Purchase Price Adjustment Hacks

There is competitive friction between buyers and sellers around the Purchase Price Adjustment clause (PPA) because each side wishes to enhance deal value, and both tend to differ on the valuation of the target; particularly in the Singapore and South-East Asian market, where the parties involved usually come from vastly different backgrounds. For instance, you may have sellers divesting a multi-generational family business versus asset or fund managers making the purchase with a certain investment horizon on their minds; or, you may encounter local founders who have grown their start-up rapidly and are more familiar with how their companies have grown organically by keeping accounts in accordance with past practice as they grow, versus MNC or private equity purchasers whose C-suite and managers are more accustomed to accounting based on generally accepted accounting principles (GAAP).

It is, therefore, imperative to be familiar with the PPA and prepare for potential disputes before they occur. Failure to prepare could leave money on the table, or result in a loss of deal value. Additionally, disputes will also be costly, time-consuming and distracting if they escalate beyond the usual cut and thrust of the standard post-completion adjustment aimed at aligning buyer’s and seller’s perception of value.

What is the Purchase Price Adjustment?

The PPA is a means to memorialise the value of the target in private M&A transactions and ring-fence fluctuations in the target’s value from the time of valuation through to completion.

A common alternative approach to the PPA is a “locked-box” sale with a fixed purchase price that is not adjusted. “Locked-box” sales are generally thought to be preferred by private equity sellers. With a “locked-box” concept, the parties agree to “lock” the price, or a deterministic formula and criteria used to calculate the price, at an agreed valuation date. This “locked” price is backed by an indemnity (and more unusually walk-away or termination provisions) in the event that the lock is broken before the completion date. With this methodology, parties will usually agree on a small amount of fixed minimum working capital to remain in the target at completion since buyers will often inject capital into the target immediately post-completion.

It is typical for a “locked-box” sale agreement to contain legal provisions setting out what a seller can and cannot do between signing and completion. This is in order to preserve the target’s value, and the provisions should be backed by an indemnity. If a sale is based on a fixed price or other “locked-box”, such provisions limiting the seller’s conduct in the ordinary course until completion are important because an indemnity claim for breach of this clause would be the only way a buyer can recover any erosion in value.

On the other hand, even though lawyers will typically draft clauses that constrain the conduct of sellers for the period between signing and closing to preserve the value of the target, having a PPA clause may confer extra protection since actions taken by a seller that erodes target value could result in a claim against the seller by the buyer under the PPA mechanism, provided such changes in valuation are included in the PPA line items. Such a claim would be in addition to an indemnity claim for breach of seller conduct undertakings.

The PPA is to be distinguished from earn-outs and other forms of deferred consideration, as the PPA is specifically intended to ensure the buyer and seller do not leave money on the table in respect of the value of the target, insofar as there are changes between the date of valuation and completion of the deal. The PPA can only be used to bridge some slight valuation gaps if the achievement of certain specific events within the completion window are included in the valuation calculation of the buyer.

Types of Purchase Price Adjustments

By far, the most common PPA is the Net Working Capital Adjustment, which is used to accommodate changes in the target’s working capital from the time of valuation up to completion.

The next most common PPA, and often occurring in conjunction with the working capital adjustment, are adjustments to financial statement line items such as cash balances, inventory, indebtedness and transaction expenses of the target.

Other forms of PPA serve to bridge short-term valuation gaps, such as the occurrence or non-occurrence of certain events by the completion date. These “events” run the gamut from the settlement of an on-going claim or dispute, securing a potential customer or supplier, achievement of certain targets, tax liability and so forth. However, this differs from an earn-out in terms of timing and is intended to cover only events that are expected to come to a close within the price adjustment period, i.e. shortly after completion.

Market Trends in Singapore Law Governed Private M&A

For context, the vast majority of mid-market to large private M&A globally will contain a PPA clause. In the US M&A market, PPAs are consistently reported to be used around 95% of the time. The PPA is also common in the European M&A market.

The same can be said of the Singapore M&A market for transaction sizes from SGD50 million and up.

Based on our data in relation to mid-market M&A deals we have worked on, the PPA clause has appeared in around 80% of the transactions, with the remaining involving locked-box mechanisms.

For smaller deals, buyers and sellers typically prefer the certainty and efficiency of a fixed price sale on a cash-free and debt-free basis. In small deals, the buyer will typically also require an indemnity from the seller covering breach of clauses setting out conduct between signing and completion aimed at preserving value. However, as the deal size grows larger, the buyer will look to more secure options such as escrow.

In summary of our data on M&A deals involving our firm:

• 80% of mid-market M&A deals contain PPA clauses;
• Working capital adjustments are typically included as part of the PPA;
• Almost all such adjustments also include adjustments for cash and other specific line items. For example, where the target is involved in the sale of goods, an inventory adjustment would often be included;
• The seller always prepares the estimated purchase price true-up and delivers it to the buyer before completion;
• Almost all deals express that the buyer prepares the purchase price completion accounts within a reasonable time after completion;
• It is rare for the buyer to have a contractual right to approve the seller’s estimated purchase price true-up at completion or later. Instead, if the buyer disagrees with the calculation, it has to raise a dispute notice after it prepares the completion accounts.

How does a Typical Purchase Price Adjustment (PPA) Work?

The parties will agree at the time when transaction documents are drafted on the closing statement’s contents.

The closing statement sets out the line items to be calculated and summed up in order to churn out the final purchase price; this typically comprises current working capital, cash, indebtedness, and reasonable company transaction expenses.

Between two and seven business days before completion, the seller provides an estimated purchase price, which is a fixed dollar value (or some other combination of cash and equity), and this is the consideration paid by the buyer to the seller at completion in exchange for the target.

Between one and three months after completion, the buyer provides the completion calculation, which is essentially a true-up of all the line items which the parties have agreed to use to calculate the purchase price. The seller would usually have a chance to verify the completion calculation and raise a dispute notice, if any.

If the seller does not raise a dispute notice, the buyer will pay the seller for any excess above the estimated consideration paid at completion, or, the seller will reimburse the buyer for any excess consideration overpaid by the buyer at completion. Often, lawyers for the parties will memorialise monetary caps around these amounts into the transaction agreement for price certainty. There is also some legal work (and creativity) around escrow holding or security arrangements to ensure that the parties honour the top-up or clawback.

In general, if the seller raises a dispute notice, the parties are compelled by dispute resolution processes memorialised in the transaction agreement to seek self-help and work to discuss and resolve the disputed items within an agreed period, usually around 10 business days to two months. Only if a dispute cannot be resolved would the parties then engage and submit the dispute to an accounting expert. This is not the usual court or arbitral dispute process because it centres around valuation metrics only. Therefore, an accounting expert is chosen as an arbiter for efficiency and cost-effectiveness.

Potential Conflicts in the Purchase Price Adjustment and Solutions

Sellers should take note that they usually will only have one chance to raise a dispute with the adjustment calculation, and that is the dispute notice. Moreover, the seller only has a short amount of time to gather the information and prepare their case as to why the buyer’s calculation was not correct or should not be determinative.

Common Conflict 1: Past Accounting Practice versus Prevalent Accounting Principles

In order for the purchase price calculated by the buyer and seller to align, they must both use the same and consistent accounting approach.

One may argue that the best way to ensure that the PPA only compensates for adjustments occurring between the date of valuation to completion would be to ensure that the completion accounts follow the same past accounting practices of the company. However, such past practices may not necessarily align with prevalent accounting principles such as GAAP or Singapore Financial Reporting Standards (SFRS). This issue is particularly acute where the target is based overseas or has many overseas subsidiaries.

On the other hand, buyers often argue that the best way to ensure the buyer receives the target in good financial condition would be to apply prevalent accounting standards to calculate the completion accounts. If the estimated consideration had been improperly calculated by the seller in the first place, the buyer should not then be bound to continue to do it “incorrectly” to determine the final purchase price.

As such, deal teams working on the transaction agreements should be clear as to which standard should apply to calculate both the purchase price estimate and the completion statements, and (where required) memorialise agreed deviations.

Buyers are also advised to appoint appropriate financial diligence teams early to evaluate the financial health of the target. Where necessary, appoint forensic accountants early because the PPA is not particularly helpful when the buyer only uncovers issues at the post-completion stage.

If at the post-completion stage, serious issues are uncovered by what is supposed to be a valuation balancing exercise, the PPA dispute resolution mechanism will strain under the pressure of the task before it. Moreover, the buyer may then be left holding a dud as M&A agreements are not easily rescinded and restitution of the parties to their pre-contract positions is often not possible.

We encourage all parties, whether the buyer or seller, to first assess from the outset which accounting standard is most favourable to them and to then negotiate for that standard to be incorporated as the binding standard to calculate the closing adjustment. Parties should also take note here that that the standard that they are most familiar with may not be the most useful standard. We often encounter foreign buyers who wish to use GAAP, even though GAAP may not be the most applicable standard and should not be chosen just because it is the most familiar option for the deal team. After completion, the target will need to continue to operate in accordance with the accounting practices of its place of operations anyway, and it might be better to become familiar or appoint advisors who are familiar with those standards earlier, for better post-completion integration purposes.

Common Conflict 2: What Counts as a Completion Account Line Item?

Lawyers for the parties will assist the buyer and seller to memorialise the specific accounting line items that would go into calculating the PPA. For example, in a working capital adjustment PPA clause, parties would typically wish to specify current assets and liabilities as contributing to the working capital.

However, even here, we can see a potential for dispute around what might be considered “current”. A seller may say for instance, that the target has historically considered certain future receivables as “current”, and relegating them to the category of “non-current” would compromise the value the sellers should receive from the buyer for work that has been done by the sellers to make those sales for which these receivables have not yet accrued.

Buyers may, however, argue these receivables are accruable too far into the future to be considered current, and that there are many factors they may come into play to disrupt the receivable from ever being paid out to the target, such as cancellation of the customer contract. Buyers will resist overpaying for current assets as it would erode the value they will receive from the target while being too lax in paying sellers for non-current assets would effectively pre-emptively transfer future value to the seller.

In order to avoid such over-payments for non-current assets, buyers may argue that a specific receivables list should have already been considered when valuing the target and such “value” already captured in the purchase price, whilst the PPA is simply a mechanism to true-up the working capital. In other words, if sellers push to include receivables that are not current, they would be receiving double the value from both the initial valuation and an overbroad assessment of current assets.

Parties and their lawyers should be careful to explicitly identify which accounts are to be included in the calculation and draft defensively to avoid attempts by either party to modify the accounts included in the calculation of the PPA. One method to draft defensively would be to specifically list out all the relevant accounts to be included in the PPA calculation.

The downside to listing all the relevant accounts in the transaction agreement is the lack of knowledge of the buyer, this is because the language may then be so explicit that while it captures all the correct current accounts so as to block attempts by sellers to extract greater value, it might fail to capture all the relevant current liabilities as well. This arises from the usual information asymmetry between buyer and seller.

Generally, the more specific the calculation metrics, the more certainty there is for both parties, but here sellers have the upper hand in terms of the knowledge. Therefore, prudent deal teams will be careful to draft terms that allow greater flexibility for buyers as compared to sellers in respect of amending or introducing new metrics. Reasonable and good faith sellers would be amenable to such stipulations even if it might be slightly more favourable to buyers because it corrects the information imbalance.

Common Conflict 3: Avoiding Overly Scrupulous Parties

Let’s assume the parties are now at the post-completion stage, and there is a dispute as to the PPA. The buyer thinks it should be paid some additional amount and disagrees with the seller’s estimated price true-up. The seller, on the other hand, strongly disagrees. What should we do?

A good PPA, as mentioned above, should contain a dispute mechanism clause that is specific to the PPA itself, and not one that would immediately turn over the entire agreement to court or an arbitrator. We often recommend the parties try self-help as a start, and if they are unable to resolve the adjustment mechanism themselves to then, hand it over to a specialist such as an accountant.

However, an overscrupulous party may still then find much to argue over, such as:

• What is the scope of the reviewer’s process and authority?
• Can the reviewer also play a fact-gathering role?
• How long should the review process take?
• Is the reviewer going to be required to give reasons or will a binding final calculation and determination suffice?

Often, the parties would already be so taxed at having identified the line items relevant to the PPA and busily involved in the post-completion integration that it may not be appropriate at this time to be so excessively scrupulous over details surrounding the reviewer’s role and actions. At the same time, if the PPA and transaction agreement were to be so extensively drafted as to go into every possible detail to the nth degree, transaction costs may be so high as to render the deal untenable.

The purchase price adjustment stage, with the deal still fresh and at the end of what is usually a high-intensity deal-making process, is vulnerable to bad actors high-jacking the PPA process in an attempt to unravel the transaction or otherwise undermine the ability of the reviewer to perform its duties.

As such, it is important to carefully draft the PPA dispute resolution clause to encourage reasonableness, resolve de minimis amounts and focus exclusively on large issues capable of resolution with access to information. At times, we also suggest interest calculation clauses to encourage timely settlement of disputed amounts. Simultaneous with careful drafting, we encourage parties to also be reasonable and business-minded, with the objective of producing a good serviceable transaction document without over-drafting for low-risk events.

Conclusion

The PPA is a standard and frequently included clause for most private M&A transactions that are mid-market and above.

Apart from the “locked-box” mechanism that may be preferred by certain private equity sellers, the general intent is to determine how to account for and compensate sellers adequately for the value of the target while balancing against potential overpayment by the buyer.

Buyers and sellers share the same competitive friction to extract as much value as possible from the target, and it is, therefore, important for both sides to be minimally aware and alert as to how the PPA may be used to extract value rather than compensate fairly, and to work together with lawyers, accountants and other advisors to ensure the PPA works as intended, and, to resolve PPA disputes quickly, fairly and cost-effectively should they arise.

This update is produced by our Singapore office, Bird & Bird ATMD LLP, and does not constitute legal advice. It is intended to provide general information only. Please contact our lawyers if you have any specific queries.