[This article was written by Bob Holmen for Fortis Advisors. Additional articles may be found at Fortis News.]
Typically, the purchase price in a private M&A transaction is adjusted based on the target company’s estimated working capital as of the closing date. This gives the sellers the benefit of assets such as cash and receivables, but nets out debt, payables and other liabilities. The parties then go through a working capital adjustment process after closing to finalize the closing date numbers, with any change from the estimated working capital serving as an adjustment to the final purchase price. Based on data that Fortis Advisors has collected from over 500 M&A deals where it has served as the post-closing shareholder representative, 64% of such deals include a post-closing adjustment provision to finalize the working capital (see the Forsite™ M&A Deal Tool, including accompanying analyses):
However, this common working capital adjustment process can lead to an unintended consequence: forcing recalculation of every holder’s merger proceeds, escrow contribution, pro rata percentages and other metrics post-closing. This problem can be avoided through a simple provision in the merger agreement (as described below).
At the closing of an M&A transaction, the parties agree to distribution of the proceeds based on the purchase price (including the estimated working capital) as applied to the capital structure of the acquired company. That capital structure may include preferred stock (that may have a built in preference on payment), common stock and stock options. In addition, the parties typically agree that a percentage of the amount to be distributed should be set aside in escrow to secure the selling shareholders’ post-transaction indemnification obligations. These calculations can be quite complex, involving sophisticated spreadsheets to properly allocate all items of consideration.
Once the working capital is finalized post-closing, any negative adjustment typically is paid to the buyer out of escrow (either the indemnity escrow or a special escrow set aside for the adjustment). A positive adjustment usually is treated as an increase to the purchase price, and the amount of the adjustment is distributed to the stockholders. However, distributing the adjustment to shareholders may not be as simple as paying each stockholder its pro rata share: changing the purchase price can result in modification of every number in the closing spreadsheet that originally allocated the purchase price.
The problem arises when different classes of stock and options receive different payouts. Preferred stock may receive a preference plus its value as common stock equivalent. Common stock likely receives its common value. Stock options receive their common value net of the applicable exercise price for the options. Thus, each type of stock and option will receive a different payout, and a different percentage of the purchase price. Then, a set percentage of those proceeds will be contributed to escrow.
As a simple example, preferred stock may receive $5 per share, common stock may receive $3 per share, and stock options (net of exercise price) may receive $2 per share. Assuming an equal number of preferred, common and options, the preferred would end up with 50% (5/10) of the proceeds, with 30% and 20% for the common and options, respectively. From those amounts, each class of security would contribute some amount (e.g. 10%) to the indemnity escrow.
When the purchase price changes post-closing, the amount received by each form of stock and option will change equally (e.g. every share gets an additional $1 per share). Thus, as adjusted, the three classes would receive $6, $4 and $3 per share, respectively, which translates to 46% (6/13), 31% and 23% of the proceeds going to each class of securities. However, the preferred previously contributed 50% of the escrow; as adjusted, the preferred should only represent 46% of the escrow, while the common and options should represent an increased share of the escrow. Thus, the increase in purchase price requires modification of escrow contributions (and any other amount taken from or attributed to each class of securities at closing).
The parties can avoid a substantial modification to the all the numbers calculated at closing by fixing the percentage payouts for each class of stock at closing. For example, the merger agreement could provide that any positive working capital adjustment will be paid out proportional to each stockholder’s contribution to the escrow fund. Another alternative is for the merger agreement to include a pro rata payout definition applicable to any positive working capital adjustment. Either of these methods avoids having to re-open the complex closing spreadsheet and recalculating every number to account for what may be a small change in the overall consideration payable to the shareholders.