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When acquiring a business, a purchaser will take numerous
steps to value the target and seek assurances from the
seller that the valuation assumptions are correct. In
a US acquisition, this process is not substantially
different from comparable transactions outside the United
States. The process typically begins with preliminary
discussions between the purchaser and the target company
or its owners, designed to assist the purchaser in developing
a valuation of the target business both as a stand-alone
operation and as combined with the purchaser’s
own business. Depending on the size and value of the
combination synergies that can be obtained, the purchaser
can use some of this self-generated value as a kind
of piggy bank to increase the purchase price it is willing
to pay, particularly in a competitive bidding situation.
Steve Navarro |
If the parties come to an understanding over price and
other key business terms, they may enter into a heads
of agreement or “letter of intent”, setting
forth their general agreement with respect to the key
aspects of the transaction. When public companies are
parties to this process, care should be taken to avoid
prematurely triggering public disclosure obligations
under home country or local securities laws.
At this stage, more substantive
due diligence would commence. This will provide the
purchaser with the opportunity to validate its business
assumptions and expand its knowledge of the business,
assets and the liabilities of the target. In addition
to its business due diligence,
the purchaser will typically involve its legal counsel,
accountants and, depending upon the size and complexity
of the transaction, may also utilise investment bankers
in this exercise.
Each of these efforts is aimed at satisfying the purchaser
that it is paying a price it feels is appropriate, and
protecting the purchaser from the unpleasant surprise
of deficiencies in the business and assets of the target
and unanticipated liabilities after the transaction
is completed. In particular, the purchaser’s management
will have determined the key economic criteria that
justify the agreed price. Often this will include, in
addition to the purchaser’s assumptions as to
the future success of the business, specific assumptions
about the value at closing of key assets, whether fixed
assets, the level of working capital, or other measures
of assets. The purchaser will be keen to make certain
that this pricing criteria is valid – that the
purchaser has “gotten what it paid for”.
However, due diligence efforts ultimately rely upon
asking the right questions, getting a full response
in a manner that the purchaser can accurately
interpret, and making certain the assets are still present
at closing.
Purchasers are well advised, therefore, to include within
the final acquisition agreement protections that specifically
address the purchaser’s pricing criteria. One
approach that is frequently used when acquiring a privately-held
business in the US, and that focuses precisely on this
necessity, is including in the acquisition agreement
a combination of a post-closing purchase price adjustment
and representations designed to support key business
assumptions.
A post-closing purchase price adjustment
typically begins with the agreed assumption that the
purchase price is in part dependent upon the satisfaction
as of the closing date of certain metrics that the purchaser
has determined are critical to its pricing model. These
metrics may take account of limited categories, such
as the level of specific components of working capital,
or broader measurements, such as net worth. However,
these are but a few typical examples, and the test should
be driven by what the purchaser has determined to be
critical to its pricing model.
Michael Pedrick
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Shortly following closing, the purchaser’s or
seller’s accountants, as may be determined through
negotiation, will prepare a closing–date balance
sheet, determining if an adjustment to the purchase
price is required based upon the formula included in
the agreement. The other party and its accountants then
will have an opportunity to review this calculation
and the related workpapers. Often any disputed calculation
is settled between the parties, but in the event of
an unresolved dispute, arbitration with accountants
independent of both parties generally is contemplated
by the agreement. This price adjustment has the advantage
of occurring promptly after closing, and is often not
subject to the initial thresholds, or limitations on
amount, commonly applicable to general indemnification
claims.
As a second line of defense, the purchaser will rely
on key representations given by the seller as to the
financial statements and other matters deemed particularly
important by the purchaser, in addition to the more
general representations of the seller. Typically, financial
statement representations confirm that the financial
statements have been prepared from the books and records
of the target, conform to United States generally accepted
accounting principals (“US GAAP”) and fairly
and accurately present the financial condition and results
of operations of the target as of the date of the financial
statements. The purchaser may be able to negotiate further
representations, confirming the absence of liabilities
not required to be disclosed under US GAAP, and the
absence of liabilities arising subsequent to the date
of the financial statements.
These representations will typically be broader than
the specific criteria agreed for the balance sheet adjustment.
While representations made in the purchase of a public
company are typically extinguished at completion, with
no further right of the purchaser to make a claim for
breach, in the purchase of a private company, the purchaser
will negotiate indemnification rights for harms suffered
due to breach of representations and warranties. The
terms of indemnification may provide for a post-closing
period to determine the accuracy of representations,
typically ranging from one to three years, may include
a threshold for claims (to avoid de minimis claims)
and will almost certainly provide a maximum liability
for the seller.
The combination of a post-closing balance sheet adjustment
and general financial representations, warranties and
indemnity, provide a useful “package” whereby
the purchaser is assured that the financial criteria
it used in evaluating the target company and framing
its purchase price model are accurate, or causing the
seller to shoulder the risk if they are not.
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