M&A Purchase Price Adjustment Clauses Drafting Provisions to Mitigate Buyers' Financial Risks and Achieve Fair Compensation for Sellers

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THURSDAY, MARCH 7, 2013

Presenting a live 90-minute webinar with interactive Q&A

W. Bryan Rakes, Partner, Venable, Baltimore

Michael T. Pedone, Vice President & Deputy General Counsel, Redwood Capital Investments, Baltimore

Matthew Roberson, Senior Vice President, SC&H Capital, Baltimore

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Purchase Price

Adjustment Clauses in M&A

March 7, 2013

W. Bryan Rakes

Venable

Michael T. Pedone

Redwood Capital Investments

Matthew Roberson

SC&H Capital

Purchase Price Adjustments: An Overview and Certain Drafting Considerations

• Overview of Purchase Price Adjustment Mechanisms

▫ General Overview

▫ Typical Mechanics and “What’s Market”

• Common Issues to Consider When Drafting and Negotiating Purchase

Price Adjustments

▫ Inconsistent Application of GAAP

▫ Inclusion/Exclusion of Items in Post-Closing Adjustment

▫ Prioritization of Consistency Versus GAAP

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General Overview

• Fundamental agreement on value, but a time-lag between signing

and closing of the deal or between latest available financial

statements and closing

▫ A fundamentally different concept from an earn-out

▫ Goal is to allow buyer to receive the benefit of its bargain by

receiving the agreed upon balance sheet (or an adjustment to the

purchase price)

• Allocates economic risks and profits of continued operations during

the pre-closing period

• Protects the buyer against potential seller abuses

• “Price is what you pay. Value is what you get.” – Warren Buffett

• Valuation is in the eye of the buyer.

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Working Capital

• Working capital is critical to the continued operations of a company

• Buyers want to ensure above adequate levels of working capital

convey with the sale

• Sellers should want to convey an adequate level of working capital,

but no more than necessary

• A purchase price adjustment is often used to assure both buyer and

seller that a mutually agreed upon level of working capital is

delivered at close

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Working Capital in an LOI

• Working capital is often addressed in the LOI, along with early

language acknowledging the need for a purchase price adjustment.

• Purchase Price Adjustment. The Definitive Agreement would

provide for an upward or downward adjustment of the Purchase

Price based on a mutually agreed working capital, net assets or

similar target metric for the Business as of the Closing that is based

on the Company’s current assets less current liabilities as

historically accounted for by the Company, excluding any expenses

related to the consummation of the transactions contemplated by

this Letter.

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Working Capital in an LOI

• Consideration to the Sellers will be adjusted on a dollar for dollar basis upward or downward

based upon the comparison of the actual closing working capital of the Company to the

normalized average working capital requirements of the Company over a twelve month

period ("Working Capital Target"), The Company will estimate the Working Capital as of the

closing date ("Estimated Working Capital") and the Consideration to the Sellers will be

adjusted for the difference between the Estimated Working Capital and the Working Capital

Target. Within 90 days of closing, Newco will provide the Sellers the actual closing working

capital balance (the "Closing Working Capital"), subject to a mutually agreed resolution

mechanism.

• There will then be a true-up adjustment based on the difference between the Estimated

Working Capital and the Closing Working Capital, The Target Working Capital, Estimated

Working Capital and Closing Working Capital shall (i) be prepared in accordance with GAAP

and consistent with past practices (to the extent in accordance with GAAP), and (ii) not

include any cash, indebtedness and other fixed obligations, income taxes, accounts receivable

from affiliates (other than those from Company incurred in the ordinary course and on terms

customary for the industry), accounts payable or other sums owing to affiliates (other than

those from Company incurred in the ordinary course and on terms customary for the

industry), Transaction-related expenses of the Company and Sellers, or any excluded assets or

liabilities.

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Adjustment Mechanics

• One step adjustments

• Two step adjustments

• Working capital adjustments

• Multiple metric adjustments

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Definitions

• “Working Capital” means, as of a given date, the total amount of the Company’s

current assets, less the total amount of the Company’s current liabilities.

• “Working Capital” means the working capital of the Business calculated in

accordance with Exhibit A attached hereto.

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Definitions Continued…

“Net Working Capital” means the following:

prepaid expenses and other current assets included in the Purchased

Assets;

less the sum of:

the accrued expenses of the Business included in the Assumed

Liabilities; and

the accrued payroll, taxes, vacation and bonus liabilities (including

commissions), and other current liabilities of the Business included in

the Assumed Liabilities other than deferred revenue;

it being understood that the following shall not be included in the calculation of

“Net Working Capital”: (x) Business Receivables; (y) Business Payables; and (z)

cash and cash equivalents.

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Definitions Continued…

“Working Capital” means the following, based on a balance sheet of Seller as of a

given date prepared in accordance with GAAP: (a) the net accounts receivable of

Seller as set forth on such balance sheet; (b) plus the accrued fees payable by Buyer to

Seller under Section 5 of the XYZ Agreement as set forth on such balance sheet; and

(c) less the sum of: (i) the accounts payable of Seller as set forth on such balance sheet,

but not including any accounts payable representing amounts payable to independent

contractors of the Business; (ii) the dollar amount of accrued but unpaid vacation time

credited to Transferred Personnel by Buyer pursuant to Section 8.3(f) hereof; (iii) the

accrued commissions payable by Seller under referral agreements as set forth on such

balance sheet; (iv) the $39,600 in setup and on-boarding costs payable by Seller to

Buyer under Section 4 of the XYZ Agreement as set forth on such balance sheet; and

(v) the deferred revenue of Seller as set forth on such balance sheet.

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Definitions Continued…

• “GAAP” means United States generally acceptable accounting principles,

consistently applied.

• “GAAP” means United States generally acceptable accounting principles,

consistently applied, as opined upon by XYZ, P.A., independent public

accountants, in connection with the Company’s audit financial statements as of and

for the year ended December 31, 2010.

• “Accounting Principles” means the accounting principles set forth on Exhibit

1.1(a). [Exhibit 1.1(a) broke down the seller’s income statement on a line-by-line

basis, describing the rules that would be used for each one.]

• Note that cash basis accounting is never “GAAP”, per se, so an alternative term

like “Accounting Principles” should be used.

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Use of a “Collar”

• “Working Capital Lower Target” means Six Hundred Sixty-Five Thousand

Dollars ($665,000).

• “Working Capital Upper Target” means Seven Hundred Forty-Five Thousand

Dollars ($745,000).

If the Final Net Working Capital is:

i. greater than the applicable Working Capital Upper Target (the amount of such excess, the

“Excess Amount”), Buyer shall pay such Excess Amount to Seller within five (5)

Business Days after the determination of the Final Balance Sheet; or

ii. less than the applicable Working Capital Lower Target (the amount of such shortfall, the

“Shortfall Amount”), Seller shall pay such Excess Amount to Buyer within five (5)

Business Days after the determination of the Final Balance Sheet.

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Adjustment Based on Physical Inventory Taken

Immediately Before Closing

Working Capital Adjustment

a. On dates to be selected by Parent (of which Parent shall provide prior notice to

Buyer), which shall be prior to the Closing Date, Parent shall take a physical

inventory of the Seller Inventory. Parent shall permit Buyer to reasonably observe

such physical inventory. Parent shall conduct such physical inventory at a time and

in a manner so as not to unreasonably interfere with the operation of the Business.

b. On or before the thirtieth (30th) day following the Closing Date, Parent shall prepare

and deliver to Buyer a statement, as of 11:59 p.m. on the day before the Closing

Date, which shall reflect the Working Capital (using the value of the Seller

Inventory determined in accordance with Section 3.6(a) above …

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Aged A/R - Exclusion or Partial Adjustment

A. if any Over 180 Account is collected by a Purchaser Entity, in whole or in part,

within sixty (60) days after the Closing Date, Purchaser shall pay to Seller ninety-

five percent (95%) of such collected amount (and Purchaser shall be entitled to

retain the remaining five percent (5%) of such collected amount);

B. to the extent the aggregate amount of 91-180 Accounts collected by the Purchaser

Entities exceeds the amount of 91-180 Accounts that are reserved as uncollectible

for purposes of calculating Net Working Capital, and such excess amounts are

collected within sixty (60) days after the Closing Date, Purchaser shall pay to Seller

ninety-five percent (95%) of such excess collected amounts (and Purchaser shall be

entitled to retain the remaining five percent (5%) of such excess collected

amounts); and

C. as used herein, (1) “Over 180 Account” means any account receivable related to the

Business that was included in the Assets and that was aged over 180 days as of the

Closing Date; and (2) “91-180 Account” means any account receivable related to

the Business that was included in the Assets and that was aged more than 90 days

and less than 181 days as of the Closing Date.

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Adjustment Based on Multiple of A/R

• If the purchase price is based, in part, on applying a multiple to the value of the

seller’s A/R, any purchase price adjustment needed to include the same multiple.

[Note 6x multiple in 3.9(c)(ii)(B) and (iii)(B) in the following provision.]

• Procedure can include a requirement that the buyer put money in an escrow account

that credit the seller for interest earned on amounts ultimately paid to it.

A/R Deferral; Collection and Remittance of Receivables.

(a) At the Closing, Buyer will retain the A/R Deferral to secure the collection of the

Seller Receivables, and Sellers shall retain control over, and be responsible for, the

collection of the Seller Receivables for one hundred eighty (180) days after the

Effective Date (the “Collection Period”). Buyer will hold the A/R Deferral in a

separate account with Depositary and pay such funds out only in strict accordance with

the terms of this Agreement.

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(b) No later than the sixty-second (62nd) day after the last day of the Collection Period, Buyer

shall pay to the Seller Agent (for further distribution by the Seller Agent to the Sellers in

accordance with Schedule 4.2(b)(i)) the Final A/R Disbursement Amount, if any, out of the A/R

Deferral (and out of the Buyer’s own funds, if the A/R Deferral is less than the Final A/R

Disbursement Amount).

(c) The “Final A/R Disbursement Amount” shall be calculated as follows:

(i) The following terms relating to the calculation of the Final A/R Disbursement Amount shall

have the following meaning:

(A) “Gross A/R Balance” means the total amount of all Seller Receivables set forth on the A/R

Report, without any reserve or allowance for doubtful accounts.

(B) “Adjusted A/R Balance” means the Gross A/R Balance, less the actual amount of Seller

Receivables listed on the A/R Report that were collected and remitted to Buyer during the

Collection Period.

(C) “Net A/R Balance” means the Adjusted A/R Balance, less Two Hundred Fifty Thousand One

Hundred Thirty-Five Dollars ($250,135).

(D) “Final A/R Deferral Balance” means the A/R Deferral, plus the actual interest paid thereon

by the Depositary from the Closing Date to the date on which Buyer pays the Final A/R

Disbursement Amount, if any, to the Seller Agent.

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(ii) If the Net A/R Balance is greater than or equal to zero (0), the Final A/R

Disbursement Amount shall be equal to: (A) the Final A/R Deferral Balance; (B) less

the product obtained by multiplying the Net A/R Balance by six (6).

(iii) If the Net A/R Balance is less than zero (0), the Final A/R Disbursement Amount

shall be equal to: (A) the Final A/R Deferral Balance; (B) plus the product obtained by

multiplying the absolute value of the Net A/R Balance by six (6), not to exceed an

amount equal to ten percent (10%) of the A/R Deferral.

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Adjustments Based on Maximum Amount of

Cash Purchase Price

• If the cash portion of the purchase price is capped, a special purchase price

adjustment my be used to ensure that the total cash consideration does not exceed

such maximum amount.

Notwithstanding the foregoing, in the event the [payment of a positive working capital

adjustment] would cause the amount of cash consideration payable hereunder to exceed

60% of the aggregate consideration payable hereunder, the amount of cash so paid will

be reduced by the amount necessary to cause the amount of cash consideration payable

hereunder to be equal to 60% of the aggregate consideration payable hereunder, and the

Purchaser will issue to the Stockholders’ Agent for further distribution to the Company

Stockholders (pro rata based upon the number of shares of Company Common Stock

held by each on the Closing Date) a number of shares of Series AA Stock equal to the

result obtained by dividing the amount of the reduction in the cash payment made as a

result of the application of this sentence by the Share Value.

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Limitation on Types of Disputes

• If Buyer determines that there are any inaccuracies in the Closing

Balance Sheet prepared by Seller, Buyer shall deliver to the Seller a

written notice setting forth the alleged inaccuracies in reasonable

detail no later than 5:00 p.m. New York, New York time on the

fifteenth (15th) day after receipt of the Closing Balance Sheet from

Seller; provided, however, that the only inaccuracies that may be

alleged by Buyer are (a) claims that Seller failed to apply the

Accounting Principles in the preparation of the Closing Balance

Sheet, and (b) mathematical errors.

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Resolving Disputes

• Appointing the Independent Accounting Firm

• Scope of Accounting Firms Review

▫ Essentially, the independent accounting firm is an arbitrator

▫ Broad enough to address the entire purchase price adjustment

▫ Not so broad to pick-up matters covered by indemnification

• Certain Limitations

▫ Review of evidence provided by the parties

▫ Outcome limited to the range between the buyer’s and seller’s

estimates

• Fees

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ISSUES TO CONSIDER WHEN NEGOTIATING AND DRAFTING

PURCHASE PRICE ADJUSTMENT PROVISIONS

• Inconsistent Application of GAAP

▫ Valuation methodologies

▫ Classification of assets and liabilities

• Inclusion/Exclusion of Items in Calculation of Post-Closing

Adjustment

▫ Identifying items to exclude from adjustment calculations

▫ Double counting problem

• Conflicts between Pre-Closing and Post-Closing Balance Sheets

▫ Prioritization of Consistency Versus GAAP Compliance

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Issue #1: Classification of Assets and Liabilities Mehiel v. Solo Cup Company

2007 WL 901637 – Superior Court of Delaware (2007)

• Pursuant to merger agreement, Solo Cup agreed to acquire SF Holdings for $671M.

• The purchase price was subject to a working capital adjustment to account for changes between March 2003 and February 2004.

Estimated working capital of SF Holdings as of March 2003: $243M.

• Merger agreement provided that any disputes relating to the adjustments would be submitted to a neutral auditor whose decision

would be “final, binding and conclusive”.

• Issue arises in the classification of a facility owned by SF Holdings in St. Thomas, Maryland valued at $5.6M.

▫ SF Holdings planned to sell the facility prior to Closing, but did not at the request of Solo Cup (Solo Cup assured SF

Holdings that doing so would be at no detriment to the SF Holdings stockholders).

▫ Pre-Closing Balance Sheet: SF Holdings classified the facility as a current asset (i.e., included in the calculation of working

capital)

▫ Post-Closing Balance Sheet: Solo Cup classified the facility as a long-term asset (i.e., excluded from the calculation of

working capital), which decreased the purchase price by $5.6M and provided Solo Cup with an asset it could later sell for

cash.

• SF Holdings submits objection to neutral auditor, who concludes that Solo Cup’s classification was correct under GAAP. Given

the merger agreement’s language, the court concluded that the neutral auditor’s decision was final and the issue resolved.

DRAFTING NOTES: Ensure that assets and liabilities are consistently classified between pre-closing and post-closing

balance sheets. Examples:

• “Current Assets shall be determined in accordance with GAAP applied using the same accounting methods, practices,

principles, policies and procedures, with consistent asset and liability classifications used in preparing the Company’s audited

financial statements for the most recent fiscal year”.

• “For the avoidance of doubt, the Facility shall be classified as a current asset for purposes of the calculation set forth in Section

3.2 regardless of any changes in the intended use of the Facility following the Closing”.

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Issue #1: Calculation Methodologies Twin City Monorail, Inc. v. Robbins & Myers, Inc.

728 F.2d 1069 – U.S. Court of Appeals 8th Circuit (1984)

• Pursuant to a purchase agreement, R&M agreed to sell its monorail division to Twin City.

• Purchase price estimated at $1.25M, though actual price to be “book value” of R&M inventory at closing

• After closing, R&M calculated the book value of inventory at $1,377,713.35.

• Twin City objects to R&M’s calculation and R&M refuses to submit to CPA for arbitration. District Court compels arbitration;

R&M appeals.

• The parties disputed the proper GAAP-compliant valuation methodology for the division’s inventory:

▫ Twin City: R&M should have used the LIFO valuation method (FIFO used more an internal management tool than

method of determining book value; R&M previously used LIFO in reporting corporate earnings)

▫ R&M: the FIFO valuation method was appropriate (the original $1.25M estimate was calculated using FIFO; R&M used

2 book values – a FIFO-based book value for the monorail division and a LIFO-based book value for R&M’s

consolidated balance sheet)

• The Court reversed the District Court’s order to compel arbitration. The arbitration clause was narrowly drafted and only

applied to disputes over the physical items of inventory included in the Statement of Inventory.

DRAFTING NOTES: Do not rely on general “consistently applied” language since some businesses (like R&M) may not

have consistent practices. Use language that clarifies or specifies in detail the GAAP policies to be utilized. Examples:

• “Current Assets shall be determined in accordance with GAAP applied using the same accounting methods, principles and

procedures, with consistent valuation methodologies used in preparing the Company’s audited financial statements for the

most recent fiscal year”.

• “Inventory shall be valued at the lower of cost or market, utilizing FIFO”.

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Issue #2: Identifying Items to Exclude from Adjustment Calculations

Accel Int’l Corp. v. Lyndon Life Insurance Co.

2002 WL 193697 – U.S. District Court, Southern District of Ohio (2002)

• Pursuant to Stock Acquisition Agreement, Accel agreed to sell stock of 3 operating subs to Lyndon for $30.2M.

• The purchase price was subject to a post-closing adjustment based on an independent auditor’s opinion as to combined

stockholders’ equity of the target subs.

• Stock Acquisition Agreement provided for a 338(h)(10) election, which had the effect of Accel bearing the tax liability of the

target subs prior to the sale.

• Auditor’s opinion as to combined stockholders’ equity would require Lyndon to pay additional $556K to Accel.

• Issue arises as to the inclusion of deferred tax liabilities on the consolidated balance sheet:

▫ Lyndon: Prior $785K Phase III deferred tax liability reserve was eliminated (increasing stockholders’ equity) in breach of the

language prohibiting alterations in the historic practices and policies of reserves. Correction results in Accel owing Lyndon

$442K per the adjustment.

▫ Accel: The elimination of the Phase III reserve was in line with historic practice. Further, not only should the Phase III reserve

be eliminated, but entire $2.665M deferred tax liability should be eliminated since the 338(h)(10) had the effect of making

deferred tax liabilities currently payable by Accel.

• Court denies Lyndon motion for summary judgment as it was material issue of genuine fact whether the elimination of deferred tax

liabilities was in breach of Accel’s historical practices.

DRAFTING NOTES: Do not rely on catchall definitions such as “working capital means current assets minus current

liabilities”. Instead, be sure to specifically identify assets and liabilities that should be included or eliminated from the

accounting-based calculations. Examples:

• “Current Assets shall mean cash and cash equivalents, accounts receivable, inventory and prepaid expenses, but specifically

excluding deferred tax assets”.

• “Current Liabilities shall mean (i) checks in transit, plus (ii) accounts payable, plus (iii) accrued expenses”.

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Issue #2: Double Counting Problem Brim Holding Co., Inc. v. Province Healthcare Co.

2008 WL 2220683 – Tennessee Court of Appeals (2008)

• Pursuant to Stock Purchase Agreement, Province sold the stock of subsidiary to Brim.

• The agreement included a working capital adjustment as well as a special indemnity clause requiring Province to

indemnify Brim from losses relating to a specific bankruptcy litigation.

• Issue arises when Brim settles the bankruptcy litigation for $500K and seeks indemnification from Province:

▫ Province: Brim already received $500K through the working capital adjustment, since the closing balance sheet

included a $500K reserve for the bankruptcy litigation resulting in a reduction in the purchase price. Paying an

additional $500K indemnification would be “double counting”.

▫ Brim: Despite the calculation of working capital and related reduction of the purchase price, the express language of

the agreement requires Province to indemnify Brim for losses relating to the bankruptcy litigation.

• Court holds in favor of Brim, since the agreement (which was to be construed in accordance with Delaware law) must be

enforced in accordance with its express terms.

DRAFTING NOTES:

• Be sure to specifically carve out special liability reserves from an adjustment calculation in agreements

containing both a post-closing adjustment and special indemnification provision.

• Note that a 2008 review of 35 private company purchase agreements containing special indemnity provisions,

only 17 (49%) carved out those liabilities out of the purchase price adjustment.

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Issue #3: Prioritization of Consistency Versus GAAP Compliance

Melun Industries v. Strange

898 F.Supp. 990 – U.S. District Court, Southern District of New York (1990)

• Pursuant to a Stock Purchase Agreement, Melun agrees to purchase the shares of S&C HoldCo from Strange for 80% of the

audited book value of the target as of August 31, 1986 (“Original Book Value”). If Melun disagreed with the Original Book

Value, Melun could terminate the agreement.

• The agreement included a purchase price adjustment based on increase or decrease of the Original Book Value between

Closing and November 30, 1986.

• Any disputes as to “the amount the [Original Book Value] increased or decreased” to be determined by neutral arbitrator.

• Strange submits pre-closing balance sheet and Melun does not object to Original Book Value or terminate agreement (despite

concerns from Melun’s accountants).

• Melun prepares post-closing balance sheet to determine adjustment which corrected certain aspects of the pre-closing balance

sheet in the post-closing balance sheet. Finds that Strange owed a significant amount to Melun per the post-closing

adjustment.

• Strange’s objections goes to arbitration, and arbitrator’s calculations also correct pre-closing balance sheet errors in finding

that Strange owed more than the purchase price paid for the S&C HoldCo shares.

• Strange files suit arguing that arbitrator overstepped the authority of the agreement and court agrees. The agreement only

allowed the arbitrator to rule on disputes as to how much the Original Book Value had changed; arbitrator was not allowed to

correct mistakes in preparing the post-closing balance sheet.

DRAFTING NOTES:

• In general, sellers want the pre-closing and post-closing balance sheets prepared consistently. Buyers want the pre-

closing and post-closing balance sheets prepared in compliance with GAAP.

• If the agreement is express as to the importance of consistency and silent as to the need for GAAP compliance,

courts are likely to prohibit corrections between the pre-closing and post-closing balance sheets.

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Issue #3: Prioritization of Consistency Versus GAAP Compliance

Stetna Line (U.K.) Limited v. Sea Containers Ltd.

758 F.Supp. 934 – U.S. District Court, Southern District of New York (1991)

• Pursuant to a Stock Purchase Agreement, Stetna agreed to purchase a group of ferry businesses from Sea Containers.

• The agreement included a purchase price adjustment based on change in “net equity” from a pre-closing balance sheet

(prepared by Sea Containers) to a post-closing balance sheet (prepared by Stetna).

▫ The pre-closing balance sheet must “be prepared in conformity with the Agreement and present a true and fair view

of the Ferry Business…and United Kingdom generally accepted accounting principles, applied on a consistent basis

with prior periods”.

▫ The post-closing balance sheet must “be prepared on a consistent basis” with the pre-closing balance sheet.

▫ Any disputes “with respect to the [pre-closing] balance sheet and the [post-closing] balance sheet” to be determined

by a jointly selected CPA who will resolve “all remaining unresolved issues” with respect to the pre-closing and post-

closing balance sheets.

• Stetna informed Sea Containers of issues with pre-closing sheet calculations and prepared the post-closing balance sheet

using divergent methods from the pre-closing balance sheet to account for the errors in the pre-closing balance sheet.

• Sea Containers sought arbitration, and arbitrator upheld the post-closing balance sheet.

• Court held that the language of the agreement allowed the arbitrator the freedom to weigh the importance of consistency

with the pre-closing balance sheet versus the compliance with UKGAAP and the true and fair presentation of the

business; however, the arbitrator could only retroactively correct the pre-closing balance sheet errors with the consent of

all parties.

DRAFTING NOTE: Absent express language prioritizing consistency between the pre-closing and post-closing

balance sheets, courts are likely to grant an arbitrator the authority to resolve the tension between consistency and

compliance with GAAP.

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W. Bryan Rakes

Venable

wbrakes@Venable.com

410.528.2303

Michael T. Pedone

Redwood Capital Investments

410.402.2228

mpedone@redcapinv.com

Matthew Roberson

SC&H Capital

410.403.1500

mroberson@scandh.com

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