So you’ve made the milestone decision to sell your family or closely held business to a sophisticated buyer—perhaps a “financial buyer” (i.e., a private equity fund) or a “strategic buyer” (i.e., a competitor) —and, to your shock and dismay, the purchase price is not simply one, lump-sum payment of cash on the barrel head at closing. You will first notice this complication in some form of early term sheet, letter of intent (“LOI”) or other document summarizing the forthcoming asset purchase agreement. You will likely see the purchase price and payment terms broken down into an elaborate, multi-paragraph formula that includes a post-closing holdback of a portion of the gross purchase price, a long-term “earn out,” or some combination of both.
Purchase Price Adjustment Provisions
All-cash asset purchasers are a rather rare bird, especially in the universe of financial buyers, who have an institutional mandate from their limited partners to assiduously minimize the risks of their profitability, revenue, leverage, and cash flow projections falling short after a deal is closed. Post-closing purchase price “adjustments” are one way to shift these risks from buyer to seller and, as a result, are par for the course in many asset deals.
Working Capital Adjustment
The most common purchase price adjustment mechanism—and the one you should have your hands around as you evaluate any offer at the LOI stage—is the working capital adjustment. A working capital adjustment gives the buyer the right to reduce the gross purchase price, usually dollar-for-dollar, by the amount of any shortfall in actual closing-date working capital versus a closing date working capital “target” that the buyer projects when the purchase agreement is signed. The working capital adjustment is usually a two-way street: the purchase price may also be adjusted upwards if actual working capital is greater than the pre-closing target. But don’t let that lull you into a sense of complacency—more on that below.
The term “working capital” can mean anything you want it to mean, and can be tailored from deal to deal. But the baseline definition of the term (or, more precisely, “net working capital”) is the difference between the seller’s current assets and current liabilities as of the closing date. This is an important formula and metric for a buyer who wants to ensure post-closing free cash flow and continuity of operations without unexpected liquidity crises: it serves as a yardstick to gauge availability of cash and accounts receivable to cover current accounts payable and payroll (and, in parallel, to meet collateral eligibility requirements under the buyer’s asset-based revolving credit facility).
So if a working capital adjustment can move up or down, dollar for dollar, then there’s really nothing to worry about as a seller, right? Not so fast. The devil is always in the details. The buyer will often drive the calculation (projection) of the target closing date working capital, and may conveniently end up overstating it as a result. As a seller, you also need to be careful to avoid the temptation to increase your AR collection activity between signing and closing, as this may dramatically impact a working capital “true-up” that excludes cash from the list of current assets included in the working capital formula.
Holdback Escrow for Sellers Can Prove Invaluable
Without question, the working capital adjustment can be an area of high exposure and headache for sellers, especially if the amount of the adjustment has not been capped in the purchase agreement. You should also be mindful of the mechanics of the procedure for trueing-up (calculating) the actual working capital figure after the closing, including the mechanism for reviewing and possibly disputing the buyer’s calculation. Finally, bear in mind that most buyers will hold back a portion of the gross purchase price to make collection of a working capital shortfall easier for them. For sellers, this is where the use of a holdback escrow—with very precise escrow instructions, dispute procedures, and payment triggers—can prove strategically invaluable.
Learn more about Stuart A. Laven, Jr., shareholder in the firm’s Business Law and Capital and Finance Groups, where he focuses his practice on financial restructuring, mergers and acquisitions, commercial finance, entertainment and media, and intellectual property (technology) licensing.