The marketplace for acquisitions of Massachusetts-based, privately-owned companies is active. Many such transactions will be executed through acquisition agreements that contain a purchase-price-adjustment provision keyed to the level of the target company’s “working capital.” This article briefly explains some common features of working-capital-adjustment provisions and addresses one component that could lead to uncertainty and frustration of the purchase-price-adjustment mechanism.
Generally speaking, “working capital” is the difference between a company’s current assets (e.g., cash and accounts receivable) and current liabilities (e.g., accounts payable). Businesses generally require a certain level of positive working capital to operate, and a buyer of a privately held company will often require that a target company have a specified level of positive working capital at closing. If a target company’s working capital is less than the amount necessary to operate the business going forward, the additional capital required to make up the shortfall effectively increases the buyer’s purchase price. Conversely, the buyer will enjoy a windfall if the target’s working capital is in excess of the minimum mandated by the buyer.
To avoid either result, many private-company acquisition agreements include a mechanism to adjust the purchase price if the seller’s working capital as of the closing differs from a previously negotiated amount. Typically, the seller is required to deliver to the buyer in advance of the closing an estimate of working capital at the closing based on an estimated balance sheet prepared by the seller. The purchase price is often adjusted at the closing on the basis of the seller’s estimate of working capital in the event that such estimate differs from the amount of working capital as specified in the acquisition agreement. After the closing, the buyer often has a limited window (e.g., between 60 and 90 days) to audit the target’s records and, with the benefit of hindsight, calculate the target’s closing working capital and verify the accuracy of the seller’s closing estimates.
If the buyer’s post-closing calculation indicates a working capital deficit not reported by the seller (or one larger than that reported by the seller), the buyer will attempt to recoup an equivalent amount of its consideration. Acquisition agreements often provide for a mandatory dispute-resolution process in the event that the parties cannot reconcile their respective calculations, and a common formulation requires that the parties submit their dispute to an arbitrator (often an independent accounting firm) for a binding determination of the target’s working capital as of the closing.
Of course, acquisition agreements also invariably include representations regarding the target company’s financial statements. Oftentimes sellers are required to append their most recent annual and interim financial statements to the agreement and represent that such statements fairly present in all material respects the financial condition of the target company as of and for the periods covered by such statements, and that such statements have been prepared in accordance with generally accepted accounting principles (“GAAP”).
Private-company acquisition agreements also often have indemnity provisions defining the buyer’s rights upon a breach of the seller’s representations, which typically are the buyer’s exclusive remedy for such a breach. Such indemnity provisions tend to specify dispute resolution procedures, often litigation in an exclusive judicial forum, time periods for making indemnification claims, as well as limits on the amount that can be recovered.
Overlap between the working capital dispute mechanisms and the indemnity provisions can lead to confusion and disputes regarding whether parties are able to proceed through arbitration, or whether they must litigate for breach of representation. If the acquisition agreement is ambiguous, a buyer may attempt to make essentially the same claim against the seller under either the working capital adjustment mechanism or the indemnity provisions – and the difference in outcome as to which provisions govern can be significant. For instance, typically there are no limits on the amount by which the purchase price can be adjusted through the working capital adjustment mechanism. Indemnity provisions, however, often place specified limits on the amount a buyer can recover for a seller’s breach of representations and warranties. In addition, indemnity provisions frequently have claim deductibles or “baskets” — meaning the buyer must incur a certain amount of damages before having the right to seek redress.
Courts have addressed such disputes with varying results. In one recent case, the purchase agreement required the seller to prepare a closing balance sheet as of March 30, 2011, and calculate “Estimated Working Capital” as of that date, “in accordance with GAAP consistently applied and following the . . . methods employed in preparing the Company’s balance sheet as of December 31, 2010 included in the Financial Statements.” Severstal US Holdings, LLC v. RG Steel, LLC, 865 F. Supp. 2d 430, 433 (S.D.N.Y. 2012). Disputes over working capital were to be referred to an independent accountant in arbitration. The purchase agreement also contained a representation by the seller that its December 31, 2010 financials were prepared in accordance with GAAP, and indemnification through litigation was the exclusive remedy for any alleged breach of representation in the agreement.
As it turned out, the parties were far apart on the calculation of working capital. The buyer maintained the seller’s estimation of working capital was overstated due to a failure to follow the required working capital calculation methodology by properly applying GAAP in the March 30, 2011 closing balance sheet, and sought an $83 million purchase price reduction through arbitration pursuant to the working capital dispute provisions. Id. at 435. The seller contended that any assertion that it failed to prepare its financial statements in accordance with GAAP was a claim for breach of representation, for which indemnification was the sole remedy. Id. at 439. Important to the court’s ultimate decision was that the seller made no representation with respect to the March 30, 2011 closing balance sheet’s compliance with GAAP, but only that its historical financials as of December 31, 2010 complied with GAAP. Thus, the Court held the dispute was not covered by the indemnity provisions in the purchase agreement and the parties were ordered to proceed to arbitration. Id. at 440-41.
Courts in other cases have paid less attention to the actual reach of the seller’s representations. Some courts have emphasized that purchase agreements typically require a seller to prepare the estimated closing balance sheet in compliance with GAAP and in a manner consistent with its historical financial statements. These courts have concluded that an assertion that the estimated closing balance sheet fails to comply with GAAP is equivalent to asserting that the historical financials fail to comply with GAAP, which is covered by the seller’s representations and thus the indemnity provision of the purchase agreement. See, e.g., Westmoreland Coal Co. v. Entech, Inc., 794 N.E.2d 667, 669-71 (N.Y. 2003); OSI Systems, Inc. v. Instrumentarium Corp., 892 A.2d 1086, 1092 (Del. Ch. 2006).
So far, no Massachusetts court has published an opinion in a case concerning the way in which working capital adjustment disputes should be resolved. Nevertheless, parties in acquisitions should strive for clarity in delineating how such disputes should be addressed.
One method for achieving such clarity is to exclude from the indemnity provision any difference over working capital calculations that may be addressed through the purchase-price-adjustment provision. See, e.g., Violin Entm’t Acquisition Co. v. Virgin Entm’t Holdings, Inc., 59 A.D.3d 171, 172 (N.Y. App. Div. 2009). Alternatively, the parties could provide that the estimated closing balance sheet upon which the closing working capital calculations are based need only be prepared in accordance with the seller’s historic accounting practices (without the seller making any representations as to the estimated closing balance sheet’s compliance with GAAP), and the parties could expressly limit the working-capital-dispute provisions to resolving differences between the seller’s closing estimates and the buyer’s post-closing calculations using the same accounting practices. Whatever the method used, addressing this issue head-on in the language of the acquisition agreement will provide the clarity necessary to allow all parties to rely on the deal they bargained for.
Alex Aber is Co-Chair of the M&A Practice Group at Foley Hoag and regularly represents buyers and sellers in public and private company acquisitions.
Matthew Miller is a partner in Foley Hoag’s Litigation Department and represents clients in litigation and arbitration concerning private company acquisitions.