Purchase Price Adjustments (Part 1)
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Purchase Price Adjustments (Part 1)
In this post, we'll be addressing purchase price adjustments.
What are purchase price adjustments?
In the typical SMB deal, the buyer may include several adjustments to the purchase price, including:
Working capital
Outstanding debts
Seller transactions costs.
Let’s start with working capital.
What is a working capital adjustment?
Among of things, working capital is a measure of a business's short-term liquidity. It is equal to a business's current assets minus its current liabilities.
Current assets are those assets that a business will consume in an operating cycle, including cash, accounts receivable, and inventory. Conversely, current liabilities are those liabilities that a business must settle in an operating cycle, including accounts payable, operating expenses, and taxes.
Regardless of how you structure your deal (see my prior post on the difference between purchasing assets and equity), you have to make sure that the business has sufficient working capital to meet its short-term obligations post-close. Otherwise, you’ll face difficulties paying creditors, and may have to inject additional capital to fund operations.
In effect, you’ll end up paying more for the business than originally agreed.
For this reason, it is common to include a working capital adjustment, where the purchase price is adjusted for a normalized level of working capital—the level of working capital that the business has historically needed to operate.
This normalized level of working capital is referred to as the peg.
If the business is delivered with less working capital than the peg, the purchase price is reduced. If the business is delivered with more working capital than the peg, the purchase price is increased.
How is the peg calculated?
Peg negotiations are two-fold.
First, the parties agree on the components of working capital that they want to include in the sale.
For example, accounts receivable (excluding receivables over a certain age), inventory (excluding unsalable or otherwise obsolete inventory), certain prepaid expenses, and accounts payable are all common components.
In contrast, cash and debt are often (although not always) excluded.
You may have heard of the expression cash-free-debt-free?
There is no need to borrow money to buy money. And there is no need to take on legacy debts (current liabilities excluded). Even in a asset sale, you ask the seller to satisfy outstanding debts at or prior to the closing.
Second, the parties agree on a normalized level for each component of working capital.
How much inventory does the business consume during a typical operating cycle? Are there certain non-recurring items that need to be excluded? Do you need to account for recent changes in accounting methods?
The typical operating cycle is 12 months. Yet a different period may be appropriate. For instance, are you acquiring a seasonable business? If so, you may want to exclude the inactive months.
Since the peg will directly impact the purchase price, negotiations are often hotly contested. The buyer will push for a higher peg to protect its interests. The seller will argue for the lowest peg possible.
To sort through this all, you will need the help of a suitably qualified CPA to calculate and negotiate the peg.
Do I have to include a working capital adjustment?
No, and, depending on the target business, it may be easier to exclude working capital.
Perhaps the target business has been informally run, making it difficult to calculate the peg? Perhaps the seller doesn’t understand the concept (and hasn’t retained suitable advisors), meaning you risk losing the deal by insisting on a working capital adjustment?
If you go this route, adjust the purchase price accordingly, and make sure that you have sufficient means to fund the working capital of the business post-close--don't leave yourself with insufficient working capital, I cannot stress that enough.
How does the working capital adjustment work?
Working capital is in constant flux. It may be difficult to know exactly what working capital is left in the business at closing.
You have a couple of options.
First, in the days leading up to close, agree on a good faith estimate of closing working capital with the seller.
In many small businesses, this is more than possible and permits the parties to know the final purchase price with certainty at closing.
Alternatively, do a post-closing adjustment.
With a post-closing adjustment, the parties review the books and records of the business several weeks after closing to ascertain exactly what working capital was left in the business. The purchase price is then revisited and adjusted as necessary.
You may choose to rely on both options, with the post-closing adjustment acting as a secondary true up. But either way, be aware that some SBA lenders won't allow a post-closing adjustment (there are ways around this, which we can discuss if ever working on a deal together).
How should I communicate a working capital adjustment in my LOI?
If you have sufficient information on hand to state the peg in the LOI, you can do so. This communicates to the seller that your purchase price offer is based on a specific level of working capital.
Often, you will not have sufficient information to state the peg at the LOI stage.
Either way, you can include some variation on the following language:
The normalized working capital at the closing of the Transaction [is $[AMOUNT] / will be calculated according to the business’s accounting principles, consistently applied]. The Purchase Price payable at closing will be increased or decreased based on the difference between the normalized and actual working capital of the business at closing, on a dollar-for-dollar basis.
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In Part 2, we’ll look at purchase price adjustments relating to outstanding debt and the seller's transaction expenses.