Why does the price in the SPA need to be so complicated?
The headline price agreed for a transaction usually represents the enterprise value of the business or company being acquired – that is, the value of the future cash flows generated in profits by the business.
In relation to almost any M&A transaction, the ongoing trading of the business being sold/acquired results in uncertainty (at the point of signing) as to the precise balance sheet position that will exist at the date of completion.
Where the price agreed represents an enterprise value, there is generally a requirement to adjust the agreed headline price, as a minimum, in relation to the level of debt, or cash, which exists in the business at completion (the purchaser will be concerned to be compensated to the extent that they acquire the business with outstanding debt, as this reduces business value; the vendor will be concerned to receive value for any surplus cash transferred, representing the profits from pre completion trading, on top of the enterprise value).
Seasonal and short-term variation in cash and/or debt will vary inversely with the level of working capital (that is, operating debtors, stocks, and operating creditors).
If the price is adjusted in respect of debt/cash alone, there is a risk for both parties that the level of net debt or net cash is inflated, in either direction, by a working capital position which is not representative of the normal or average level of working capital funding required in the business (either as a result of seasonal factors in the business, or from stretching creditors or accelerating receipts around completion).
It is therefore generally the case that, for a transaction where the price is to be “trued up” by adjustment in respect of the net debt position, a further adjustment is also made to the extent that working capital at completion varies from an agreed normal/average level.
A contractual mechanism and process to calculate and determine such adjustments post completion must therefore be included in the sale and purchase agreement. Disputes commonly occur in relation to such adjustment processes, both as a result of complexity in the process, and the differing interpretation that may be placed on subjective accounting judgements by the two parties, and as a result of one or both parties taking an aggressive approach to the process as an opportunity to negotiate for further value.
If, for example, closing took place at a seasonal high point in inventory, the cash position would be lowered, as a result of the additional investment required to build the inventory level.
If the price for the business were then adjusted for cash/debt alone, the seller would suffer a loss of value in relation to the seasonal investment in extra inventory reducing ‘their’ cash.
In the opposite position, where inventory or working capital at closing is less than the average, the purchaser would lose out by paying for extra cash (or less debt) when they would rapidly then have to invest further cash in the business to build working capital back to the ‘normal’ level.
It is therefore generally advisable that, for a transaction where the price is to be “trued up” by adjustment in respect of the net debt position, that adjustment is also made to the extent that working capital at completion varies from the normal or average level.
The agreed ‘debt-free/cash-free’ price is 100 million. The company has a bank loan of 12 million, and generally also has a small amount of cash.
The company has normal average Inventory of 20 million; average Receivables of 10 million; and average Creditors of 15 million. Total average working capital is therefore 15 million.
At closing, inventory has been built in advance of a seasonal sales peak. Purchases to enable this have been largely paid off by closing. Total closing working capital is therefore 30 million. Cash at closing is 6 million, including 2 million collected by the specific focus on cash collection at closing.
Adjustment of the headline price in respect of both cash/debt and working capital is necessary to ensure that the net cash paid by the buyer to acquire the business and settle the debt matches the agreed headline price.
Similarly, it is only with both adjustments in place that the seller receives full value
– had inventory not been built up, working capital would have been lower, and cash would have been correspondingly greater. Since the buyer would have had to pay for such extra cash, omitting the adjustment for working capital results in lost value to the seller compared to a lower inventory, higher cash scenario.