Purchase Price Adjustments (Part 2)

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Purchase Price Adjustments (Part 2)

In most SMB deals, working capital is the primary adjustment. But there are also other common adjustments.

In this post, we’ll look at those other common adjustments. This includes adjusting for: (1) outstanding debt; and (2) seller transaction expenses.

(1) Adjusting for outstanding debt

What is a debt adjustment?

As explained in Assets or Stock (or Merger)?, when you purchase the equity of a company, you’re buying everything in it: the good, the bad, and the ugly. This includes the company’s debts.

You don’t want these debts. You’re about to saddle the company with even more in the form of a loan (SBA or otherwise). And even if the business were robust enough to service it all, debt is a drag on cash-flow and net profits.

More importantly, your lender doesn’t want these debts, and likely won’t fund the deal unless they are paid off at or prior to the closing. After all, your lender wants priority on loan repayments and the company’s assets (in the case of a liquidation).

One solution is to have the company pay off all debts prior to the closing. But this assumes that there is sufficient money to do so. There may not be.

Alternatively, the seller can deliver a certified list of all outstanding debts as of the closing (often termed a closing indebtedness certificate). You can then promise to pay off those debts in exchange for a corresponding reduction in purchase price.

This is the debt adjustment.

When is it necessary to include a debt adjustment?

If you are purchasing the equity of the target company, always.

Again, your lender is unlikely to finance the deal unless all debts are paid off. And even where the seller indicates that she wants to pay off those debts prior to the closing, a debt adjustment is the backstop that makes sure this happens.

Asset sales are different.

Remember, with an asset sale you get to pick and choose which liabilities to assume.

So you can simply leave behind any unwanted debts; there is no need to adjust the purchase price.

But outstanding debts can still present a problem, even with an asset sale.

You may not be able to close without paying off those debts. Selling all or substantially all of the assets of the company may violate the terms of any outstanding loan agreements.

And, regardless, it is good practice to insist that the seller pays off all debts prior to closing. This will make it less likely that aggrieved creditors will try to come after you post-close.

How should I communicate a debt adjustment in my LOI?

There is no need to explicitly call out the debt adjustment in your LOI.

As discussed in Purchase Price Adjustments (Part 1), SMB transactions are usually cash-free-debt-free. The seller is on notice that something has to happen with any existing debts. Where necessary, a debt adjustment is the usual mechanism.

(2) Adjusting for seller transaction expenses

What is an adjustment for seller transaction expenses?

Sellers also hire lawyers and accountants to help them close deals.

Deal fees are something that buyers and sellers have in common.

But since the seller is also the owner of the target company, it may be that the company, not the seller (in her individual capacity), has hired those lawyers and accountants.

Are you purchasing the target company’s equity? If so, it bears repeating, you’re buying everything in it. If the company has hired the seller’s advisors, your purchase could include a bill for their services.

Yet it is customary for the parties to pay their own transaction expenses—you don’t want to pay seller’s transaction expenses.

What to do?

Roll out a similar playbook as with the debt adjustment.

The company can pay the seller’s transaction expenses at or prior to the closing.

Alternatively, the seller can deliver a certified list of all outstanding transaction expenses as of the closing. You can then promise to pay those expenses in exchange for a corresponding reduction in purchase price.

This is the seller transaction expenses adjustment.

Make sure to request pay off letters from the seller’s advisors, attesting to the fact that they’ve been paid in full at the closing, or placing a sum certain on the amount that you will owe.

When is it necessary to adjust for seller transaction expenses?

If you are purchasing the equity of a company and the company (rather than the seller in her individual capacity) has hired the seller’s advisors, you should include a seller transaction expenses adjustment.

Conversely, this adjustment is not needed with an asset deal. You’ll leave those liabilities behind when closing.

How should I communicate a seller transaction expenses adjustment in my LOI?

As with the debt adjustment, there is no need to call out the seller transaction expenses adjustment in your LOI.

But you should include the following statement (or something similar):

The parties will each pay their own expenses incurred in connection with the proposed transaction, including the fees of their legal and financial advisors.

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In my next post, we’ll look at the equity rollover—the ways in which a seller can keep an ownership position in the acquired company post-close.