Purchase Price Adjustments in M&A Transactions
In an M&A deal, purchase price/headline price is the most crucial factor for the transaction for buyers and sellers. However, the seller does not get the headline price after the deal closes, and there are many adjustments that sellers must be aware of while consummating the transaction. In this post, i share my insights on these purchase price adjustments, the incentives that purchase price provision gives buyers and sellers, and how to control these incentives.
Generally, the buyers pay sellers cash or stock in exchange for the seller’s stake. The cash consideration is more straightforward, while issuing equity implies that the buyer stock must get registered under the securities laws. When the seller receives the buyer’s stock, the seller conducts a buyer’s due diligence and demands representations from the buyer.
Fixed Vs Contingent
The purchase price is fixed or contingent when there is an adjustment in the purchase price at a closing date or if the price gets subject to post-closing adjustment. For a private deal, these adjustments take the form of earn-outs and Contingent value rights for public transactions. This contingent consideration allows buyers and sellers to allocate the risk of target performance between signing and closing and after closing as an earn-out/CVR.
The buyers and seller agree to the purchase price at the time of signing. However, the seller gets paid when the deal closes. In the stock payout, the parties need to figure out how to adjust for the buyer’s stock price fluctuations between the signing and closing. To handle this, parties either keep the number of shares issued as consideration fixed at closing (fixed exchange ratio) or the value of shares fixed (fixed price). If the stock price volatility is higher, the parties use a “Collar”, where the collar decides the range where the fixed volume of shares/price can fluctuate, thus mitigating risks for the parties. When the price falls outside the range, the buyer has to issue additional shares to target to compensate for the risk.
In a fixed exchange ratio where the no of shares issued as consideration gets fixed in exchange for the target shares, the consideration the target receives at the closing fluctuates depending on the buyer’s stock price. If the buyer’s stock prices increase after the deal announcement, the target receives a windfall; if it plummets, it receives a lower consideration. Conversely, if the buyer’s stock price declines at the deal announcement, the market thinks the buyer has overpaid for the acquisition. Thus, the target’s consideration at the closing reflects the transaction risks. As a result, fixed exchange ratio transactions are more common, especially when the target and buyer are in the same industry.
In fixed-price stock deals, the value of consideration gets fixed, whereas the shares issuances changes depending on the buyer’s stock price at closing. If the buyer’s stock price plummets, it has to issue more shares resulting in higher dilution. Such deals are standard when the buyer acquires a target from a different industry, and the target is not ready to take the buyer’s industry-related risks.
Closing Date Price Adjustments
In private M&A, the buyer determines the purchase price based on the target’s financial state at closing, allowing the purchase price to fluctuate between signing and closing. In my experience, the most common adjustments are the working capital adjustments followed by the target’s net debt. The buyer arrives at the target’s expected working capital by taking the average of its working capital in the last six months. This calculation varies depending on the cyclicality of the target’s business. If the target’s actual working capital exceeds the expected working capital, the purchase price increases, and if it is less than the expected working capital, the purchase price gets reduced. We calculate the working capital as the difference between non-cash current assets and no-debt current liabilities. We generally exclude taxes from the working capital as the buyers want a separate tax indemnity, and the target has to pay its outstanding indemnified taxes. If the target has outstanding debt, interest payments get accelerated at closing. If the buyer assumes the target’s debt, the outstanding debt gets deducted from the purchase price.
In many deals, purchase price provisions result in perverse incentives that have to get regulated by covenants. For instance, the target will refrain from making necessary investments between the signing and closing, thereby receiving excess cash at closing. The buyer can resist such actions by drafting covenants that the target will run the business under normal conditions and spend on existing marketing budgets/continue capital projects on a pre-agreed schedule.
The buyer determines the purchase price based on the target’s financial position at closing. However, rarely does the buyer calculate this at the closing date. In typical scenarios, the target estimates its financial position a week before closing and shares these calculations with the buyer. The buyer relies on the target’s calculation and pays the consideration. Then, the buyer examines the target’s books at closing and true up the price to determine the adjustments on the closing date. Finally, the buyer arrives at the statement and shares it with the target. In the case of disputes, both parties can appoint an accountant to determine the closing adjustments and the accountant’s verdict is binding. Rarely do these disputes go to courts.
In an earn-out, the seller receives a portion of the purchase price after closing based on its performance. Earn-outs happen when there is a valuation gap, and the buyer and seller disagree on the price. In addition, the buyer assumes that the target’s projections are aggressive, whereas the target thinks it is realistic. Thus earn-outs are a portion of the purchase price at risk contingent on the post-closing performance of the target. The earn-out metrics can change from financial (revenues, EBITDA) to operational (new customer additions, success of IP), and the duration of the earn-out period varies between 1–3 years.
Earn-out calculations trigger disputes between the parties, and most of these disputes end up as litigations. Thus, the buyer needs to give the target clarity on the earn-out computations and the target’s autonomy to run the business during the earn-out period to achieve the targets. Post-deal closing, the buyer assumes 100% control of the target, whereas the target has not received 100% of the consideration as a part of its price gets paid after closing. Thus the target must have the freedom to run the business to achieve its earn-out targets while at the same time, it does not compromise on the overall value of the business.
In my experience, the buyer resorts to games posing obstacles to the target achieving its goals. For instance, in the COVID crisis, many buyers resisted making necessary investments in the target business due to the financial crunch. Thus, target firms could not achieve their earn-out metrics not because of their performance but of the lack of investments by the buyer resulting in a dispute between the parties.
Sometimes, the buyer gets acquired by another firm before the target receives their earn-outs. In such situations, the target wants their earn-out payments accelerated and paid before the control changes from the buyer to another party.
The purchase price adjustments are a crucial component of deal negotiations. The headline price and the target’s consideration diverge due to purchase price adjustments. Therefore, both parties, especially the seller, need to understand these adjustments and how they get computed, so they do not leave money on the table. In addition, these adjustments help the buyer mitigate potential risks, preventing them from overpaying the target shareholders.