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The Purchase Price Adjustment (PPA) mechanism is found in over 90% of private-target M&A transactions. Given its economic affect, it’s a heavily negotiated provision pre-closing but often sell-side counsel isn’t retained post-closing to see the outcome of their hard work. As an experienced professional shareholder representative, here are five of the most common Purchase Price Adjustment issues we experience during the post-closing period:

1. Failure to timely deliver the purchase price adjustments

According to the 2021 American Bar Association Private Target Mergers & Acquisitions Deal Point Study, 80% of transactions do not contain a provision addressing what happens when the buyer fails to deliver an updated closing statement. This may result in last-minute requests for an extension from the buyer or delays in resolving the outstanding adjustment. While it may be practical to grant the extension to avoid causing friction early on, there is legal precedent in Schillinger Genetics, Inc. v. Benson Hill Seeds, Inc., 2021 WL 320723, at *18 (Del. Ch. Feb. 1, 2021) that supports the claim that failing to timely deliver an updated closing statement results in the buyer’s inability to seek a true-up or recover a potential PPA deficit from the escrow fund.

As is always the case, clarity on what exactly happens should the buyer fail to timely deliver an updated closing statement can reduce friction caused by the unknown and give the buyer clear guidelines as to what to expect should they fail to follow the terms.

2. Seasonal or monthly fluctuations

While seasonal or quarterly fluctuations are more important when setting the Peg or Target Net Working Capital (NWC), we have also seen it come into play for the post-closing true-up as well. This is particularly relevant for companies that experience big swings in sales, inventory, and cash between off and prime seasons. For those types of companies, we recommend using a 3–6-month average to cover any variables should the closing date slip due to extended negotiations or regulatory approval. Depending on when shipments are processed, this can lead to drastic changes in inventory on hand, accounts receivable, and cash account balances. Additionally, some companies have large swings in inventory, sales, and cash between the start of the month and the end. Parties should ensure they are keeping this in mind when preparing the estimated closing statement in advance of closing to properly account for shipments leaving the warehouse or inflows of cash corresponding to decreases in Accounts Receivable, especially in non-cash deals where that change could result in a negative adjustment for the shareholders.

3. Defined terms 

We repeatedly see the following terms cause confusion or friction post-closing, as a result of being imprecisely defined in the definitive agreement:  

Adjustment Time: The purchase price is usually determined as of the Adjustment Time, but what time is that exactly? There can be a significant difference to use the broad “Closing Date,” which could include close of business on that date versus “12:01 a.m. EST on the Closing Date,” which would not include transactions from that day.

We’ve experienced an instance where the closing was on the last day of the quarter and the estimated closing statement included reference to inventory that would have been in the warehouse on 12:01 a.m. PT on the Closing Date but was shipping out that morning. The buyer submitted a final closing statement that did not include the inventory, as they had interpreted “Closing Date” as of the time the Certificate of Merger was filed later that day. In this instance, the over $400,000 discrepancy resulted in a dispute that caused tension early on for a transaction that had several years of milestones to come.   

Saleable vs. Nonsaleable Inventory:  While not applicable for all business types, there are certainly industries that process inventory orders through major third-party distributors such as Amazon or Target. For those companies, it is important to define what qualifies as a “saleable” asset, as third-party distributors often have strict guidelines on what inventory they will accept into their warehouse based on potential expiration dates. Often times that inventory could still be saleable direct to consumer, and therefore have some value, but may not be included in inventory calculations if the buyer decides to qualify it as nonsaleable.  

Aged Receivables: While Generally Accepted Accounting Principles (GAAP) does recommend having some type of reserve for aged or potentially uncollectable accounts receivable (AR), it is silent as far as how that reserve should be calculated. Having accounting metrology in the agreement that states all calculations should be in accordance with GAAP does not provide enough clarity. It is preferable to include a specific timeframe for aged AR to ensure that both parties are working under the same pretenses. In addition, simply referencing a company’s historical practices can be difficult if there are no accounting representatives remaining at the company with whom the representative can discuss.

Current vs. Long-Term Assets:  It’s important that the preparer of the estimated closing statement understands the difference between current and long-term assets, especially if the accounting methodology requires GAAP compliance. This is particularly true when determining the value of a lease, which is specifically defined (and more recently updated) under GAAP. In addition, if a client has assets that are unique in nature and subject to degradation, these should be explicit in the agreement as well, if not explicitly clear through historical/past-practices. For instance, we experienced a transaction where there were post-closing disputes regarding the timeline of depreciation for a whiskey barrel when the selling company was a distillery. The company did not have consistent historical past practices and trying to find what was “market standard” was a challenging task for such a unique asset.

4. Accrued tax liabilities

We recommend that instead of including estimated tax liabilities in the purchase price adjustment, all tax liabilities are calculated pursuant to the indemnification terms and addressed once that liability is known and realized. Otherwise, both the seller and the buyer are negotiating hypothetical estimates and will often times adjust or manipulate the numbers to better suit their argument. Nearly 50% of transactions are already excluding tax assets and tax liabilities from the PPA. The seller may have included potential tax credits that reduce tax liability that have not yet been claimed or confirmed, particularly R&D tax credits or VAT tax credits. It’s best for the parties to seek indemnification once that amount is known instead of debating the merits of potential tax credits or liabilities.

5. Lack of information

It is critical for the shareholder representative to have electronic access to the books and records of the company in order to conduct a thorough review of the adjustment. In situations where this access isn't clearly stated in the agreement, it can be challenging to collaborate with the buyer to perform our due diligence and attempt to dispute the underlying calculations included in the adjustment. 

The goal with the Purchase Price Adjustment is to have a small delta that doesn’t severely impact either party, however agreements that lack clarity or leave room for interpretation can open the door for significant disputes. While parties might think simply stating that the calculations are to be prepared in accordance with GAAP is sufficient, certain of the items we have included here, which don’t relate to GAAP, have caused the biggest disputes, or swings post-closing. These are important items deal-parties should keep in mind during such complex negotiations to ensure the desired outcome is achieved.  

If you’d like to explore the idea of using a professional shareholder representative on your transaction to help streamline the closing and post-closing process, contact us today.

Shareholder Representative engagements are offered through a Wilmington Trust, N.A. subsidiary, WT Representative, LLC.

Wilmington Trust is not authorized to and does not provide legal, acccounting, or tax advice.

Wilmington Trust’s domestic and international affiliates provide trust and agency services associated with restructurings and supporting companies through distressed situations.

This article is for educational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.

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