ACC SF Bay Area
Corporate and Securities Committee
NUTS AND BOLTS OF M&A DEALS:
Demystifying the Working Capital Adjustment
December 1, 2014 (San Francisco)
December 2 , 2014 (Palo Alto)
presented by
Stephen Ballas, SVP and Deputy General Counsel, CBRE
Adam R. Dolinko, SVP and General Counsel, CSR
Kevin Iudicello, Managing Director, Pagemill Partners
Louis Lehot, Partner, Cooley LLP
Craig Menden, Partner, Cooley LLP
Adam Reilly, Head of West Coast M&A, Deloitte
Agenda
•  Panelists
•  Why Adjust Purchase Price for Working Capital?
•  Setting some baselines
•  Key Definitions and Other Considerations
•  Mechanics
•  Dispute Resolution
•  Payment Issues
•  Alternatives
•  Common Issues / Sample Provisions
•  Takeaways
•  Questions
2
Panelists
Stephen Ballas
Adam Dolinko
Kevin Iudicello
Louis Lehot
Craig Menden
Adam Reilly
CBRE
CSR plc
Pagemill Partners
Cooley LLP
Cooley LLP
Deloitte
SVP, Deputy
General Counsel
SVP and General
Counsel
Managing Director
Partner
Partner
917-940-0001
sballas@gmail.com
650 440-0499
adolinko@mac.com
650 387 3021
kiudicello@pmib.com
650 796-7280
llehot@cooley.com
650 843 5725
cmenden@cooley.com
Partner, Head of
West Coast M&A
415 601 0637
areilly@deloitte.com
3
Why Adjust for Working Capital?
•  PROBLEM:
•  Purchase price determined before DD complete or how much WC needed
•  What Buyers are solving for:
•  Protect against working capital depletion
•  Offset potential increase in purchase price if cash infusion needed post-close
•  Don’t deter Sellers from acting rationally
•  What Sellers are solving for:
•  Conserve pre-closing cash accumulated
•  No penalty for pre-closing capex spend or other rational behavior
•  Get Buyer agreement pre-closing for how post-closing metrics measured
WC Adjustments protect purchase price and value and conserve cash
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Setting some baselines
•  Working capital (“WC”):
§  Minimum capital to maintain current operations in current business cycle
•  Calculating a target’s WC:
§  WC = current assets - current liabilities
§  WC target = estimate of WC based on normalized historic averages
•  WC adjustments (“WCA”) are ubiquitous in M&A transactions:
§  WCA were in ~80% of PLC study and ~80% in ABA study
Working capital adjustments will appear in the vast majority of M&A deals
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Key Negotiated Definitions
•  Current Assets
•  Current Liabilities
Definitions to WCA component are highly negotiated
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Current Assets
§  OFTEN INCLUDES:
•  Cash and cash equivalents (excluded if deal priced on cash free/debt free basis)
•  Accounts receivable (identify collectability issues)
•  Inventory (for asset purchases, may require physical check at closing)
•  Prepaid expenses
•  Other short-term assets (restricted cash, marketable securities)
§  OFTEN EXCLUDES:
•  Portion of prepaid expenses which will not benefit buyer after closing
•  Deferred tax assets and long-term assets
•  Receivables from target’s affiliates, D&O’s and stockholders and their affiliates
•  Doubtful receivables / bad debt
Buyer will narrowly define current assets
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Current Liabilities
§  OFTEN INCLUDES:
•  Accounts payable (may exclude disputed payables)
•  Unpaid transaction expenses
•  Accrued taxes (increasingly excluded if seller agrees to pay them)
•  Accrued expenses
§  OFTEN EXCLUDES:
•  Payables to target’s affiliates, D&O’s and stockholders and their affiliates
•  Deferred tax liabilities
•  Disputed accounts payable
•  Lines of credit/notes payable (excluded in cash free/debt free deals)
•  Current portion of long term debt (excluded to the extent debt is paid off)
Buyer will define current liabilities expansively to capture all
short term debts and obligations
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Common Exclusions from Working Capital
Definition
•  Common exclusions from WC definition:
§  Debt and debt components
§  Cash and cash equivalents (if deal price on cash-free basis)
§  Deferred tax assets and/or liabilities
§  Employee liabilities
§  Intercompany accounts
§  Customer deposits
§  Related party receivables
Exclusions from working capital definition highly negotiated
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Possible Additions to Working Capital
Definition
•  Possible non-GAAP additions to WC definition:
§  Transaction expenses
§  Transaction expenses of seller – investment banking fees, attorneys’ fees,
employee bonuses
§  Capital expenditures and leasehold improvements
§  Aggressive approach because not current assets under GAAP
§  Long-term deferred revenue
§  Deferred tax assets
§  Deferred compensation/pension liabilities
§  Year-end bonus accruals
Tailor working capital definition with appropriate non-GAAP items
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Best Practices for Definitions
•  Include detailed definitions to avoid ambiguity that leads to disputes
§  Cite to specific balance sheet line items for clarity
•  Be mindful of interplay between WCA and other clauses in agreement
•  is there a rep that accounts receivable are collected?
•  Collected within some number of days?
•  Reserve for doubtful accounts
•  Specific indemnity may be better solution than including matter as a WCA
•  Tailor definitions to unique aspects of business:
§  E.g. watch for large cyclical working capital changes in historical data
Draft definitions carefully and consider which items appropriate for WCA
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Timing of Working Capital Adjustments
•  “One-step” means adjust WCA at closing only
•  “Two-step” typically means seller reports WCA at closing and Buyer adjusts
post-closing
•  Increasingly agreements use “two-step adjustment”
•  Mechanics of the typical two-step adjustment:
§  At closing adjust based on estimate and final post-closing adjustment
§  After closing (60-90 days) adjust once target’s financial statements finalized
Buyer reviews financials post-closing to adjust purchase price
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Mechanics of Calculating the Adjustment:
Preparing Financial Statements
•  Parties determine who prepares financial statements used to calculate PPA
§  At Closing:
§  Seller usually prepares, in better position because still has control of the target
§  After Closing:
§  Buyer usually prepares, in better position because it maintains books and records
Control over financial statement preparation varies with time and leverage
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Mechanics of Calculating the Adjustment:
Preparing Financial Statements (Continued)
•  Parties should determine whether or not financial statements are audited
•  Some of target’s accounting practices may not be GAAP-compliant:
§  Should decide on GAAP and consistency with Buyer’s statements
§  Ensure calculation of target/estimate and final working capital consistent
•  Parties may refer to balance sheet to outline the calculation:
§  Identify what is included and excluded for Current Assets and Current Liabilities
§  Include zero balances for line included items not applicable to benchmark
§  Use reference balance sheet for benchmark and closing working capital number
§  Limitations – caps, baskets, upward/downward, interest?
Parties agree in advance on details/mechanics of calculations for PPA
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Dispute Resolution
•  Parties may appoint independent accountant to act as arbitrator
•  Resolve dispute according to detailed process:
§  Appoint accountant or set out process for appointment
§  Define scope of accountant’s review
§  Determine who bears accountant’s fees (even split, proportion, winner takes all,
loser pays all ?)
§  Define a range of values within which the accountant’s determination must fall
•  Accountant may act as expert or arbitrator – understand the difference
•  Interplay with other reps and warranties – can buyer also claim for breach?
Understand dispute resolution process and spell out in detail
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What to do in case of emerging dispute?
•  Stakeholders should seek legal advice to assess:
•  alternatives to accountant/expert, arbitration or judicial action
•  avoid waivers of procedural deficiencies
•  input on selection of accountant/expert/arbitrator
•  negotiate engagement letter for accountant/expert/arbitrator
Disputes quickly take on legal dimensions beyond the accounting
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Payment Issues
•  Escrow accounts or holdbacks commonly used:
§  Provide security for potential purchase price adjustments (including WCA)
§  Post-closing indemnification claims
•  Average amount held in escrow in private M&A deals was ~7% in recent
study, reflecting seller-friendly environment
Escrow accounts and holdbacks can protect buyer
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Common Issues
1.  How do you measure current assets or liabilities?
2.  What if Sellers do not prepare financial statements in accordance with GAAP?
3.  What if financials are GAAP at year end but no accruals at interim periods?
4.  Who prepares post-closing statement of working capital?
5.  Who pays the true up? Seller or does it come from escrow account?
6.  Unilateral adjustment or can Buyer be required to pay additional amounts?
7.  What if business operates with negative working capital?
8.  How much time do the parties have to finalize or dispute Working Capital
calculation?
9.  What accounting rules should be used to calculate working capital?
10. How are disputes resolved?
11. How are accountants selected?
12. Special industry conventions?
13. What comes out during due diligence...
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Takeaways
•  WC adjustments protect purchase price and value and conserve cash
•  Definitions to WCA component are highly negotiated
•  Tailor working capital definition with appropriate non-GAAP items
•  Understand method of preparation of target financials
•  Compare against buyer method of preparation and understand differences
•  Post-closing control of financial statement preparation is key
•  Spell out dispute resolution process in detail to avoid unintended consequences
•  Interplay of working capital adjustment on reps and indemnity
•  Escrow accounts and holdbacks can protect buyer
•  Caps, baskets, set-off, can collar the adjustment
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Panelists’ Thoughts and
Audience Questions
Thank you for attending!