Purchase price adjustments
Purchase price adjustments are a common feature of business sale transactions. The purchase price adjustment adjusts for differences in key accounts between the buyer and seller exchanging contracts and completion. The purchase price adjustment ensures a fair and equitable transaction that is consistent with the agreed contract terms.
In agreeing to the terms of the transaction, the total consideration for 100% of the shares in the target company will usually be determined by:
- The value of the business (Enterprise Value), which includes the working capital and plant and equipment required to operate the business;
- Any surplus assets to be acquired, such as property or investments are added to Enterprise Value; and
- Any non-working capital related liabilities to be assumed by the acquirer, such as debt or provisions, are deducted from Enterprise Value.
- The most frequent working capital adjustments relate to working capital and net debt and are usually negotiated in all transactions.
Normal Working Capital
The Enterprise Value assumes that there is a “normal” level of working capital available for the business to deliver the projected earnings. A purchase price adjustment should be included in sale and purchase contracts to ensure that an appropriate balance of working capital is included which protects the interests of both the vendor and the acquirer.
The two main ways to consider targeted working capital are:
- Average working capital - for a business with stable earnings from both a historical and forecast perspective, and limited seasonality, the average working capital balance may be an acceptable measure on which to base completion working capital.
- Forecast working capital - where a business is set to experience growth, is contract or job based, or has seasonality in its earnings, completion net working capital should be forecast. The forecast net working capital should give consideration to forecast earnings, historical working capital ratios, and the impacts of any specific contracts.
Where cash and/or debt is to be taken on by the acquirer, a net debt (cashless debt) adjustment will also be included in the sale and purchase agreement. The net debt adjustment allows for the purchase price to be reduced/increased for any additional/reduced net debt to be taken on by the acquirer.
The key drivers that will impact net debt between the execution of contract and sale completion are set out in the table below.
The intertwined relationship of net working capital and net debt, means that any variance in actual working capital at completion will usually be reflected in the net debt position if this is also included in the contract.
Completion net debt should be considered prior to signing the contract, and ideally forecast. If forecasts are not completed a number of events may occur that could adversely impact the vendor and purchaser, for example, specific capex or working capital investment made by the seller to deliver future contracts. As the acquirer will receive the benefits of the new capex, target net debt may be adjusted to reflect the required capex.
Other Common Purchase Price Adjustments
To maintain the integrity and equity of the agreed transaction terms, the following purchase price adjustments may also be considered:
- Provisions, including warranties, and employee leave liabilities. These provisions are usually estimated in accordance with an agreed methodology and re-calculated at completion;
- Tax liabilities, in the event of a share acquisition, a purchase price adjustment is likely to include an adjustment for the actual tax liability at completion. Tax liabilities may also be included in the net debt calculation; and
- Plant and equipment, although assets to be transferred are usually addressed by the completeness of an asset listing.
- In relation the above adjustments, the future tax consequences of these assets and liabilities should also be considered.
The purchase price adjustment can have a material impact on the ultimate transaction consideration, however is a necessary requirement for sale and purchase agreements to protect the interests of both the buyer and seller. Sellers not dedicating appropriate time and resources to understand the adjustment mechanisms could realise substantially reduced proceeds. Conversely, if the purchase price adjustment is not appropriately documented, buyers may have to outlay significantly more capital to complete the acquisition and ensure that the target business is in a position to deliver forecast earnings. This increase in total investment, will also decrease the return on capital for the purchaser.
For these reasons it is recommended that financial and legal advisers are engaged in considering purchase price adjustments early in the sale process to understand, evaluate and document the adjustments in advance to avoid delays or surprises with transaction completion.