Most acquisitions are finalized before closing-date financial statements have been prepared. When the closing-date financials become available, a purchase price adjustment may be required. This article explains why financial experts are invaluable in drafting PPA provisions and helping resolve disputes.
Businesses put a great deal of time and effort into structuring acquisitions, but the most critical juncture can come after the deal has closed. With the input of a qualified financial expert, you can draft purchase price adjustment (PPA) provisions that minimize the likelihood of a dispute. And, in the event of a dispute, the expert can pave the way to a satisfactory resolution.
Most acquisitions are negotiated and finalized before closing-date financial figures are available. The parties must rely on previously issued “reference financials” to fill the gap. When the closing-date financials become available, a PPA is made to reconcile any disparities between the two.
Bearing PPAs in mind, buyers often approach a transaction by offering a higher purchase price, under the assumption that funds from the PPA will partially offset that price. The seller’s goal is to minimize the amount of the purchase price it must return.
The technical terms that lace a PPA provision in a purchase agreement can lead to different interpretations when the time for adjustments rolls around. Several of the provision’s components demand close attention:
Materiality. Financial information is defined as material if it would influence the user’s decision. Generally accepted accounting principles (GAAP) allow the exclusion of immaterial items from a balance sheet, but a buyer might not agree that excluded items were truly immaterial. The PPA provision, therefore, should establish a materiality standard for calculating the price adjustment. The provision might specify a dollar amount or certain factors that could be used to determine materiality.
Consistency. It’s commonly understood that, when there’s a conflict between GAAP and a seller’s historical accounting practices, GAAP prevails. But that could result in closing financials that comply with GAAP and reference financials that don’t. The PPA provision can explicitly identify areas where the parties will accept deviations from GAAP.
Preparation of balance sheets. The seller usually prepares the estimated closing balance sheet; the buyer prepares the actual closing balance sheet. Some purchase agreements require the seller to prepare both, but this can prove difficult, especially if the buyer, who controls the postclosing books, fails to cooperate.
Bases for the adjustment. PPA provisions often hinge on working capital adjustments or balance sheet elements, but other formulas are available. PPAs may turn on earnings, cash flow, tangible net worth or total net worth. Net worth adjustments, however, consider noncash items that rarely relate to the PPA’s goal.
Valuation reserves. Buyers sometimes attempt to boost the purchase price by increasing reserve levels in the closing balance sheet. To avoid disputes, the PPA provision should exclude valuation reserves and should treat accounts receivable and inventory on a gross basis for purposes of determining the working capital target. Ideally, the provision will lock in reserve levels, thereby preempting the exercise of discretion or judgment.
More than an afterthought
By drafting the PPA provision carefully, you can save your client time and resources in the postclosing phase, and, in the event of a dispute, qualified experts can expedite the process. Without nagging PPA issues dangling overhead, your clients can focus on integrating their new businesses.
Sidebar: Dealing with postclosing disputes
Financial experts can play a valuable role in the event of a dispute, serving as a consultant, testifying expert, or both.
Initially, an expert can translate the financial language and explain the accounting, financial, economic, tax, valuation and related issues. An expert can also:
- Evaluate whether GAAP has been applied consistently,
- Resolve earn-out issues,
- Analyze reference and closing-date financials,
- Calculate the PPA,
- Scrutinize the other party’s calculations for flaws,
- Negotiate a reasonable settlement range, and
- Allocate the purchase price for tax purposes.
Should the dispute proceed to trial or alternative dispute resolution, a financial expert can decipher the financial language for the fact finder, explain the client’s position regarding an appropriate adjustment, and rebut the opposing party’s position.