ACC SF Bay Area. Corporate and Securities Committee NUTS AND BOLTS OF M&A DEALS: Demystifying the Working Capital Adjustment

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1 ACC SF Bay Area Corporate and Securities Committee NUTS AND BOLTS OF M&A DEALS: Demystifying the Working Capital Adjustment December 1, 2014 (San Francisco) December 2, 2014 (Palo Alto) presented by Stephen Ballas, SVP and Deputy General Counsel, CBRE Adam R. Dolinko, SVP and General Counsel, CSR Kevin Iudicello, Managing Director, Pagemill Partners Louis Lehot, Partner, Cooley LLP Craig Menden, Partner, Cooley LLP Adam Reilly, Head of West Coast M&A, Deloitte

2 Agenda Panelists Why Adjust Purchase Price for Working Capital? Setting some baselines Key Definitions and Other Considerations Mechanics Dispute Resolution Payment Issues Alternatives Common Issues / Sample Provisions Takeaways Questions 2

3 3 Panelists Stephen Ballas Adam Dolinko Kevin Iudicello Louis Lehot Craig Menden Adam Reilly CBRE CSR plc Pagemill Partners Cooley LLP Cooley LLP Deloitte SVP, Deputy General Counsel SVP and General Counsel Managing Director Partner Partner Partner, Head of West Coast M&A

4 Why Adjust for Working Capital? PROBLEM: Purchase price determined before DD complete or how much WC needed What Buyers are solving for: Protect against working capital depletion Offset potential increase in purchase price if cash infusion needed post-close Don t deter Sellers from acting rationally What Sellers are solving for: Conserve pre-closing cash accumulated No penalty for pre-closing capex spend or other rational behavior Get Buyer agreement pre-closing for how post-closing metrics measured WC Adjustments protect purchase price and value and conserve cash 4

5 5 Setting some baselines Working capital ( WC ): Minimum capital to maintain current operations in current business cycle Calculating a target s WC: WC = current assets - current liabilities WC target = estimate of WC based on normalized historic averages WC adjustments ( WCA ) are ubiquitous in M&A transactions: WCA were in ~80% of PLC study and ~80% in ABA study Working capital adjustments will appear in the vast majority of M&A deals

6 6 Key Negotiated Definitions Current Assets Current Liabilities Definitions to WCA component are highly negotiated

7 7 Current Assets OFTEN INCLUDES: Cash and cash equivalents (excluded if deal priced on cash free/debt free basis) Accounts receivable (identify collectability issues) Inventory (for asset purchases, may require physical check at closing) Prepaid expenses Other short-term assets (restricted cash, marketable securities) OFTEN EXCLUDES: Portion of prepaid expenses which will not benefit buyer after closing Deferred tax assets and long-term assets Receivables from target s affiliates, D&O s and stockholders and their affiliates Doubtful receivables / bad debt Buyer will narrowly define current assets

8 Current Liabilities OFTEN INCLUDES: Accounts payable (may exclude disputed payables) Unpaid transaction expenses Accrued taxes (increasingly excluded if seller agrees to pay them) Accrued expenses OFTEN EXCLUDES: Payables to target s affiliates, D&O s and stockholders and their affiliates Deferred tax liabilities Disputed accounts payable Lines of credit/notes payable (excluded in cash free/debt free deals) Current portion of long term debt (excluded to the extent debt is paid off) Buyer will define current liabilities expansively to capture all short term debts and obligations 8

9 9 Common Exclusions from Working Capital Definition Common exclusions from WC definition: Debt and debt components Cash and cash equivalents (if deal price on cash-free basis) Deferred tax assets and/or liabilities Employee liabilities Intercompany accounts Customer deposits Related party receivables Exclusions from working capital definition highly negotiated

10 10 Possible Additions to Working Capital Definition Possible non-gaap additions to WC definition: Transaction expenses Transaction expenses of seller investment banking fees, attorneys fees, employee bonuses Capital expenditures and leasehold improvements Aggressive approach because not current assets under GAAP Long-term deferred revenue Deferred tax assets Deferred compensation/pension liabilities Year-end bonus accruals Tailor working capital definition with appropriate non-gaap items

11 11 Best Practices for Definitions Include detailed definitions to avoid ambiguity that leads to disputes Cite to specific balance sheet line items for clarity Be mindful of interplay between WCA and other clauses in agreement is there a rep that accounts receivable are collected? Collected within some number of days? Reserve for doubtful accounts Specific indemnity may be better solution than including matter as a WCA Tailor definitions to unique aspects of business: E.g. watch for large cyclical working capital changes in historical data Draft definitions carefully and consider which items appropriate for WCA

12 12 Timing of Working Capital Adjustments One-step means adjust WCA at closing only Two-step typically means seller reports WCA at closing and Buyer adjusts post-closing Increasingly agreements use two-step adjustment Mechanics of the typical two-step adjustment: At closing adjust based on estimate and final post-closing adjustment After closing (60-90 days) adjust once target s financial statements finalized Buyer reviews financials post-closing to adjust purchase price

13 13 Mechanics of Calculating the Adjustment: Preparing Financial Statements Parties determine who prepares financial statements used to calculate PPA At Closing: Seller usually prepares, in better position because still has control of the target After Closing: Buyer usually prepares, in better position because it maintains books and records Control over financial statement preparation varies with time and leverage

14 14 Mechanics of Calculating the Adjustment: Preparing Financial Statements (Continued) Parties should determine whether or not financial statements are audited Some of target s accounting practices may not be GAAP-compliant: Should decide on GAAP and consistency with Buyer s statements Ensure calculation of target/estimate and final working capital consistent Parties may refer to balance sheet to outline the calculation: Identify what is included and excluded for Current Assets and Current Liabilities Include zero balances for line included items not applicable to benchmark Use reference balance sheet for benchmark and closing working capital number Limitations caps, baskets, upward/downward, interest? Parties agree in advance on details/mechanics of calculations for PPA

15 15 Dispute Resolution Parties may appoint independent accountant to act as arbitrator Resolve dispute according to detailed process: Appoint accountant or set out process for appointment Define scope of accountant s review Determine who bears accountant s fees (even split, proportion, winner takes all, loser pays all?) Define a range of values within which the accountant s determination must fall Accountant may act as expert or arbitrator understand the difference Interplay with other reps and warranties can buyer also claim for breach? Understand dispute resolution process and spell out in detail

16 16 What to do in case of emerging dispute? Stakeholders should seek legal advice to assess: alternatives to accountant/expert, arbitration or judicial action avoid waivers of procedural deficiencies input on selection of accountant/expert/arbitrator negotiate engagement letter for accountant/expert/arbitrator Disputes quickly take on legal dimensions beyond the accounting

17 17 Payment Issues Escrow accounts or holdbacks commonly used: Provide security for potential purchase price adjustments (including WCA) Post-closing indemnification claims Average amount held in escrow in private M&A deals was ~7% in recent study, reflecting seller-friendly environment Escrow accounts and holdbacks can protect buyer

18 Common Issues 1. How do you measure current assets or liabilities? 2. What if Sellers do not prepare financial statements in accordance with GAAP? 3. What if financials are GAAP at year end but no accruals at interim periods? 4. Who prepares post-closing statement of working capital? 5. Who pays the true up? Seller or does it come from escrow account? 6. Unilateral adjustment or can Buyer be required to pay additional amounts? 7. What if business operates with negative working capital? 8. How much time do the parties have to finalize or dispute Working Capital calculation? 9. What accounting rules should be used to calculate working capital? 10. How are disputes resolved? 11. How are accountants selected? 12. Special industry conventions? 13. What comes out during due diligence... 18

19 19 Takeaways WC adjustments protect purchase price and value and conserve cash Definitions to WCA component are highly negotiated Tailor working capital definition with appropriate non-gaap items Understand method of preparation of target financials Compare against buyer method of preparation and understand differences Post-closing control of financial statement preparation is key Spell out dispute resolution process in detail to avoid unintended consequences Interplay of working capital adjustment on reps and indemnity Escrow accounts and holdbacks can protect buyer Caps, baskets, set-off, can collar the adjustment

20 Panelists Thoughts and Audience Questions

21 Thank you for attending!

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