Sophisticated M&A professionals use various forms of consideration and pricing formulations, including working capital and locked-box adjustments, fixed price/exchange ratio collars, and valuation and earnout mechanisms when drafting merger agreements. The smooth interplay between these elements can make a transaction sail through closing, but in some cases, counterparties see opportunities for gains that are not well understood by the other.

HOW MUCH CAN NET WORKING CAPITAL ACTUALLY ADJUST?

Net working capital adjustments are one of the most common areas of tension and dispute as parties rush to closing. Today the accounting structures are often more complex. And questions on the definition of working capital and other accounting terms are typically not the primary focus of the deal parties. 

For some buyers, gaming the working capital adjustment is a negotiation opportunity to claw back auction enhanced valuation. The participants in this session at the M&A Conference at the University of Chicago, which was chaired by Elizabeth Donley a Partner at Hogan Lovells, discussed with great fluidity the intersection of law and accounting as it related to specific closing considerations. 

Michael Wolf, Deputy General Counsel at Baxter, characterized in his experience, disputes can arise from either a misunderstanding or communication breakdown in some transactions, or a move to shift value at closing or post-closing, which is the other motivation one should understand.

In either case, to get the net working capital adjustment correct, Wolf says you need a multidisciplinary team that properly looks at sub-accounts, footnotes, legal definitions or accounting terms, etc. They also need a few days to study the adjustments as they relate to the deal documents. 

Brett Shawn, Senior Vice President, Assistant General Counsel at Warburg Pincus, then considered this area in "no indemnity" deals, which are increasingly common, where the purchase price adjustment will be limited to an escrow. In those cases, one will want to be absolutely sure the definitions are right because the remedy is going to be limited. 

Reciprocal caps and the use of example schedules were also considered as any calculations and presentations should likely be consistent with past practice. 

Compensation reserves and deferred revenue were also areas considered in this discussion as opportunities to reign in some of the swing in working capital. Including these items in indebtedness is probably a good practice, for the buyer, because they will likely not be subject to the basket. 

SETTING THE WORKING CAPITAL IN A LOCK-BOX

In Europe, the lock-box closing mechanism has become common practice, offering an innovative replacement for the net working capital adjustment, although at a different stage in the deal process.

In this model, you negotiate an equity bridge between the balance sheet at particular points of time at the start of the deal process and at closing. Some leakage is permitted between the "lock date" and closing. Otherwise, the working capital is locked in. The earnings of the business are then, theoretically, contained for the benefit of the buyer during the period to close.   

This seller fairly construct provides a clean break, according to Donley, and removes the opportunity / risk of losing value at closing.

Wolf provided a cautionary note that deals with an extended period between signing and closing will present a greater risk for the buyer if there is a lockbox in place. 

On the other hand, as Shawn pointed out, if it is a growing business and you have a six-month period from signing to closing, then you're basically getting six months of seller financing. 

Donley offered the insightful view that, as far as remedies, with representation and warranties insurance becoming standard, there is an important question on protection from interim breeches that may be addressed in some transactions through the lockbox.

Donley also cautioned that the lockbox only fits specific scenarios, where there are full company audited financials, as opposed to a carve-out transaction, for example, where you have daily cash sweeps and corporate allocations.

Responding to a question, Wolf commented on the experience of private equity funds charging interest based on the lockbox between the inception date and closing. This is another item to understand and negotiate.

EARNOUTS, POPULAR DESPITE THEIR CHALLENGES

Earnouts can be a particularly effective solution where you have a meaningful difference in value between a buyer, typically because you have a speculative asset in the middle. 

Where you have an asset that's being acquired from founders, who are critically important to the future success of the business, buyers typically want some of the transaction consideration dependent on their performance post-close. The classic challenge, as Donley explains, is defining how it's going to work.

The covenants around earnouts are very heavily negotiated, but they are still ripe for disputes according to Shawn. “The most common thing that people will focus on during the legal drafting stage is some sort of covenant that the buyer is going to use ‘commercially reasonable efforts’, or some other standard, to make sure the earnout is achieved and not do things that are unnatural to minimize or manipulate the achievement of the earnout,” he said.

Similarly, buyers would be wise to monitor operational manipulation, as sellers may be tempted by the incentive to maximize the earnout in a manner that is inconsistent with standard business practices, yet not in a method that would violate the language in the agreement.

In Wolf’s experience, earnouts are best used in binary situations where there are clear levers that will adjust valuation in future periods (i.e. a regulatory approval). He offered the view that different outlooks on the trajectory of the business are often not well served through earnouts.  

Revenue-based earnouts are typically less susceptible to gamesmanship than profitability, the participants offered. In either case, there are some interesting obligations around "implied faith and fair dealing". 

In some jurisdictions, there are additional obligations to use some form of "commercially reasonable efforts" to achieve a milestone payment. That is something to pay attention to because even though you may think you are successful in negotiating a barebone set of obligations, you may be signing up for more under the applicable law of the contract.

WOULD YOU LIKE YOUR EXCHANGE RATIO FLOATING OR FIXED?

Using a rollover can really motivate your seller, as they will be directly invested in the success of the enterprise after the close. This can be common in private equity deals and a nice way to align incentives. 

For strategic acquirers, paying with equity can be much more challenging when acquiring a closely held company, although there may be financial or tax benefits to consider. However, you can wind up issuing so much stock that you cross the 20% threshold you may need to vote for your shareholders. 

Another dynamic that Shawn explained is that if you issue so much stock that the target is going to become a significant shareholder, the buyer will start to look for representations in the purchase agreement and they may want to conduct their own diligence. 

There are also two-way closing conditions and break-fee issues to consider, not to mention the allocation of payment between the shareholders if there is an indemnity claim, which makes this issue an important consideration as you model potential swings in the value of securities if you’re using them as an acquisition currency.