Drafting Purchase Price Adjustment Clauses in M&A (PDF)

According to the general principle of freedom of contract, the parties are independent to choose the form, quantity and the scope of guarantees. It is up to the parties in deciding how detailed the guarantee clauses ought to be. From a seller’s point of view, guarantees are a way to raise the purchase price at the expense of increased liability risk. If the seller feels confident that all the data provided to the buyer are correct, complete and not manipulated in anyway, he should be happy to issue guarantees. In cases where the parties have not agreed to all terms in the M&A contract or there is an argument about the purchase price, this move might persuade the buyer to agree and convince him that his concerns are limited by these guarantees. From the buyer’s point of view, guarantees are a helpful tool to overcome uncertainties which have occurred during due diligence or negotiations.

Guarantees that can influence the purchase price are not only issued for retrospective qualities or characteristics, but also for future ones. Typical forms of guarantees include: equity guarantee, working capital guarantee, asset guarantee, debt-free guarantee, guarantees concerning parts or the complete financial statements, and the non-realisation of certain risks in the future.Some of them will be discussed at the following in detail.

Guarantee of Financial Statements:

Probably one of the most important guarantees is the one about financial statements. Regardless of which method of purchase price adjustment is used, all of them depend on the numbers in the financial statements. Therefore, these statements must be reliable. A guarantee typically involves the preparation of the financial statements according to GAAP, in compliance to formal and material continuity of past prepared financial statements, and its completeness and correctness. From a buyer’s perspective, this type of guarantee should always be drafted in an M&A contract as it builds the foundation for post-closing adjustment and earn-out clauses. That also ensures the buyer about the numbers that build the basis for the company valuation. The guarantee of the financial statements goes hand-in-hand with other purchase price adjustment tools.

Equity Guarantee:

An offset of the guarantee of the financial statements is the equity guarantee. Both parties agree to an estimated balance of equity at a certain future point-in-time. The estimated balance of equity could, for example, be calculated by taking the book value of equity of the last balance sheet, increased by the planned profit. If the estimated balance of equity equals the actual balance of equity by that time, the purchase price falls due. If there are any variances in terms that the actual balance of equity is higher or lower as the estimated balance of equity, purchase price adjustments will take place. As a consequence, the purchase price which the buyer has to pay can increase or decrease. It is commonly accepted that a negative purchase price, which stands for an additional payment by the seller in case the actual balance of equity does not reach the estimated balance of equity at the point in time when the object of purchase is handed over, is contractually excluded.

This kind of guarantee does not only take solely the equity into account. It also considers other assets of the balance sheet. To name a few, the buyer can reduce the following risks: distribution of company profits by the seller after the signing date, withdraw of cash of the target by the seller after signing date, reduction of profit through exercising an option with regards to items included in the financial statement after the signing date (for example, alteration in accruals) or the reduction of revenue reserves.

An equity guarantee is a very attractive guarantee for a buyer, since it leads to an intense minimisation of his risk. It is not so attractive for the seller, because his ability to calculate future revenues is limited by the guarantee and he has partially to bear the risk of future business development. Therefore, this guarantee will lead to an increase in purchase price to equalise the seller’s risks.

A legal counsel drafting this kind of guarantee has to be aware of the conceptual scope of the term ‘equity’. Equity in terms of a legal, economic or commercial context can be distinguished and include different financial assets. The term must be precisely defined in order to prevent future misunderstanding.

Working Capital Guarantee:

The working capital guarantee when compared to the equity guarantee is not as comprehensive and therefore easier to reach an agreement between the parties. It is also an offset of the guarantee of the financial statements. Working capital guarantees insure against fluctuations in the company’s operational current assets. It is preferred by companies that have comparatively high fluctuations in operational current assets, like the consumer goods industry. The objective of a working capital guarantee is that the seller assures a certain amount of working capital at the closing date. This assures the buyer that there will be no outflow of liquidity until that date.

Similar to equity, working capital is ambiguous. It is not clearly defined what exactly can be subsumed under ‘working capital’. All definitions agree that ‘working capital’ represents the current assets financed by long-term debts, or in other words, the difference of current assets and current liabilities. Various definitions take diverse balance sheet items into account. Here are some definitions of working capital:

‘Operating working capital comprises of operating cash, accounts receivable, stocks (inventories), and other current assets (such as prepaid expenses) less accounts payable and other current liabilities (such as tax payable)’.

Working capital is cash, marketable securities, accounts receivable and inventory, less accounts payable, accrued liabilities and short debt.

Working capital is the sum of stocks, operating liquid assets, accounts receivable and other current assets, less trade accounts payable, other accounts payable and deposits received.

‘(Working Capital) refers to current assets less current liabilities. Current assets include cash, marketable securities, debtors and stock. Current liabilities are obligations that are expected to be repaid within the year’.

‘Short-term or current assets and liabilities are collectively known as working capital.’ Current assets include but are not limited to cash, marketable securities, accounts receivable and inventories. Current liabilities include but are not limited short-term loans, accounts payable, accrued income taxes and current payments due on long-term debt.

It is essential for the drafter of this clause to define precisely which items are included in ‘working capital’ and which are not. That is the only way to avoid any ambiguity after the closing about the calculation of the purchase price. A detailed scheme should be enclosed as an annex of the contract, stating the relevant items of the balance sheet which identify working capital.

Comparable to an equity guarantee, the working capital guarantee has a purchase price adjusting effect if the guaranteed working capital is not given at the closing date. Depending on the fluctuations, the purchase price can be higher or lower. The drafting counsel must be aware of the fact that the working capital guarantee alone cannot prevent manipulations. On the basis that working capital is only a result of a mathematical mixture of current assets and current liabilities, it is easy to manipulate the amount of it. For example, long-term assets and long-term debts are not part of the various working capital definitions. An accounting exchange on the asset side can take place, where long-term assets, like machines, can be sold. The liquidity increases and hence the working capital increases as well. At the closing date, the working capital would be higher than the guaranteed one and the purchase price would be increased. The consequence is that the buyer pays a higher purchase price for the company that is of a lower value, since assets are sold.Another possibility is to create bank debts, which are usually not covered under the working capital definitions, that increases the liquidity and ultimately the working capital. Through these manipulation possibilities, the seller can influence a higher purchase price. Therefore, legal counsels should use a combination of guarantees that collude to prevent manipulations."