By Helene Banks, Cahill Gordon & Reindel
Tick. Tick. Tick. Tick.
Many private equity investors imagine a countdown clock as they hurriedly prepare to buy or sell a business. “Time kills deals” is the cliché, and both buy- and sell-side management teams are acutely aware of the need to reach closing day in a timely fashion.
But today, nearly 90 percent of middle-market deals involving private-company targets include post-closing purchase-price adjustments, meaning that closing day no longer signals the conclusion of most transactions.
In this environment, PE investors who rush to closing without careful preparation are likely to trigger a second and much more dangerous countdown clock — attached to one of the hidden time bombs lurking in the target’s balance sheet.
Post-closing adjustments typically come in two flavors: closing balance-sheet adjustments and earnouts.
Both types are strictly governed by the letter of the purchase agreement, the balance sheets and any related covenants or exhibits.
Equally important: Once the paperwork is signed on closing day, the possibility for further negotiating these documents is foreclosed.
As a result, smart buyers and sellers will ensure that the purchase agreement, balance sheets and related covenants and exhibits are carefully prepared — negotiating deal terms with the care and attention to detail of a bomb squad — so as to defuse potential conflicts arising out of post-closing balance-sheet adjustments.
Here are five balance-sheet-related tips every management team in the PE community should consider as they negotiate the terms of their next post-closing price adjustment.
- Resolve any confusion, disagreements or potential misunderstandings during the development of the preliminary closing balance sheet. Avoid waiting until after closing to raise a balance- sheet-related issue, when it will be much more difficult, and perhaps impossible, to negotiate a favorable resolution.
- Clearly define each balance-sheet item in the contract before closing. Too often, buyers and sellers realize only after closing that they have different definitions of current assets and current liabilities. For each line item, ensure the historic components are established and clearly understood. In addition, utilize the definitions to identify and detail components within each line item. Precision is key.
- For each line item utilized to calculate the post-closing purchase-price adjustment, ensure that the purchase agreement specifies any important applications of GAAP. Remember: While GAAP provides guiding principles, management has significant discretion concerning how they are applied. To ensure that discretion is not a source of disagreement, attach as an exhibit a financial statement that shows the calculations.
- Eliminate potentially contentious line items from the closing balance sheet. Instead, utilize separate covenants to specify the business understanding in regard to these accounts. For example, separate covenants are often used to clarify the treatment of related-party transactions and the treatment of transaction-related costs and expenses.
- Utilize the purchase agreement to manage any conflicts of interest that might arise in the development of the closing balance sheet. Consider: Will the preparer be compromised by having a vested interest in the outcome? Will the other party retain access to the books, records and personnel necessary to double-check the closing balance-sheet calculations?
Post-closing conflicts are extraordinarily common in today’s deal-making environment. Smart management teams will utilize these best practices and others to anticipate, identify and defuse the most explosive dangers.
Helene Banks is a partner at Cahill Gordon & Reindel LLP, where she has advised publicly held and private companies on M&A for nearly 30 years. She can be reached at [email protected].