Purchase Price Adjustment

A purchase price adjustment is a provision in the agreement for the sale of a company or business under which the price paid at completion is later corrected, up or down, once the financial position of the target on the completion date has been measured. The parties agree a headline price when they sign, but the business keeps trading until the deal closes, and its cash, borrowings and working capital change in the meantime. The adjustment ensures that the buyer pays for what it actually receives and that the seller is paid for what it actually hands over.

Adjustments of this kind are standard in mergers and acquisitions of private companies, and are the dominant pricing method in the United States. The phrase is also used for other changes to the consideration after closing, such as an earn-out or a claim under an indemnity, and in accounting for revisions to the amounts recognised for an acquisition during the measurement period.

Buyers generally value a target on a cash-free, debt-free basis and assume it will be delivered with a normal level of working capital. The amount payable for the shares is then derived by a bridge. Starting from the agreed enterprise value, the parties add cash held by the target, deduct its debt, and add or deduct the amount by which working capital exceeds or falls short of an agreed target. Transaction costs borne by the company are usually deducted as well.

Each element has its own provision. The net debt adjustment deals with cash and borrowings and operates pound for pound. The working capital adjustment compares actual working capital at completion with a target, often called the peg, set by reference to the average level over the previous year or more. The peg prevents a seller from inflating the cash balance before completion by delaying payments to suppliers or collecting receivables early, since any such gain in cash is offset by a shortfall in working capital.

Because the true figures cannot be known on the day of completion, the mechanism works in two stages:

1. Estimate. Shortly before completion the seller delivers a good-faith estimate of cash, debt and working capital, and the buyer pays the price calculated from it.
2. Preparation. After completion, one party, usually the buyer because it now controls the books, prepares completion accounts or a closing statement within a set period, commonly 60 to 90 days.
3. Review. The other party has a period to review the draft with access to working papers, and either accepts it or serves a notice of the items in dispute.
4. Resolution. The parties negotiate. Items they cannot settle are referred to an independent accountant, who acts as an expert and whose decision is final on the matters referred.
5. True-up. The difference between the estimated and final price is paid by whichever party owes it.

The agreement specifies the accounting policies to be used, in an order of priority: specific policies set out in the agreement first, then the policies used in the target's previous accounts applied consistently, then the relevant accounting standards. This hierarchy is the most heavily negotiated part of the mechanism, because differing treatments of items such as stock provisions, accruals and revenue cut-off can move the price materially.

To make sure an adjustment in the buyer's favour can be collected, part of the price is often paid into an escrow holdback and released once the accounts are final. Some agreements cap the adjustment, apply a minimum threshold below which no payment is made, or make the escrow the buyer's only source of recovery.

The main alternative fixes the price rather than adjusting it. Under a locked-box mechanism, the equity price is calculated from a balance sheet drawn up at a date before signing. The buyer takes the economic risk and benefit of the business from that date, and the seller undertakes that no value has been or will be extracted from the company, apart from specified permitted payments, with any other leakage repayable in full. There is no adjustment after completion.

A locked box gives price certainty and avoids post-closing disputes, which suits sellers and auction processes, and it is common in European private equity transactions. Completion accounts give greater accuracy and suit situations in which no reliable recent balance sheet exists, such as the carve-out of a division, or in which the business is seasonal or changing rapidly.

Several other mechanisms change the consideration after closing. Earn-out consideration makes part of the price depend on the future performance of the business. Claims for breach of warranty or under indemnities are commonly treated in the agreement as reductions of the purchase price, largely for tax reasons.

Under international and United States accounting standards for business combinations, an acquirer has a measurement period of up to one year from the acquisition date to finalise the fair values of the assets and liabilities acquired and the consideration transferred. Adjustments made within that period, where they reflect facts that existed at the acquisition date, are applied retrospectively and change the amount of goodwill. Later changes generally go through profit or loss. Thorough due diligence on normal working capital is the best protection against later dispute.