Purchase price adjustments (PPA) are used in M&A transactions to ensure that the agreed value for the purchase of shares or assets is realised. Typically, an adjustment is called for where there is a period of time between signing and completion of a transaction, or where there is a gap in time between the latest available financial statements and completion of the transaction.
Negotiation concerning purchase price adjustments can be as material as the effort put into the top line price negotiation. However, perhaps because of the drafting M&A lawyers have conceived to document PPA arrangements, and the fact that the parties tend to settle disputes relating to adjustments, there are few legal cases dealing with disputes concerning PPA issues. Despite this, the parties to the transaction should ensure that the ‘purchase price adjustment’ mechanism is well understood commercially, and properly documented in appropriate and legally enforceable provisions contained in the sale contract, to avoid dispute and unintended outcomes.
The ‘purchase price adjustment’ used in a sale and purchase transaction will vary depending on the nature of the business, the type of transaction and the parties’ commercial expectations.
The most common purchase price adjustment is the ‘working capital’ adjustment. On the ‘Completion Date’ of a transaction a purchaser will typically want to be certain the target company or business has enough ‘working capital’ (current assets minus current liabilities (WC)) to continue to operate in the manner previously conducted by the vendor. If the WC of the business on completion is greater than, or less than, the agreed target WC level, then the purchase price is adjusted accordingly. The target WC level is usually determined by reference to a base balance sheet following the purchaser’s due diligence investigations.
There are also circumstances where the purchase price may be adjusted dollar-for-dollar by EBITDA (earnings before interest, taxes, depreciation and amortisation) at completion, for example if the negotiated purchase price is based on a multiple of EBITDA or EV / EBITDA (enterprise-value-to-EBITDA ratio).
In some cases, the purchase price may be adjusted based on ‘non-financial’ metrics. This may include the occurrence or non-occurrence of a specified event, such as the length of time it takes for the transaction to complete (up until a ‘cut-off’ date), or to obtain a material regulatory approval.
In the case of a standard WC price adjustment mechanism, completion accounts are prepared (usually by the vendor and its accountants) and delivered to the purchaser within an agreed timeframe following completion. The agreement should provide for how and when completion accounts must be delivered, and what the purchaser must do on receipt of those accounts (e.g. rejection / acceptance of accounts). The transaction document should include a suitable dispute resolution mechanism.
Alternatively, the purchase price may be adjusted by way of a “two-step” adjustment process. First, the initial completion accounts are prepared (usually by the vendor and its accountants) and compared with the reference or base accounts. The purchase price is adjusted accordingly. Final completion accounts (usually prepared by the purchaser and its accountants) are then used to determine if any further adjustments are necessary following completion. This type of adjustment mechanism is more common in transactions involving U.S. entities.
Disputes tend to arise when the drafting used to document a PPA is deficient, unclear or a worked example (typically in a schedule) is unable to be understood with adequate certainty by an independent party (for example, an independent expert accountant). There are several simple things that can and should always be considered when preparing a PPA draft to avoid uncertainty or dispute.
Some of the topics that require careful consideration when advising clients or negotiating and drafting a ‘purchase price adjustment’ regime and an associated dispute resolution procedure are:
The parties should agree the valuation parameters early in the transaction negotiation. This aspect of the negotiation should involve both legal and financial advisers, even at a preliminary stage.
From a legal perspective, the preferred course of action is to incorporate the agreed valuation methodology in the sale agreement (including specific accounting treatment of material items), to reference the application of Australian accounting standards and to identify specific accounting principles, policies and procedures that will be used as the basis for calculations.
Where a PPA provision forms part of the deal, the parties must identify and agree on accounting treatments before relevant transaction documents are signed. For example, disputes can arise regarding the treatment of conditional payments (eg pursuant to a contractual arrangement) or revenue earned over the course of a business activity (eg the course of production of a product). A transaction document should also include a worked example or method for preparing the ‘completion accounts’ wherever possible.
In all cases, the parties should agree the same accounting principles, policies and procedures used to prepare the company’s most recent annual accounts (ie the base accounts, used to set the price) also form the basis of preparation of the completion accounts.
In some instances, unintended consequences may arise as a result of the interaction between adjustment provisions and other important provisions in a sale agreement. One example is the scope and operation of warranties and indemnities, which may allow a party to claim for the same item by way of a post-completion adjustment as well as under an indemnity. Careful drafting is essential to minimise these risks.
Chicago Bridge & Iron Company N.V. v Westinghouse Electric Company LLC is a 2016 US case that highlights the importance of carefully considering the relationship between purchase price adjustments and other provisions which may impact on price. In that case, the sale and purchase agreement contained a representation in favour of the purchaser that financial statements would be prepared in accordance with generally accepted accounting principles by the US Securities Exchange (GAAP). This representation expired at completion of the transaction. However, the Court found that the working capital adjustment provision allowed the purchaser to make adjustments to the purchase price to correct any non-compliance with GAAP.
Disputes regarding PPA provisions may arise even if the adjustment procedure is sufficiently detailed and well thought out. The reasons for disputes can vary, including calculation errors, accounting treatment of balance sheet items or differing interpretations of the contractual provisions. Appropriate dispute resolution provisions should be incorporated in the sale agreement. They should include a timeframe during which a party may contest the completion accounts and a mechanism for referring the dispute to a third-party expert, or an arbitrator, in the event that the parties cannot reach an agreement.
Funtastic Ltd v Madman Film and Media Pty Ltd is a 2016 Victorian Supreme Court case in which an independent expert accountant, engaged under dispute resolution provisions in a share sale agreement (SSA), determined a reduction in consideration payable for shares under the terms of PPA adjustment provisions. The parties agreed in the SSA that the decision of the independent expert accountant would be, absent ‘manifest error’, “conclusive and binding on the parties for the purpose of determining amendments to the draft Completion Accounts”.
Funtastic (the vendor) sought declarations that the expert made ‘manifest errors’ in applying the relevant PPA provisions. What is ‘manifest error’ will be informed by ordinary principles of contractual determination and in the Madman case the term was “…given its ordinary commercial meaning shaped by what a reasonable businessperson would understand it to mean, having regard to the background, context and commercial purpose or objects of the contract”.
There are only a limited range of circumstances in which challenges to expert determinations will succeed. In the Madman case, having regard to the context of the relevant SSA, ‘manifest error’ was confined to clear and obvious errors.
Purchase price adjustments can have a material impact on the value of a transaction and should not be overlooked. At a minimum, parties should ensure that:
This article is not legal advice. It is intended to provide commentary and general information only. Access to this article does not entitle you to rely on it as legal advice. You should obtain formal legal advice specific to your own situation.
This article was co-written by Law Clerk, Dong Hoon Kim.
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