Valuation Challenge: 'Purchase price puzzle'

Jeffrey Rosen and Michael Diz of Debevoise & Plimpton discuss the valuation and negotiation of purchase price adjustments.

This article originally appeared in the December 2009 Private Equity Manager Monthly, a monthly printer-friendly publication delivered to subscribers to Private Equity Manager.

You are engaged in a negotiation to buy or sell a company that has considerable variation in its operating working capital. It is a personal service business and throughout the year accrues very substantial bonuses that are paid at year end. In addition it pays tax in a number of jurisdictions that either do not require estimated tax payments or require them quarterly based on prior year taxes. It is quite clear that the purchase and sale agreement will contain a working capital adjustment. How should you approach the negotiation of that adjustment and how would your answer change depending upon whether you are the buyer or the seller?
Purchase price adjustments are nasty, intricate things with lots of traps for the unwary and many opportunities for shifting value. These provisions merit early and systematic attention and have a surprising ability to puzzle even veteran negotiators. We will first review the basics of purchase price adjustments and then look at how the fact pattern described above can be approached in purchase price adjustment negotiations.
The basics
At first blush, a working capital adjustment is a simple drafting and accounting exercise – determine the amount by which the sum of current assets (typically excluding cash) minus current liabilities is greater or less than a target, and adjust the purchase price accordingly. Sometimes adjustment provisions start with an estimate of the adjustment at closing to get the numbers pretty close when payments are first made and then true up post-closing. Other times, they just do it all post-closing.
But there’s a lot going on under the hood. And buyers and sellers are likely to have pretty different perspectives on all that activity. The seller likely wants to keep the exercise as mechanical as possible – its goal is simply to compare closing date net working capital to the target using exactly the same measurement mechanics and metrics.  
The buyer, however is usually pleased to have a little wiggle room – it’s an opportunity to challenge accounting practices, claim inventory reserves are too low, and argue about revenue recognition. That disparity of views typically leads to a fairly spirited negotiation of provisions through which the seller seeks to protect itself, for example by tethering the adjustment to specific accounting rules or including language allowing for a readjustment of the target if it wants to add new liabilities or actuarial techniques. In essence, the seller wants to make this a “counting” exercise while the buyer is quite content to let it evolve into an “accounting” exercise.
In addition, there are a surprising number of drafting quirks and pitfalls – how to dovetail the adjustment provisions with any indemnification arrangements in the deal; how to specify the exact moment at which working capital is measured so it captures those aspects of the transaction it is intended to capture and no more; how to narrow and streamline the scope of the inevitable arbitration mechanism; how to deal with disagreements over the pre-closing estimate; and many more.
Two perennial problems
The two issues in our fact pattern illustrate the power of working capital adjustments as well as the need to assess and frame the issues early in a negotiation.  The first – which concerns accrued taxes – stems from the mildly remarkable fact that our tax colleagues have persuaded the world that under no circumstances should buyers be responsible for income-based taxes attributable to the pre-closing period. Because we generally approach deals with that in mind, we have an urge to strip accrued taxes out of the working capital adjustment – but what exactly does that mean? Clearly it’s not enough to take account of them in setting the target and exclude them in the determination of closing date working capital, because that just makes the buyer pay a positive purchase price increase equal to the amount of the tax accrual in the target working capital number. Therefore, the argument goes, accrued taxes should be taken out of the working capital target as well.
But why? If the company accrues $10 million of taxes per quarter and pays estimates quarterly that means it has an average “float” or free financing for taxes of $5 million. If the goal of the purchase price adjustment is to determine the company’s average or normative working capital needs, why shouldn’t that financing opportunity be taken into account? What is it about the fact that it happens to be a tax liability that leads to a different result?
This is a pretty common debate, and one that can be expanded to other liabilities and to quirkier working capital issues (for example, if the working capital target for some negotiated reason includes projected growth in accounts receivable, there is a strong argument that a tax provision should also be included in the determination for that target).  There are a number of ways of thinking about and negotiating these “tax target” type issues and all of them benefit from an early effort to see if this will be a significant issue in the deal in question and, if so, to characterise and structure the debate in a way that increases the likelihood of prevailing.
The second issue in our fact pattern arises frequently in the purchase of businesses the expenses of which are highly seasonal. The business in our example defers until the end of the year a substantial amount of its compensation expense, in the form of year-end bonuses. In such a situation, the seller might well structure the transaction using for target working capital the amount at 31 December, which, let’s assume, would include as a liability the prior year’s $100 million in bonuses. Assuming a debt-free/cash-free structure and a closing date at the end of the first quarter, the buyer could well find itself faced with a $75 million purchase price increase because of the positive working capital adjustment (the prior year’s bonus will have been paid and the accrual for the current year would only be $25 million).
The buyer’s first reaction is likely to be that it should not have to pay, directly or indirectly, any amount in respect of pre-closing bonus accruals and that the accruals should be yanked out of the target balance sheet to achieve this result (sounds a little like the tax argument). The theory would typically be that these bonuses related to earnings on the seller’s watch from which the seller benefited. While that is all true, just about every liability on the closing or the target balance sheet relates to earnings on the seller’s watch and therefore this argument can be tough sledding. Moreover, the seller forcefully makes the contrary argument, which is that the free financing inherent in the bonus arrangement is an immutable characteristic of the current asset and liability cycle of the business and is a serious asset that reduces the cash required to generate earnings.
A second way to discuss the issue is not to argue about inclusion of the bonus liability from the start, but rather to assert that that accrual should be included at an average level rather than at that its maximum, 31 December level. This, in our experience, is a not uncommon way of equilibrating working capital issues (and on our facts would reduce the upward purchase price adjustment to $25 million). It effectively concedes the seller’s logical point but asserts that the value of the financing opportunity is the average balance, not the minimum balance (which certainly does seem more nearly right).
It’s worth noting that there really is not a right or wrong answer to the bonus question – it just depends on where you sit. Seller is saying “you are buying a business that allows you to pay last year’s bonus out of next year’s income – all you need to do is draw down your revolver at bonus time and then pay it back the next year. That is what I have always done and it is what you will do post-closing.” And buyer is saying the reverse: “you got the earnings, you should pay your bonuses and I will pay mine” (although in reality buyer will presumably do exactly what seller says – that is, he will draw down on his revolver to pay the purchase price, pay it back as cash flow comes in and then draw it down again at bonus time).
Once the bonus issue has become part of the working capital debate it becomes, in our experience, difficult to extract it from that debate, and splitting the difference through some form of average working capital target becomes irresistible. A buyer determined to obtain maximum value would therefore be well-advised from the very outset to exclude bonus accruals from the entire working capital mechanism and insist that they should be treated as debt. Sometimes an early assertion of that position will simply carry the day without further explanation. And sometimes it’s necessary to argue either that bonus accruals just feel more intimately related to prior earnings than other expenses, or that the ability to so defer compensation may not be an enduring feature of the business model.

A myriad of issues, many quite specific, should shape the parties’ views of the best way to structure and negotiate a particular purchase price adjustment. The side that masters those issues early and proposes a structure that channels the negotiation in a felicitous direction (from its perspective) can often extract real value from the process. There are, in short, many “right” answers to the issues that arise in the negotiation of working capital adjustments, but, depending where you sit, some are more right than others.
Jeffrey Rosen is a partner and Michael Diz is an associate in the New York office of Debevoise & Plimpton. A version of this article originally appeared in the Summer issue of the Debevoise & Plimpton Private Equity Report.