The initial offer a business buyer makes to a seller is rarely set in stone. In most cases, the two parties must negotiate purchase-price adjustments (PPAs) — differences between the originally stated and the final price at closing.
Why would a deal’s price alter between announcement and completion? Reasons include change to the seller’s net working capital, unexpected deal negotiation delays and due diligence findings. Because PPAs can cause major conflict, sellers should know what adjustments are considered routine and what might be excessive and worth fighting for.
Protecting a Deal’s Value
In most cases, a business buyer makes an initial offer without having all the information needed to objectively assess the target’s value, particularly when the seller is a privately owned company. So the buyer bases the bid on the selling company’s recent financial statements and other available information, such as market position and growth potential.
Once a buyer gets a chance to conduct thorough due diligence, its perception of the target’s value may change. PPAs are meant, in part, to address such revised assessments. But they’re also intended to account for fundamental changes — such as the availability of capital — in the weeks or months between the transaction’s signing and closing.
Types of Adjustments
PPAs related to working capital adjustments are common in M&A deals, even in “sign and close” transactions where a purchase agreement isn’t signed until closing. Such adjustments shift the original purchase price up or down, depending on changes to the seller’s net working capital (measured as current assets minus current liabilities). Unfortunately, working capital can’t be confirmed in real time, so PPAs usually set a final purchase-price determination date for some time after closing.
Many other financial issues can affect the final purchase price. A seller might suffer a substantial net income loss — or, see an unexpected boost in income. Or its outstanding adjustable-rate debt obligations may grow because of rising interest rates. Then there are the occasional unwelcome due diligence discoveries. A buyer might request a PPA if it discovers that the seller has greater-than-anticipated legal liabilities or other potentially costly issues such as pension obligations.
Promised events that don’t actually occur can also change the price. For example, a seller might expect that a new product will obtain regulatory approval. If during deal negotiations regulators actually deny approval to the product, a PPA may be in order. And what if the deal doesn’t close when it’s supposed to? A PPA can be used to account for costs related to time delays.
When Much is Too Much
PPAs have their drawbacks. Although upward adjustments are possible, most PPAs are downward adjustments that benefit buyers. For this reason, sellers often try to cap them at a certain amount or percentage. However, buyers generally resist such caps, arguing that they weaken protections against unforeseen losses or liabilities. Deal negotiations can easily get bogged down — and a merger may even collapse — if a seller believes the buyer is requesting too many PPAs that reduce the company’s final purchase price.
When PPA disagreements begin to threaten a deal, it may be best for both parties to limit adjustments and simply negotiate a more amenable price and deal terms. If this isn’t possible, one potential compromise is to agree that any PPAs above an agreed-upon number or percentage will be paid as an earnout. (See “Bridging the gap.”)
PPAs help ensure that changes in the selling company’s value are accurately reflected in its final price. But they can be tough to negotiate, which is why you need an experienced M&A advisor to guide you during deal negotiations.
Sidebar: Bridging the Gap
It happens: A buyer insists on purchase-price adjustments (PPAs) and a seller flatly refuses to accept them. Can this marriage be saved? Possibly, if the parties agree to an earnout, which typically helps bridge the gap between what a buyer and seller each believe a company is worth. These payments are made some time after the deal closes and usually are based on the company’s postmerger performance. Often, selling owners stay on as employees or advisors after the merger to help promote strong financial performance and the meeting of earnout targets.
Unfortunately, the solution itself isn’t always simple. Earnout negotiations can be contentious in their own right. Among the issues buyers and sellers need to agree on are:
Form of payment. Will the seller receive a cash payment or stock options? Tax issues can complicate this decision.
Date of payment. Will the seller automatically receive earnout payments on specific dates (for example, beginning one year after closing) or is payment contingent upon the company achieving certain performance goals?
Seller’s rights. If the new owner manages the business poorly and its performance suffers enough to cancel earnout obligations, what rights does a seller have?