Previously, we wrote about the use of earn-outs as a means by which buyers mitigate the risk of a target's post-closing under-performance by holding back part of the purchase price and paying it out as the target meets certain financial targets. In this post, we examine a related topic that is often confused with earn-outs but in fact is a separate tool in a deal-maker's kit: post-closing balance sheet adjustments.
Unlike an earn-out where parties look to the future performance of an acquired business, a balance sheet adjustment is the parties' opportunity to draw comparisons between the business as it existed at closing and the business that existed at the time that the purchase price was agreed upon. Typically these dates are weeks, if not months apart, and without a purchase price adjustment the buyer bears the risk that the target's balance sheet at closing may no longer support the price of the acquisition. A seller faces the opposite challenge – if the business has grown since the purchase price was negotiated, it will want to be compensated for the increase in value. To address this, the parties agree that, upon closing, a comparison will be drawn between a chosen financial metric (or multiple metrics) at the relevant two time periods. The net difference, whether positive or negative, will be paid by the party who benefits from the difference.
Whereas earn-outs are present in a minority of deals in the United States and Canada, balance sheet adjustment provisions were present in 95% of select United States private M&A deals signed in 2018 and Q1 2019 (the Surveyed Deals). This figure is higher than any other survey period in the past decade. Of the adjustment provisions in the Surveyed Deals, over 90% used working capital as the chosen financial metric, with other less popular options being debt, cash and assets. Working capital is a flexible metric commonly calculated by deducting current liabilities, such as accounts payable, from current assets such as cash and accounts receivable. This is the most popular adjustment as current assets and current liabilities will likely show the greatest fluctuation during the adjustment period.
While certain aspects of post-closing balance sheet adjustments continue to be heavily negotiated and deal-specific, some appear to be blessed with near unanimous support. For example, in 99% of Surveyed Deals, the buyer prepares the closing balance sheet. Similarly, in almost all of the Surveyed Deals US GAAP was the agreed accounting methodology, with common modifiers being "consistent with past practices" and "with specified modifications". Another adjustment mechanism that has broad approval is the parties' agreement to have the target produce a preliminary estimate on closing. This interim step, which was present in 97% of Surveyed Deals, affects the closing price paid by the buyer, but any such adjustment remains subject to the final post-closing adjustment. The popularity of the provisions detailed above does not mean that a party cannot negotiate an alternative arrangement, particularly in Canada where none of them enjoy the same level of broad utilization. However, the party seeking to argue against what appears to be a largely settled market may face an uphill battle.
Post-closing balance sheet adjustments are already an important aspect of many Canadian M&A deals, and will likely increase in prevalence if the trends in the United States are any indication. Negotiating these mechanisms requires a keen understanding of the market, and an appreciation of the high-stakes post-closing issues that can result from the balance sheet adjustment process. Deal-makers and their legal counsel should work closely with financial advisors to identify and address the issues that can arise in this arena.
Originally Published by Norton Rose, November 2020
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