Drafting the Agreement: Best Approaches to Working Capital, Earn Out, and Other Specialty Purchase Price Clauses
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Drafting the Agreement: Best Approaches to Working Capital, Earn Out, and Other Specialty Purchase Price Clauses

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Drafting the Agreement: Best Approaches to Working Capital, Earn Out, and Other Specialty Purchase Price Clauses Drafting the Agreement: Best Approaches to Working Capital, Earn Out, and Other Specialty Purchase Price Clauses Presentation Transcript

  • WORKING CAPITAL, EARN OUT AND OTHER SPECIALTY PURCHASE PRICE CLAUSES: TIPS AND TRENDS Law Society of Upper Canada: Buying and Selling a Business March 18, 2014Ted Maduri 416.941.5412 tmaduri@davis.ca
  • WORKING CAPITAL ADJUSTMENTS
  • Working Capital = current assets – current liabilities • Estimated WC (pre-closing) vs Actual WC (post-closing) • Seller should convey a business with sufficient working capital to operate for a period of time • If not the case, make an adjustment • Not purely a financial calculation – negotiation • PROs: value precision and CONs: leads to disputes • Don’t forget to focus on setting Estimate or Target
  • Current Assets (PLC definition) Accounts receivable, inventory and prepaid expenses and cash and cash equivalents, but excludes: • the portion of any prepaid expense of which the buyer will not receive the benefit after closing; • deferred tax assets; and • receivables from any of the company’s directors, employees, officers, affiliates or shareholders and any of their respective affiliates; determined in accordance with GAAP
  • Current Liabilities (PLC definition) Accounts payable, accrued taxes and accrued expenses, but excludes: • payables to any of the company’s directors, employees, officers, affiliates or shareholders and any of their respective affiliates; • deferred tax liabilities; and • the current portion of long term debt; determined in accordance with GAAP
  • Adjustment – Tips: where the action happens… • Who prepares? (Most common: buyer) • Timing? ~60 days • Accounting principles? GAAP • Dollar for dollar (most common) or try cap/deductible • One-way or two-way (most common) • Security: escrow/holdback (not yet that common) • Seasonality • Dispute resolution…if you can’t beat ‘em…
  • Dispute Resolution • Good faith attempt to resolve • TIP: Threshold before dispute can be lodged • Choice: court, arbitration or accountant • TIP: Add deemed consent • Define process, scope, fees, binding or not
  • LOCKED BOX MECHANISMS
  • Locked Box Mechanisms • Calculation moved up, making it a fixed price deal • Parties agree on an equity price at signing based on a historically-based balance sheet • As cash, WC and debt are known at that date, price is set and any change (i.e., “leakage”) covered by reps/warranties and indemnity • Popular in Europe, especially Britain
  • Working Capital vs Locked Box
  • Locked Box Mechanisms Pros • Fewer disputes • Price certainty • Less granular negotiation • Less process Cons • Seller disincentive? • Less precise; reliance on projections • More diligence • Weaker leakage remedy • Frequently need other adjustments
  • When to use a Locked Box? • Certainty of final price is a priority • Audit or other high quality information available to vet reference balance sheet • Comparability of competing bids priority (sellers) • Speed to signing priority • Post-closing time and resources limited but sufficient time available pre-closing • Seller will not need complicated leakage exceptions
  • EARN-OUTS
  • When to Use Earn Outs • Uncertainty about future performance/value of target • Little operating history • Volatile economy/industry • Success dependent on future event (e.g., product launch) • Limited funds or credit available for purchase price at closing • Tactical reasons (e.g., win auction process)
  • Setting and Meeting Targets • Typical targets • Revenue/sales • EBITDA • Business milestones • Passage of time • Prone to disputes • Accounting rules • Source of success? • Externalities Earn-Out Metrics (2012 Canadian Study)
  • Issues • Risk of over/underpayment • Reduced flexibility/control during earn-out (buyer and seller) • “Gaming” the earn-out • Seller commanding resources to hit targets • Buyer withholding resources needed to hit targets • Future events (e.g., other M&A) • Complex to negotiate and monitor • Disputes
  • Tips • Consider alternatives • Set objective targets that genuinely align interests • Agree on measurement and payment details with input from accountants and tax advisors • Plan for future liquidity events • Set the rules of engagement for the earn-out period, including consequences for breaches • Integrate with other post-closing adjustments • Include dispute resolution
  • THANK YOU! Ted Maduri Partner, Toronto 416.941.5412 tmaduri@davis.ca Follow us @DavisLLP