Purchase Price Adjustments Can Alter a Deal’s Final Price Tag– March 24, 2015 by Justin Thomas

After lengthy negotiations, a buyer and seller agree upon the value of the business for sale and document it in the Letter of Intent (LOI). Time to break out the Champagne?

Not quite yet.

Round two generally includes making purchase price adjustments, which are often built into the final Sale and Purchase Agreement (SPA) and can affect the final cash payment in a deal. While purchase price mechanisms are meant to preserve value and allocate the economic risks and profits of pre-closing operations to the buyer and seller in an equitable and “fair” manner, all too often these mechanisms are used by one or both parties as a means of manipulating overall deal valuation.

How the Most Common Types Work

The most common purchase price mechanisms, net debt adjustment and working capital adjustment, work hand-in-hand and are necessary when a deal is being valued on a “cash-free/debt-free” basis, which is the norm for M&A transactions.

When a deal is valued as cash-free/debt-free, the buyer establishes the enterprise value, or headline price, for a business and agrees to: 1) pay the seller an additional amount for any cash left in the business, and 2) reduce proceeds paid for any debt transferred in the sale, resulting in the net debt adjustment.

Let’s look at an example:


In the above example, if a business has $25,000 of cash and $75,000 of debt at closing, the headline price would be reduced by the net debt amount of $50,000. To ensure sellers do not reduce working capital as a means to artificially increase the cash balance at closing, and alternatively ensure sellers are compensated for additional working capital invested in a business, a working capital adjustment mechanism complements the net debt adjustment. Typically, purchase price is adjusted on a dollar-for-dollar basis to the extent closing working capital is higher (price increase) or lower (price decrease) than a negotiated working capital target or “peg.” While the peg is generally a fixed number, it can also be defined as a percent of trailing sales or some other negotiated metric. Alternatively, the working capital adjustment may be structured to only be a positive or negative adjustment; it can include a floor or cap, or it can be set up so that purchase price is only impacted to the extent closing working capital is higher or lower than a defined range, e.g., 10% higher or lower than the target.

The Devil is in the Details

The specific language used in the SPA to define cash, indebtedness, working capital, target working capital, accounting principles and even GAAP are negotiable and critical to the final cash purchase price. As a buyer or seller in a transaction, be aware that, unfortunately, there are no standard definitions for these key terms (in particular, debt is often defined as more than just bank debt or outstanding notes), and there is no standard way to establish the appropriate net working capital target.

The best way, and possibly your last chance, to preserve value in a deal is to ensure you are using the most advantageous definitions during the balance sheet due diligence process. Assess upfront with your advisors what the right language is for your specific deal and what is considered in line with the current market. Then make sure that both sides of the table, seller and buyer, are on the same page.

We want to hear from you! We encourage you to comment below on this blog post, share it on social media or contact Justin Thomas at jthomas@cohencpa.com or a member of your service team for further discussion.

This communication is published by Cohen & Company for our clients and professional associates. Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this publication should be taken only after a detailed review of the specific facts and circumstances.