No two M&A transactions are exactly alike, but one issue that will arise in almost every deal is that of a purchase price adjustment (PPA). Exactly when and why PPAs are structured, and how they measured are critical issues directly impacting how much money a seller will ultimately receive from the buyer in a transaction.
So what exactly is a purchase price adjustment, and how is it typically used in a transaction? There are many reasons they can exist, and in different forms, but in general a purchase price adjustment is used to ensure that a buyer will receive the amount of net assets that existed when the purchase price was determined and agreed to by the parties.
As background, a transaction usually comes together in stages, the first of which is when the parties agree on a basic price and deal structure (e.g. is the buyer buying assets or stock for a certain price). At this stage there is typically a term sheet or Letter of Intent (LOI) signed by the parties laying out this basic deal and some related terms and conditions. Once the LOI is signed, the buyer has an agreed upon time period to kick the tires of the business (have accountants review the books, etc.). This stage is often referred to as the Due Diligence period, and usually takes 60 to 90 days, or longer. Usually concurrently, negotiations regarding final documentations occur, third party lending arrangements and agreements are put into place, etc. And as final steps, the agreed upon documents are signed and the transaction funds.
Purchase price adjustments are often used as a mechanism to protect a buyer from a reduction in the value of the company during the period between the date of when a value is agreed upon (e.g. in a letter of intent), and the date that the transaction closes. While there are a number of measures that can be used to deal with changes in the business during this time period, a Working Capital Adjustment mechanism is probably the most common. For example, a degradation in working capital during the due diligence period concerns a buyer. Conversely, a seller doesn’t want to leave excess value behind for the buyer (over and above what the buyer envisioned receiving).
Exactly how this Working Capital Adjustment is measured is a critical negotiation, and can mean a big difference in either the pockets of the seller or buyer. Issues should be addressed such as whether the measurement will be based on generally accepted accounting principles (GAAP), even when the seller’s books may not have been kept on a GAAP basis. Agreement on which specific general ledger accounts are included or excluded from the calculations, and how much working capital is “normal” can have tremendous implications to the transaction’s end result to the seller and buyer.
Different types and measures of PPAs run a wide spectrum. Some measures other than working capital can include for example EBITDA (earnings before interest, taxes, depreciation, and amortization), net assets or net worth, and even the occurrence of an event (i.e. close by a certain date in advance of impending tax rate changes). Each of these negotiations and calculations can be complex, and another good reason to have a CFA investment banker on your side of the M&A negotiation table.
Posted by Brad Purifoy.