “Agreement”) and the closing. Closing Adjustments are negotiated to reflect changes in the target’s financial condition between a certain pre-closing date and the closing date. More particularly, the WCA will provide for an adjustment to the purchase price to reflect changes (usually both increases and decreases) from (a) a predetermined baseline working capital amount (“Baseline Working Capital”) to (b) the working capital amount present at closing (“Closing Working Capital”). By implementing a WCA, buyers get peace of mind knowing that:
Defining “Working Capital”
Working capital means the minimum capital required by the enterprise to maintain current operations in its current business cycle. Whereas, net working capital means the difference between current assets and current liabilities. Ideally, the target’s balance sheet will be the starting point for determining the current asset and current liability accounts.
Current assets typically include cash, cash equivalents, accounts receivable, inventory, and prepaid expenses. But depending on the industry and the nature of the target's business, additional assets may be appropriate. Current assets typically do not include certain prepaid expenses that will not benefit the buyer post-closing, doubtful receivables, receivables (note payments) from related parties, and deferred tax assets.
Current liabilities typically include accounts payable, accrued expenses, and accrued taxes. But like current assets, additional liabilities may be a factor in a particular target’s balance sheet. Current liabilities typically do not include payables to related parties, disputed accounts payable, and deferred tax liabilities.
Adjusting the Purchase Price
If an adjustment is in fact mandated under the terms of the Agreement, the parties have some options when deciding how to implement the adjustment. Most deals favor a dollar-for-dollar adjustment. It is simple and both the buyer and target are equally protected. Depending on the relative bargaining position of the parties, they may opt to place certain limitations on the amount of the purchase price adjustment.
Firstly, similar to an indemnification basket, the parties may implement a de minimis threshold; i.e. a range within which neither party pays a purchase price adjustment.
Secondly, the parties may elect to cap their exposure to an adjustment by establishing a “ceiling” (or a “cap”) and/or a “floor.”
The ceiling represents an upper limit to any adjustment amount the buyer will be obligated to pay the target. On the other hand, the floor represents a limitation on the amount that a target would pay or give back to the buyer, establishing in effect a “floor” for the purchase price.
Post-closing adjustments are typically included in the transaction documents of any M&A transaction when there is a period of time between the determination of purchase price consideration and the closing of the acquisition, usually substantial enough to have a bearing on the value of the target determined as of the signing date. The rationale for using post-closing adjustments is to bridge the gap between the value of the target as determined at the time of signing of the transaction documents and at the time of close of the transaction and to allocate the risks of business operations during this period between the purchaser and the seller.
The adjustments in relation to purchase price may be based either on the balance sheet accounts or on the basis of performance of the business of the target. Usually a reference balance sheet is prepared at the signing stage and a preliminary purchase price is set forth in the transaction documents, together with appropriate price adjustment clauses. The initial purchase price is adjusted post the determination of the closing accounts, to account for the changes between the reference accounts and the closing accounts with respect to the chosen balance sheet items. In such a case, the risks in relation to the items not covered by the price adjustments are assumed by the purchaser. A few price adjustment mechanisms that are typically employed by the parties in M&A transactions are enumerated herein.
The parties may agree to revise the purchase price to account for changes in the net working capital between the time of estimate and the time of closing. The purchaser would assume the risk in relation to the items not included in the definition of net working capital. In the absence of such an adjustment mechanism, the seller might be able to influence the purchase price by adopting certain methods including putting off the payments to be made by the target in respect of inventory/ other items, urging the debtors to repay earlier than the due / expected date.
The seller and the purchaser may also agree to compute the final purchase price based on the preliminary purchaser price with the deduction of debt (as of the closing date). In such cases, parties typically negotiate on the items to be included within the scope of the 'debt' to be deducted from the preliminary purchase price. The purchaser is not protected from risks in relation to the items not included within the scope of the definition of 'debt'.
The adjustment provisions may also contain upper and / or lower limits for the adjustment amounts (a clause capping the adjustment amounts) or may contain clauses providing that the adjustment may not happen unless an upper or lower benchmark is exceeded.
Concept of Earn Out
The seller and the purchaser may have different opinions as far as the valuation of the business is concerned (which is based on performance forecasts and assumptions as to long term prospects) that is being sold. As a mechanism to hedge against such uncertainties, parties’ resort to utilisation of deferred consideration strategies, such as ‘earnouts’.
In a typical earnout deal, parties will provide for only a part of the purchase price to be paid upfront and the balance consideration, i.e. the earnout, is linked to the achievement of certain predefined financial, operational or commercial post-acquisition milestones. Therefore, the earnout is structured as a function of the post-acquisition performance of the business.
The earn-out becomes payable only upon the satisfaction of the pre-defined milestones which are intrinsically linked to the manner in which the business will be managed post-acquisition. For instance, where parties agree to retain seller-managers during the transitory phase, the agreed upon milestones might be something that is a function of the performance of these seller-managers, such as a revenue target or an EBITDA multiple.
Earnouts may be seller-managed or purchaser-managed. A typical seller-managed earnout deal would see the seller or its representatives being retained in the management of the business during the earnout period or the transitory phase post-acquisition. It is the seller that will aid in driving the business towards the agreed upon milestones.
In a purchaser-managed earnout, however, the seller plays a more passive role. The seller does not typically participate in the day-to-day management of the company and will have limited rights of oversight and veto powers restricted to crucial business decisions only.
In India, of course, earnout transactions generally tend to be in the nature of purchaser-managed earnouts. Of the few seller-managed earnout transactions that are a part of the public domain, most are structured in a manner where representatives of the seller-management are retained as employees during the transitory phase. These managers are paid the earnout component as a component of their overall compensation package. In other words, seller-managed earnout transactions have popularly restricted the earnout from being reflected in the total consideration for the M&A deal.
The earnout period and milestones agreed upon by the parties is therefore the by-product of lengthy negotiations and is of considerable importance to the earnout mechanism. Typically, parties will choose one or more of a revenue and/ or non-revenue-based milestones.
A revenue-based milestone is usually a variation of EBITDA and/ or gross revenue targets, and a non-revenue-based milestone might be based on the creation of new intellectual property, new product lines and/ or new customers.
Security for Deferred Payment
In case, the payment of the purchase price is partially deferred, then the seller will usually require the buyer to provide some form of security to backstop the payment. This can take the form of a general security interest in the purchaser’s personal property (or the personal property of the target company itself in the case of a share sale), a mortgage of real property, a pledge of shares (usually of the target company) or a guarantee from a corporate parent or principal, amongst others.
Utilizing Put & Call Options in M&A
The Put & Call options are contracts that can give either a seller an option to sell at a later date or a buyer an option to purchase at a later date for a given price or under certain circumstances. The contracts generally expire after an agreed date. These contracts are highly common on the stock market and are being utilised in M&A.
Buyer Call Option.
When a buyer has a call option, the buyer has the rights to force the vendor to sell them under certain circumstances.
For instance, while purchasing a small company the buyer will assume a 100% ownership post transaction and pay 100% of the price at the transfer of ownership. The previous owner or top managers are then contracted to assist in the transition, which can result in numerous complications. The use of the call option when acquiring a company can create a positive impact on the transaction. Some of the key benefits of the same are listed below:
Incentivising the previous owner: If a controlling stake in a company is initially purchased, the remaining shares can be held by the owner and placed under a call option. If certain contracts are retained, or profit margins met, the owner can receive a set price for the remaining shares in the business, at some point after the initial transfer of ownership.
Tax Benefits: Taxation may be a substantial cause for the acquisition of a company within a stipulated period of time. Using the call option enables a buyer to disperse the purchase price over a period of time thereby ensuring that the tax benefits are realised and a fair price is still paid at the same time.
Structuring: Spreading the payment over a certain period of time may enable a safer and greater use of debt to increase the equity growth and tax concessions that come with the acquisition of a company which is achieved by an agreed upon upfront payment.
Vendor Put Option
A vendor may provide for a put option that can force the purchaser to buy at a certain price under certain triggers.
Benefits for vendors can include:
Realising the full value of the business: If selling contracts and tenders are pending, the owner will want to receive a price that takes into account the future profitability of the business. Without a put option, the owner may choose to postpone the sale of their business. If a put option is put in place for a portion of the business, the option may ensure that the value of tenders which are currently being processed are fairly included or not included depending on the outcome. This ensures a faster and more profitable transaction for both parties.
Owners maintaining their legacy: Very often business owners want their legacy and years of hard work to be recognised and not lost when the transfer of ownership of business takes place.
Merger and Acquisitions are some of the most powerful and versatile growth tools employed by companies of all sizes and industries. A well timed and well managed purchase or merger can boost both the short term and long term outlook for many organizations.
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