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Presenting a live 90-minute webinar with interactive Q&A

M&A Post-Closing Purchase Price Adjustments:

Planning and Drafting Strategies Defining Working Capital, Setting Baseline Amount, Specifying Accounting

Principles, Navigating Overlap With Indemnification Clauses

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, MAY 25, 2017

John J. McDonald, Partner, Troutman Sanders, New York

Michael Weinsier, Partner, Troutman Sanders, New York

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CALIBRATING THE DEAL: PURCHASE PRICE ADJUSTMENTS IN

M&A TRANSACTIONS

Michael Weinsier Partner

Troutman Sanders LLP

Michael.Weinsier@

TroutmanSanders.com

John McDonald Partner

Troutman Sanders LLP

John.McDonald@

TroutmanSanders.com

May 25, 2017

THE OBJECTIVE OF PURCHASE PRICE ADJUSTMENTS

• Businesses being acquired are often priced based on multiple of

revenues or earnings (EBITDA).

• However, the financial components underlying those metrics could

change between negotiation of the deal (LOI signing) and closing.

• To bridge the gap, the purchase price is specified in the purchase

agreement, but is adjusted based on the amount of the applicable

metric as of closing.

• The most common adjustment is “net working capital” (“current assets”

minus “current liabilities”, so only <1 year assets and liabilities), but there

are many other possibilities, including the following:

“Net worth” (i.e., “assets” minus “liabilities”, so include >1 year assets

and liabilities).

“Minimum cash at closing” (but be careful to avoid double counting

with the NWC adjustment).

6

NUANCES RE: PURCHASE PRICE ADJUSTMENTS

• NWC Adjustment or Accounts Receivable Guarantee?

Most NWC adjustment are intended to address the issue that the exact

NWC balance may not be known until the books are closed after

closing of the acquisition, particularly for complex businesses.

However, in some deals, the sellers will guarantee collection of A/R.

Need to distinguish any such guarantee from the sellers’ financial

statements reps re: calculation of A/R reserves in accordance with

GAAP, which are not a guarantee that particular A/R items will be

collected.

If the sellers guarantee collection, any uncollected receivables are

typically assigned to the sellers.

• No Double-Counting.

Need to confirm no overlap/double-counting of the purchase price

adjustment with the sellers’ indemnification obligations to buyer.

Important because the purchase price adjustment is usually not subject

to indemnity basket or cap. 7

WHAT IS INCLUDED IN NET WORKING CAPITAL?

• Baseline is “current assets” (cash + A/R) minus “current liabilities” (A/P

and other short-term liabilities), but there are many nuances.

• Industry-specific items – e.g., earned but unbilled revenue, prepaid items,

customer deposits.

• Reserves on accounts receivable (a component of “current assets”) and

accounts payable (a component of “current liabilities”) are often heavily

contested issues.

• Receivables outstanding >90 days are sometimes written down to zero

as there is less likelihood of collection. Payables outstanding more than

90 days are cause for concern because seller may be “stretching out”

payables due to cash flow issues. Receivables and payables may be

reserved due to disputes with customers or suppliers.

• How are inventories (a component of “current assets”) valued - LIFO,

FIFO? Stale inventory not sold within 1 year of manufacture are

sometimes written down to zero. 8

WHAT IS INCLUDED IN NET WORKING CAPITAL (cont.)

• Need to specify treatment of other “current liabilities” – for example,

accrued salaries, bonuses, vacation, sick pay and sales commissions.

• In “asset purchase” deals, only include “current assets” to the extent

included in the “purchased assets” and “current liabilities” to the extent

included in the “assumed liabilities”.

• In “cash free/debt-free” deals, exclude cash from “current assets” and

borrowed money debt from “current liabilities” to avoid double-counting.

• In “debt-free” deals, buyer often gets indemnification from sellers for any

seller debt, in addition to NWC adjustment, since long-term debt (more than

1 year) would not be a “current liability” included in NWC.

• Exclude from “current liabilities” the sellers’ “transaction expenses”

(i.e., attorneys, accountants and investment banker fees and expenses,

sale bonuses paid to employees and other deal-related expenses), since

sellers will pay those, to avoid double-counting.

9

HOW IS NET WORKING CAPITAL DETERMINED?

• “Bottoms-up” or “True-up”?

Parties can do a “bottoms-up” GAAP analysis and, if the seller’s

historical accounting practices weren’t GAAP, then the adjustment

process corrects the deviations - “buyer favorable” formulation.

Alternatively, the parties can do an “apples to apples” true-up process

in which GAAP is interpreted using same policies, practices,

assumptions as company's historical/audited financial statements -

“seller favorable” formulation.

• Example NWC Statement or NWC Calculation Rules?

Attach an “example NWC statement” (e.g., pro forma closing balance

sheet) as an exhibit to the purchase agreement to minimize disputes

later about the way in which the NWC calculation should be performed.

Alternative is to attach “NWC calculation rules” (e.g., procedures for

accruing and reserving against accounts receivable and accounts

payable). 10

HOW IS NET WORKING CAPITAL DETERMINED (cont.)?

• Objective is “normalized” level of NWC, so seller should benefit from

increase over LOI NWC amount or be penalized for drop since LOI NWC

amount, since LOI NWC amount was used to determine purchase price.

• However, it is sometimes not advisable to use NWC from most recent

balance sheet as target if working capital fluctuates over time due to:

Seasonality.

Intra-month variations as A/R is collected and A/P paid down.

• Sometimes, the NWC target is set as an average amount of NWC, as

reflected on the company’s balance sheets over several quarters during

the year or over several years.

• Sometimes, there are multiple NWC targets depending on when during a

month or the year the closing occurs.

• Sometimes a “buffer” (or “collar”) concept is used in which there is no

adjustment if the final amount is within a defined band around the target

amount. “Caps” and “floors” are also used occasionally, but aren’t typical. 11

PURCHASE PRICE ADJUSTMENT PROCESS

• Typically, the steps in the process are: (1) delivery of proposed closing

balance sheet; (2) response/objection by the other party; (3) negotiation

period; and (4) submission of disputed items to third party for resolution.

• The purchase price adjustment can be “downward only” (buyer-favorable)

or upward & downward (more “fair”, but buyer needs to be prepared to

potentially pay more than the stated purchase price).

• Typically, there are two adjustments - one at closing based on seller's

estimate and another adjustment 60, 90 or 120 days post-closing based

on buyer's determination.

• If there is an “at-closing” adjustment, the estimated closing balance sheet is

typically either "prepared in consultation with the buyer" or must be

"reasonably acceptable" to the buyer.

• Sometimes, the estimated closing balance sheet becomes final (i.e., no

post-closing adjustment) if buyer fails to deliver its post-closing NWC

statement by end of specified 60/90/120-day period post-closing. 12

DISPUTE RESOLUTION MECHANISM

• The purchase price adjustment provision will typically include a timeline

with specified numbers of days for actions and a process for resolving

disputes in order to expedite resolution in a cost-effective manner relative

to litigation or arbitration.

• Sometimes the parties are obligated to negotiate any disputes in good

faith.

• Often an independent accounting firm is designated to resolve any

disputes that remain after negotiation by the parties.

• The scope of authority of the independent accountant is typically

specified.

• A process for the submissions made by the parties to the independent

accountant of their respective positions is sometimes detailed.

• Who pays the independent accountants’ fees and expenses relating to

resolution of the dispute.

13

DISPUTE RESOLUTION MECHANISM (cont.)

• Notices of objection - Sometimes the form and scope of any objections

are specified (e.g., it must identify and explain in detail each item in dispute

and state the dollar amounts of such objection).

• Sometimes there are limits on the types of objections that can be raised:

“…the Buyer objections shall be limited to claims that the Closing

Balance Sheet (i) was not prepared in accordance with the accounting

principles set forth on Schedule A; and (ii) contains mathematical errors.

• Time limits for responses - Most agreements require each party to object

within a set time period after receipt of the other party’s submission, after

which it will be deemed to have accepted the submission.

• Access to information - Most agreements require the submitting party to

provide access to its work papers and other items necessary to evaluate

the submission, which is necessary because, after the closing, the sellers

will no longer have access to company records.

14

DISPUTE RESOLUTION MECHANISM (cont.)

• Can objecting party amend or revise its objection after submission?

• Need to address the interplay between the access to information

requirement and the time periods specified for responses:

Melun Industries v. Strange, 898 F. Supp. 995 (S.D.N.Y. 1992): Agreement required

Buyer to deliver closing statement 15 business days after Seller provided “all documents

necessary” to determine the purchase price adjustment. Seller provided financial

statements to independent accountant and accountant provided an internal memo

identifying a minimal purchase price adjustment (~$20k). Months later, Buyer provided a

closing statement reflecting a Buyer favorable adjustment of about $250k. Seller

challenged the closing statement as untimely. Court rejected argument based on the

vague language used in the agreement.

• What happens if the buyer fails to provide a post-closing balance sheet

calculation within the specified time period?

Buyer loses right to seek adjustment – the sellers’ estimate used at

closing becomes final.

Seller gets to prepare the calculation.

15

DISPUTE RESOLUTION MECHANISM (cont.)

• Typically, an “independent accounting firm” resolves disputes re:

purchase price adjustment. Considerations when selecting an independent

accounting firm include:

Industry experience (knowledge re: industry-specific accounting

practices).

Arbitration or litigation experience (preferably including purchase

price adjustment disputes).

Independence (no prior business relations with buyer or seller).

• Approaches to determining the independent accounting firm:

In the purchase agreement, specify the name of the independent

accounting firm.

Specify in the purchase agreement that the independent accounting firm

will be a “nationally recognized” accounting firm that is “reasonably

acceptable” to both parties.

16

SCOPE OF AUTHORITY

• Scope of Independent Accountant’s Authority - To avoid potential for

unnecessary delays and costs, parties should draft with precision the scope

of the disputes which are within the purview of the independent

accountant’s authority.

• Whether the independent accountant may undertake a wholesale review

of the accounting calculations, or is limited to addressing only the

disputed items.

• Whether the independent accountant may resolve procedural disputes

(e.g., whether requirements related to specificity of objections, access to

information and/or time deadlines have been met, and the consequences of

non-compliance).

• Whether the independent accountant may correct errors in the target

balance sheet/working capital calculation.

17

LIMITATIONS ON AUTHORITY

• There are typically limitations on the independent accounting firm’s

authority:

Result cannot be higher or lower than the parties’ respective final

positions on the disputed items.

“Baseball” limitation: the independent accounting firm must pick one

party’s position or the other.

• Whether the independent accountant is acting as an arbitrator (“split the

baby”) or as an accounting “expert”.

• Circumstances, if any, under which the independent accountant’s decision

may be appealed/overturned – e.g., independent accountant’s

determination is “final and binding on the parties absent fraud or manifest

error”.

• If the purchase agreement provides for arbitration of disputes, clarifying

whether enforcement of the accountant’s decision is subject to

arbitration or handled by the courts. 18

DISPUTE RESOLUTION MECHANISM (cont.)

• The purchase agreement sometimes specifies how the parties can make

their arguments to the independent accounting firm:

Written briefs or “position papers”; and/or

Oral testimony (under oath), with or without cross-examination.

• What information will be available to the independent accounting firm?

Limited to the parties’ submissions.

Independent accounting firm has ability to request additional briefings,

documents, conduct hearings, etc.

• Time period for independent accounting firm to render a decision:

Non-specific: “as promptly as possible”.

Within 30, 60, 90 days after the matter is submitted to independent

accountants.

19

WHO PAYS THE INDEPENDENT ACCOUNTANTS’ FEES?

• Which party pays the fees of the Independent Accounting Firm? There

are several different approaches:

Buyer and seller split the costs, 50/50. Seems fair, but it doesn’t create

any incentive for the parties to act reasonably.

Loser pays all. Seems reasonable, but may be hard to determine who

is the “loser” when there are multiple disputed issues and not all are

decided in favor of the same party.

Each side pays fees proportionally based on how close its position is

to the independent accounting firm’s determination of disputed items

(probably most common approach).

“Baseball method” – the party whose position was farthest from the

independent accounting firm’s determination pays all of the fees.

incentivizes the parties to take reasonable positions and usually results

in a resolution prior to engaging an independent accounting firm.

20

HOW IS PURCHASE PRICE ADJUSTMENT SATISFIED?

• Holdback vs. Escrow to Secure Sellers’ Downward Post-Closing Purchase

Price Adjustment Obligations:

Holding back some of the purchase consideration or placing funds into

escrow with a third party bank gives buyer a ready source of recovery.

Although a holdback is more buyer-favorable, a third party escrow is much

more common.

• Purchase Price Adjustment Escrow vs. Indemnification Escrow.

Sometimes there is a separate escrow fund for the post-closing

purchase price adjustment, rather than satisfying it out of the

indemnification escrow.

Typical duration of purchase price adjustment escrow is relatively short

(60, 90, 120 days post-closing) as only need enough time to complete the

purchase price adjustment process. By contrast, indemnification escrow is

usually significantly longer: 12-24 months. As a result, sellers may be more

willing to agree to a purchase price adjustment escrow than to increasing the

indemnification escrow to also cover purchase price adjustments.

21

HOW IS PURCHASE PRICE ADJUSTMENT SATISFIED (cont.)?

• Non-Cash Transaction Consideration:

If there is non-cash transaction consideration (e.g., buyer stock, seller notes,

earn-out), is downward purchase price adjustment satisfied just from the

cash transaction consideration or also from the non-cash transaction

consideration? If so, in what order?

Buyers typically prefer cash consideration, sellers the reverse.

• What if the Purchase Price Adjustment Amount Exceeds the Escrow?

Are the sellers jointly & severally liable for excess or is each only liable for his

or her pro rata share?

• Effect of Failure to Pay Purchase Price Adjustment.

If sellers fail to pay a downward purchase price adjustment within specified

time period after final NWC is determined, the unpaid amount typically

accrues interest from the due date at prime rate plus a specified amount of

percentage points, which is non-exclusive remedy (buyer can also sue for

damages). In some cases, parties provide that any positive or negative

adjustment amount owed will bear interest from the closing date. 22

THANK YOU!

John McDonald

Partner

Troutman Sanders LLP

(212) 704-6234

John.McDonald@

TroutmanSanders.com

Questions?

Michael Weinsier

Partner

Troutman Sanders LLP

(212) 704-6194

Michael.Weinsier@

TroutmanSanders.com 23