The purchase price in private M&A transactions is often subject to post-closing adjustment mechanisms related to the target company’s working capital, cash, and net debt as of the closing date. Such mechanisms help facilitate the negotiation of the transaction on a cash free/debt free basis with normalized working capital. Ideally, these adjustments also help ensure that the seller gets paid for what it delivers (including profits realized through closing), and the buyer only pays for what it actually receives (and not, for example, for inventory the company no longer has).

Such post-closing adjustments are often implemented smoothly, the purchase price is trued-up, and the parties are off to the races with their new business or fresh capital. Yet there are those cases where the parties may disagree on the size of the adjustments called for, and a neutral accountant is asked to resolve the dispute. On the theory that it’s best to avoid any disagreements in the first place, here are three best practices to minimize any post-closing haggling:

1. The adjustment mechanism should fit the transaction.
Putting in place a working capital adjustment mechanism is premised on the assumption that the amount of working capital matters from a valuation and business standpoint. But this is not always the case. In situations where its valuation impact is limited, ensuring that this sort of adjustment mechanism is not entered into the purchase agreement as one of many “customary” provisions can help avoid disproportionally large disputes.

Here’s an example of how this might play out:

The target company operates a technology based-business, whose products and services have become outdated. The buyer is a rapidly growing company with a different product and is interested in the target company for its existing infrastructure, back-office, and otherwise already scaled up business as it seeks to accommodate its own growth.

A customary working capital adjustment provision is included in the agreement. The working capital is to be determined in accordance with GAAP and past practices (with GAAP having priority). The buyer agrees to pay $20 million for the target, but as a result of the seller’s pre-transaction business struggles, the $12 million value assigned to inventory is very high relative to the purchase price.

Post-closing the buyer takes the position that the company’s inventory is outdated and that GAAP calls for a sizeable inventory allowance for excess and obsolete inventory. The buyer then asks for a $10 million purchase price adjustment, which equates to a 50 percent discount of the original purchase price.

In this example, the buyer was not paying for the inventory as part of an operating business. Rather, it was paying for the target company’s business platform. If the seller had recognized the impact of the provision upfront, it would not have agreed to its inclusion.

Similarly, in the opposite situation, if the target had purchased additional inventory leading up to the closing, the buyer would not have wanted to pay for it through the adjustment mechanism. This entire situation could have been avoided by using an alternative to the working capital mechanism or by carefully customizing it.

2. There is more to the target’s accounting than a summary schedule.
Balance sheet adjustment mechanisms, such as working capital adjustments, rely on comparing the relevant amount as of the closing date to a target amount. Both are often determined using the seller’s historical accounting practices and/or GAAP.

But using the target’s accounting in this way assumes that the requisite accounting information is available and consistent—and that the company’s accounting practices are clear. When this is not the case, it can wind up being costly for either the seller or the buyer, depending on the given situation. In these circumstances, an honest common-sense assessment of the company’s accounting and underlying documentation can prevent a lot of problems.

Here are some examples of what to watch out for:

• The target company grew using a buy-and-build strategy that involved many M&A transactions, including some that took place within the past few months.

• The target is a carve-out from a large multinational that crosses legal, divisional and geographical boundaries. And while it is a large purchase for the buyer, it represents less than 1 percent of the seller’s market cap.

• The target has grown rapidly and its accounting department appears to be in a permanent state of chaos. During due diligence it is readily evident that the information flow is slow and dependent on the institutional knowledge of a few accounting personnel.

Yet all too often, the target’s historical accounting practices are simply incorporated into the purchase agreement by referencing an exhibit schedule (partial trial balance) or historical financial statements. This can be a recipe for a dispute. It can also be avoided by simply making sure that the accounting practices to be applied are crystal clear. Often, this can be accomplished—at least before the transaction—by including support schedules and narratives that underpin the agreement’s summary schedule.

3. The impact of the adjustment mechanisms should be considered during the final negotiations.
It is not uncommon for buyers to receive a last-minute discount on the purchase price in connection with due diligence findings. For example:

• A manufacturer of custom products may have a dispute with a customer about a shipment delay, and during the diligence period the customer cancels a significant order.

• During a plant tour, the buyer spots outdated equipment on one of the production lines that will need to be replaced.

• The buyer notices that, while the target company’s inventory turns appropriately on average, some inventory items turn too fast and others not at all.

In each of these instances, the buyer would receive a discount that may overlap with the working capital adjustment:

• For the custom product cancellation, the negotiated discount can effectively overlap with a write-off of work in progress and the recognition of a contingent payable.

• For the production line upgrade, the required investment can partially overlap with a write-off of the spare parts inventory.

• For the inventory segmentation, the discount to boost inventory for popular items can effectively overlap with the write-off of obsolete inventory.

In each of these examples, the issue is not necessarily the negotiated discount or accounting adjustment itself, but the potential overlap between them. Since the adjustments are generally only made as of the closing date, and not in the target working capital, the buyer may be presented with an opportunity to use the post-closing working capital mechanism to ‘double-dip’ and demand a discount without offering a compensatory write-off. But if the negotiator for the seller is aware of the potential overlap, this can be easily sidestepped.

Vincent Biemans is a managing director of Berkeley Research Group, LLC and the coauthor of M&A Disputes: A Professional Guide to Accounting Arbitrations (Wiley).