July 26, 2017
Purchase price adjustments are a complex weave of technical accounting, financial and legal issues. Sometimes overlooked, the practical implications of timing, access to records and the personnel involved are just as critical.
Stock purchase agreements can have two “flavors” of purchase price adjustments — working capital adjustments and earn-out adjustments. Working capital adjustments are intended to compensate either the buyer or seller for changes in working capital from the due diligence period to closing. The base or initial unadjusted purchase price is typically calculated and negotiated considering the working capital levels present during the due diligence period. Fluctuations in working capital, up or down, between due diligence and closing, will adjust the purchase price dollar for dollar. Earn-out adjustments are used when the seller is an owner-operator who a buyer wants to incentivize to continue operating the business after acquisition. Earn-out adjustments are also used when a buyer and seller have disparate views of the business’s prospects, which drive the valuation of the base purchase price, but both parties still want to execute a deal. Earn-out adjustments are measured by an earning metric such as EBITDA (earnings before interest, taxes, depreciation and amortization) or revenue over a specified time frame after closing, typically one to two years.1
The process by which a buyer and seller exchange calculations of the working capital and earn-out adjustments, and objections thereto, is contractually prescribed by the purchase agreement, as is the process for submitting unresolved disputes to a neutral accountant. The contractual terms used for the neutral accountant can include “neutral accounting referee,” “independent accountant,” “independent auditor,” or something similar. The neutral accountant is a certified public accountant with dispute resolution experience from a national accounting or consulting firm and is typically defined as acting in the role of an expert rather than as an arbitrator. The neutral accountant’s ruling, called a “determination,” is final, binding and unappealable, absent manifest error or fraud.
LINES IN THE SAND ARE QUICKLY DRAWN
The seller prepares an estimated closing statement a few days immediately preceding closing. This statement is an estimate of working capital as of the closing date, but is prepared prior to the closing date, so it inherently includes estimations of activity during the intervening days and estimates for the typical end of period accounting adjustments that will not be finalized until weeks or months later. While the estimated closing statement does not irrevocably establish the seller’s position, it is an opportunity for the seller to put a first stake in the ground. It is from this stake that subsequent positions by buyer and seller are measured, so the seller should maximize the time it has before closing to put his best foot forward.
A buyer will prepare a closing statement for a working capital adjustment two to three months after the closing date. The closing statement is typically a buyer’s responsibility, given that it now possesses the accounting books and records. This is the buyer’s first and only shot at establishing the ceiling of the purchase price adjustment in her favor; the purchase price can later move in the seller’s favor, but no further in the buyer’s favor beyond this opening salvo. Development of the closing statement becomes all too often a low priority while the new management focuses on integrating the acquired business. Buyers can best position themselves during the purchase price adjustment process by beginning work on the closing statement immediately after closing. The buyer will then have full access to the books and records and should perform a deep dive to identify adjustments required in accordance with Generally Accepted Accounting Principles (GAAP) consistently applied and/or the terms of the purchase agreement.2
Because earn-outs are based on the performance of the acquired business for a certain time after acquisition, there is inherently more time for the buyer to prepare an earn-out statement. However, as the buyer integrates the business, she needs to consider business and accounting decisions in the context of how the decisions impact the earn-out. For example, if the buyer begins allocating overhead expenses to the acquired business, does the definition of the earn-out allow that overhead to be included? Or if the buyer decides to introduce a new product line, should those earnings be included? The buyer should implement a process immediately after closing to track the earn-out calculation and consider the impact of decisions during the relevant period. To the extent that changes could arguably impact the earn-out, the buyer might want to proactively initiate a dialogue with the seller, who will undoubtedly be tracking the earn-out as well, to avoid diluting its incentivizing impact and to pre-empt a dispute.
LITTLE TIME TO RETALIATE
After the working capital statement or earn-out statement has been delivered by the buyer, the seller will have from a few weeks to several months to analyze the statement and prepare a response, termed the objection notice. Just as the buyer may not move the goal post after the working capital or earn-out statement has been provided, the same applies to the seller’s objection notice.3 In the case of working capital adjustments, the seller will have access to the books and records of the sold business until closing and should use that time to prepare as access afterward will be limited.
Losing the institutional knowledge of former personnel will also be a constraint on the seller; the accounting and finance personnel likely will have moved with the acquired business to the buyer, and the seller will not have access to them after closing. Purchase agreements commonly have provisions allowing the seller access to the records and personnel needed to facilitate preparation of the objection notice; however, those provisions do not necessarily allow pervasive discovery, and tight drafting can afford the buyer the opportunity to attempt to restrict the flow of information. Some purchase agreements will allow for disputes over discovery during the pre-objection notice phase to be submitted to the neutral accountant, which the seller should use when he expects the objection notice will be impaired by limited access.
The purchase agreement will specify the detail to which a seller can object to specific items in the working capital or earn-out calculation, including the quantum of the objection and the underlying rationale. To the extent the seller feels unduly constrained by lack of access to records, or people, or by the compressed time frame, he must walk a fine line in the objection notice to adhere to the specificity requirements while also objecting to the constraints. A seller who does not adhere to the specificity requirements for the objection notice runs the risk of a neutral accountant determining that the seller’s objections are invalid, leaving a potential for those objections to be barred.
In the case of an earn-out, the seller owner-operator is often still involved in the business at a high management level, such as president or chief operating officer, and thus the access to records and personnel is less constrained.4 In these situations, the seller’s personal interest will drive him to keep track of the earn-out performance in real time. Often, the seller foresees issues while the earn-out clock is running and may begin disputing items before the earn-out statement is even prepared. In a situation like this, the buyer needs to balance the economic desire to minimize the earn-out with the intent of the earn-out to incentivize the seller to continue effectively operating the business. The buyer should understand what access the seller has to the records and people pertinent to the earn-out calculation; however, any attempts to limit access unnaturally could be deleterious to the seller’s motivation to perform.
The finance and accounting staff preparing the working capital or earn-out statements are often the seller’s former employees. Due to human nature, allegiances will not shift overnight on the closing date. Given the short runway to the closing statement, particularly for a working capital adjustment, a buyer needs to make sure that personnel understand their duty as employees is now to the buyer, but must do so in a manner that gains cooperation and trust. The buyer should also be cognizant of the potential for information leaks to the seller by those employees and take safeguards to prevent it.
There can be overlap between disputed items in an adjustment and claims for breach of representations and warranties relative to financial statements provided by a seller to a buyer during the period of due diligence. For example, in a purchase price dispute a buyer can argue that items were not historically accounted for by the seller under GAAP and must be adjusted in the closing statement.5 The inherent implication is that the historical GAAP financial statements were incorrect, and thus the GAAP representation was breached. That intersection of the purchase price dispute and GAAP representations is a hotly debated and litigated legal issue for another article. However, there is a related personnel issue that comes into play: The former seller’s employees who prepared those financial statements subject to the breach claim are now employees of the buyer, arguing that their own accounting under the seller was wrong. Irrespective of the merits of the claim, the employees will be inherently biased to defend their historical accounting, and in the most serious situations, they could be forced to do so to avoid exposing themselves to personal liability. Again, the buyer must walk a fine line here to shift allegiances and eliminate inherent defensive bias while successfully integrating employees for the long run.
Buyers typically have the edge on access to records, information and personnel, but they must take advantage of the compressed time frame between the deal closing and provision of the closing statement. Sellers can counter that advantage with preparation before closing and maximization of their contractual right to access in drafting and in post-deal execution. The legal and accounting issues in purchase price disputes are complex, but the timing, access, and personnel issues can be paramount.
2. Purchase agreements usually prescribe that working capital adjustments are calculated in accordance with an accounting standard such as GAAP –Generally Accepted Accounting Principles in the United States – or International Financial Reporting Standards – as “consistently applied” by the seller historically. There is an inherent, and often disputed, rub between what is the appropriate accounting per the standards versus consistent application.
3. The goal posts established by the closing or earn-out statement and the objection notice typically cannot be moved; under certain facts and circumstances it is possible, but it is uncommon.
4. As stated previously, earn-outs can be used in situations where a seller is not involved in the ongoing business. In those circumstances, the constraints of access are like working capital adjustments.
5. This situation was referred to in a prior footnote as the rub between “GAAP” and “consistently applied.”