The best way to deal with conflicts between business buyer and seller is by preventing conflicts in the first place
By William H. Wiersema, Miller Cooper & Co., Ltd., Principal, CPA, EA Contributing Editor
The current market continues to be favorable for those looking to sell small to mid-sized businesses. However, to ensure they receive their due, sellers should be aware of contract safeguards. After control passes to the buyer at the closing, significant adjustments to the purchase price and contingent consideration occur. The outcomes of agreed-upon working capital and earnout mechanisms may not align with seller expectations, leading to conflict.
Buyers and sellers should aim to prevent post-closing disputes, which are costly and can lead to sellers withdrawing from the transition process. Many litigants feel that the only real victors are the lawyers, even if they win the case.
The key is to build in protections to purchase agreements before closing to keep disputes from arising in the first place. It behooves sellers to address working capital, debt, and earnouts specifically.
True-up working capital
Sales of businesses, regardless of their structure, are typically cash-free and debt-free, aligning with valuation practices. In addition to the net proceeds, sellers keep the cash in the bank but must settle any bank and other borrowed funds. The net proceeds adjust up or down based on the change in actual closing working capital (“CWC”) relative to target working capital (“TWC,” also known as a benchmark or peg). TWC provides a threshold the seller must meet to receive at least full price.
The WC adjustment protects the buyer from the seller taking more cash at closing by speeding up collections or postponing purchases. The goal is to capture the true movement in WC between the Letter of Intent and closing, using the same assumptions and accounting methodologies for the final CWC as were used in setting TWC. TWC starts with current assets minus current liabilities, excluding cash and debt, from the selling company’s balance sheet. Buyers usually aim for a high TWC, while sellers may negotiate it lower.
While WC may seem straightforward, many disputes can arise when agreements omit critical details. For example, buyers may double-charge seller escrows for invoices included in CWC. Buyers can count inventory post-closing and deduct the “shrinkage” from amounts due sellers, without allowing sellers to approve or even know of the count.
Far more common are disputes over the valuation of assets. According to accounting rules, assets are recorded at cost but subject to markdown to realizable values, meaning market value less disposal expenses, if below cost. The past accounting practices of sellers can be challenging to define, since they are often applied on an ad hoc basis. The parties may agree to use generally accepted accounting principles (GAAP) instead, which usually involves establishing a reserve or contra against inventory cost. However, because of the subjectivity involved, it’s crucial for the parties to agree on a specific estimation method.
Significant distortions can occur when the parties use the seller’s method to set TWC, but the buyer applies another method for CWC. While both methods may comply with GAAP, they can yield drastically different results, and lead to bitter disputes. For instance:
> Sellers may reserve by-item, such as an account receivable after exhausting collection efforts, or an excess or obsolete inventory when slated to be liquidated or disposed of.
> Buyers might opt for a formula, such as reserving all accounts receivable over 90 days past due, or all inventory on hand that exceeds six-months’ usage.
>Sellers and buyers may disagree on TWC. Ideally, the period used for averaging should align with the same twelve-month period used in determining the company’s valuation. While common, the twelve-month approach can be unsuitable in many situations. For instance, a company may be growing rapidly, or its volume may be highly seasonal. WC can fluctuate significantly within any given month depending on the billing cycle. Other adjustments involve non-operating assets such as investments. A common shortcut is to consider one month s operating expenses.
Disputes can be prevented when the parties reach and document a consensus in the purchase agreement, including the TWC calculation, CWC estimate at closing, and illustrated accounting guidance for the true-up. The principles should clearly state that they take precedence over GAAP and refer to specific past practices as exceptions. Otherwise, the CWC calculation can be too open-ended and leave the buyer without recourse.
Alternatively, some buyers may negotiate a true-up of reserves, meaning actual collection of receivables or sale of inventory during a period post-closing, such as 180 days. They might also analogize to GAAP rules that include subsequent evidence through the issuance date of financial statements. However, sellers would argue that estimating CWC at closing equates to issuance, whereas buyers would claim it is when CWC is finally settled.
Define ‘debt-like’
A significant adjustment to WC proposed by buyers involves not only the removal of debt but also non-bank items that could be perceived as similar to debt. Known as debt-like items (“D-L”), they are grouped with debt to be funded by the seller in a cash-free, debt-free transaction closing. Sellers fully cover D-L, instead of being responsible only for delivering the difference between TWC and CWC. A prime example of D-L is cash deposits received in advance from customers, which are refundable if the product or service goes undelivered.
There are varying views on what constitutes D-L. Mike Adhikari, a renowned expert on the subject, adopts a broader perspective: “Operating liabilities are assumed by the buyer as part of the Enterprise Value. They typically include standard levels of trade Accounts Payable (A/P) and certain accrued expenses,” he writes. “The economic rationale behind assuming operating liabilities is that the benefit of settling them will accrue to the buyer, not the previous owner.” Only the operating liabilities are WC, while non-operating ones would be D-L. Non-operating liabilities might include taxes and payroll depending on structure.
In the 2023 edition of Middle Market M&A by Kenneth Marks et al (to which the author of this article was a contributor), strategies suggested for sellers to lessen the impact of D-L include “recognizing work in process” or “accruing the estimated cost of services.”
The focus for preventing D-L disputes is narrower than for WC. D-L is ambiguous and open to negotiation, having no single correct answer. Ultimately, the definition of “indebtedness” in the purchase agreement determines which items are D-L.
Craft an earnout
In addition to the cash transaction, under “earnouts” sellers may receive future compensation by meeting financial metrics. Earnouts often bridge valuation gaps between the buyer and seller, such as when a seller claims significant future growth or unverified add-backs. Measurements can be based on revenue, earnings before interest, taxes, depreciation, and amortization (EBITDA), net income adjusted for certain assumptions, and so on. The simpler an earnout metric is, the easier it is for the parties to comprehend and apply the process. Revenue is often preferred for this reason.
However, earnouts can present various problems. At their worst, earnouts merely postpone the negotiation of purchase price. Critics argue that complex earnouts inevitably lead to disputes. Avoiding conflicts benefits everyone. As much as possible, earnout agreements should define the seller’s influence in post-close operations relative to the buyer’s, particularly regarding resource commitments.
Aside from non-financial disputes, which may arise from the division of authority, the most common ones relate to unexpected expenses incurred by the company post-closing. When seller operations merge into the buyer’s, the company may no longer be identifiable, making it challenging to measure performance as a standalone. Specific language can exclude charges by buyer affiliates or the holding company for management fees, general overhead, or other intercompany burdens. Agreements should specify arm’s length pricing for sales to and purchases from affiliated entities. They can also carve out sale-related compensation, fees, and expenses.
Operational changes can also cause financial issues. For instance, a larger acquirer introducing new personnel benefits can reduce EBITDA. Failing to increase manufacturing overhead rates for inventory exacerbates the effect. Similarly, the increased overhead may go uncapitalized if volume decreases under a new buyer. Buyers also determine reserves against assets that might suppress EBITDA. A change in reserve methodology could lower earnings to miss an earnout.
As advisable for WC, purchase agreements should include templates, codify accounting policies, and incorporate pro forma computations that are as simple and unambiguous as possible. Agreement appendices should specify the method of converting seller records to the agreed basis of accounting. Definitions of net income or EBITDA should also address the treatment of non-operating items, such as payments Paycheck Protection Program loan forgiveness and extraordinary occurrences.
*Reprinted with permission from the April 2024 issue of Electrical Apparatus magazine.
