Purchase Price Adjustments in Asset Purchase Agreements
The first thing most people look for when reviewing an asset purchase agreement is the total purchase price. This is the headline number, but in many transactions this number is subject to post-closing adjustments. There can be earn-out provisions that vary based on how the business performs in the months or years after closing, there can be indemnification claims that reduce the amount the seller receives from any holdback or a seller note, and there can be purchase price adjustments based on working capital. This article focuses on working capital purchase price adjustments as many first-time sellers are unfamiliar with them and the effect they can have on the overall deal.
Purchase price adjustments exist to account for variances between the value of the business at closing and the value of the business as stated in the asset purchase agreement. The simplest illustration of how such a variance might arise is in a store selling goods direct-to-consumer. The business will often carry inventory to ship to customers when they place an order. As the amount of inventory fluctuates, there should be a mechanism to adjust the purchase price shortly after closing.
When calculating the purchase price, both parties estimate the business’s working capital from historical data. This estimate establishes the baseline from which any adjustments will be made, so both parties should work diligently to be accurate. This estimate will be included as part of the purchase price and stated as its own line item in the asset purchase agreement, and then the asset purchase agreement will set forth the mechanism for calculating any adjustments. The most common reasons for purchase price adjustments are introduced below.
Accounts Receivable
Most SaaS and Ecommerce businesses don’t have accounts receivable, but businesses that operate on deferred payment terms may see purchase price adjustments based on the buyer’s ability to collect on those outstanding payments as they become due. A common mechanism in dealing with accounts receivable is to assume a certain percentage of accounts receivable will not be collected (based on historical rates of write-offs) and project that percentage forward to encompass any accounts receivable existing as of closing. If within a certain period of time a greater or lesser amount of the accounts receivable are paid than the original assumption, then the purchase price will be adjusted accordingly.
Inventory
If the business holds physical inventory, for example an Ecommerce store, then most buyers want to purchase the existing inventory so that the business can continue operating smoothly after closing. When the asset purchase agreement is being negotiated, though, it is impossible to know exactly how much inventory the business will have at closing. To account for this, a certain amount of inventory is assumed in the asset purchase agreement and should be stated explicitly. Then at closing, the parties run an inventory report and the purchase price is changed to reflect the discrepancy between the assumed value of the inventory in the asset purchase agreement and the actual value of the business’s inventory at closing.
Prepaid Subscriptions
Many SaaS businesses offer annual subscriptions as a way to increase upfront revenues. From the buyer’s perspective, people on pre-existing annual subscriptions are customers who need to be served but who will generate no revenue until their subscription renews. These customers can only cost the buyer money during their existing subscription through customer support tickets and the like. If there are lots of prepaid annual subscriptions, sellers should be prepared for the buyer to ask for a reduction in purchase price to account for the ongoing operating liabilities the buyer is assuming. The amount of any deduction will be negotiated and could depend based on factors such as the number and age of subscriptions, churn or melt rate, and the percentage of customers on annual subscriptions.
Avoiding Problems with Purchase Price Adjustments
Since purchase price adjustments change the amount of money being exchanged, the last thing either party wants is for there to be disagreements about how they are calculated. To mitigate this risk, the parties should be as specific as possible in detailing the procedures to determine any purchase price adjustment. The time and date used for determining the purchase price adjustment is often when closing formally occurs. It doesn’t have to be the moment of closing, but there does need to be an exact time. In brick-and-mortar businesses, there is often a brief closure where inventory is counted and accounts are paused to allow the relevant calculations to be made. Software tools simplify this process so that it may not be necessary to cease operations to count the inventory, but the process does need to take place.
Minimizing the risk of disputes also includes detailing the procedure for resolving any disputes over purchase price adjustments. Normally, the buyer will be the one who prepares the paperwork supporting any purchase price adjustment (this is referred to as a closing statement). After the closing statement is sent to the seller, the seller will have a period of time (30 days is common but this could be less in smaller transactions) to review it. In the event there is a dispute, the parties should try to work things out amongst themselves. To diffuse tensions before they rise, the parties could agree in advance to mediation and/or arbitration in the event of a potential dispute by putting such a clause in the asset purchase agreement. Purchase price adjustments are not something you want to have to resolve in court given the time and expense of litigation.
If you need further assistance understanding how purchase price adjustments work or are in the process of negotiating an asset purchase agreement, contact us at info@barlowwilliams.law and we will be happy to discuss your situation.