In an M&A transaction, several mechanisms exist in order to align the incentives of the parties and to reduce the risks assumed by each. From the perspective of purchasers, one important risk in a transaction is exposure to value leakage. A substantial amount of time can pass between the time deal terms are agreed upon and the closing of the acquisition agreement. Purchasers want to ensure that they are getting what they bargained for, while the seller will be concerned about leaving the purchaser with a windfall on closing.

Purchasers can guard themselves against value leakage through the negotiation of purchase price adjustments (PPAs). There are several types of PPAs that can be negotiated in order to address the purchaser’s risk of value leakage and to provide a mechanism to compensate the seller for a stronger than expected closing financial position.

The most common type of PPA used in recent private Canadian M&A transactions is the net working capital adjustment. In the American Bar Association’s 2014 Canadian Private Target Mergers & Acquisitions Deal Points Study (the ABA Study), 70% of deals sampled with PPA provisions included a net working capital adjustment. This post will outline the framework for net working capital PPAs, key considerations, and an alternative means for working capital value protection.


The purpose of net working capital PPAs is to ensure that the target company is left with an adequate or, at least, a known level of working capital post-closing, preserving its ability to continue day-to-day operations. If working capital is depleted, a purchaser may find itself in the unexpected position of needing to inject additional cash into the target business, effectively increasing the cost of the transaction. Depending on negotiations and the goals of each of the purchaser and the seller, net working capital PPAs can be calculated in several ways. At its most basic, the net working capital PPA provides for a change in purchase price contingent on a deviation from a known or agreed level of net working capital at the time the deal is signed compared to the level of working capital actually in the target business at the time of closing. If net working capital increases during this period, the purchase proceeds are adjusted upward, while the opposite is true if there is a decrease in net working capital, resulting in a reduction in the purchase price.

Key considerations

Basis for adjustment

In determining the basis for a net working capital PPA, parties will most often negotiate a working capital “peg” required to be in place as of closing and will adjust the purchase price based on deviations from that level. Alternatively, parties may negotiate an acceptable band of working capital, which only results in a PPA if the final level of working capital falls outside of this band. According to the ABA Study, 95% of sampled deals with post-closing PPA provisions provided for a PPA adjustment that was adjusted from the first dollar of deviation, while the remaining 5% provided for a PPA only if a certain threshold value is exceeded.

Timing of adjustment

From a timing perspective, the parties may choose to make a single closing adjustment once the full closing date balance sheet becomes available (usually within 30 to 60 days of closing). Alternatively, the parties may opt to calculate and make an initial PPA on the closing date based on a reference or estimated balance sheet, followed by a final adjustment “true-up” when the final closing date balance sheet becomes available. From a practical perspective, using a working capital PPA mechanism that contains both an initial and a final adjustment can often reduce the expected size of the final adjustment (so long as the parties are confident that the initial closing estimate is relatively accurate). This approach can be particularly useful where the parties are seeking to minimize the impact of future adjustments after the closing date by getting a close approximation of the final purchase price into the right hands at the time of closing.

Responsibility for calculating the adjustment

While the initial reference balance sheet is invariably prepared by the seller, the ABA Study shows an increasing trend in the preparation of the final closing balance sheet by the purchaser. 61% of surveyed deals containing PPA provisions tasked the purchaser with the responsibility of preparing the final closing balance sheet, up from 52% in the 2012 study and 29% in the 2010 study.

What standards need apply?

If a reference balance sheet is used, it should be prepared using the same standards as the final balance sheet to limit confusion and facilitate the calculation of adjustments. Of equal importance is determining the agreed upon standard of accounting. In the ABA Study, the most common methodology for the closing balance sheet is GAAP consistent with the target’s past practices (39% of all deals with PPAs). This standard has been increasing over the course of the ABA studies (e.g., in the 2010 study, only 19% used the GAAP consistent with past practices standard) at the same time as the seller’s responsibility for preparing the closing balance sheet has been decreasing, perhaps because the use of this standard gives the seller a degree of comfort in the basis of balance sheet preparation. The next most common standard is based on GAAP without mention of past practices. Of course, any deviations from standard accounting practices can be negotiated, but such deviations should be clearly outlined in the acquisition agreement in order to avoid disputes.

Whose pockets?

One important consideration applicable to all transactions with PPAs is the determination of who will hold the money prior to a final determination of any applicable PPAs. How this plays out is usually highly dependent on the particular context of the parties to the transaction. Often a portion of the purchase price will simply be held back by the purchaser pending a final PPA adjustment; however, where the amount of PPAs are expected to be significant or the negotiations contentious, the parties may prefer the comfort of setting up a separate escrow account to hold the funds and making PPAs from this escrow.

According to the ABA Study, of the subset of transactions containing a PPA, approximately 43% did not make use of a separate escrow or holdback mechanism, 23% of deals had a specific escrow set up for PPAs, while a further 18% of deals did not have a specific PPA escrow but did allow for the settlement of PPAs from an indemnity escrow.

An alternative: the “locked-box” mechanism

As an alternative to using PPAs to preserve value, the parties to an acquisition agreement may agree on a fixed purchase price, referred to as the “locked-box” mechanism. The “locked-box” mechanism provides for a purchase price determined based on a reference date prior to closing, at which point the seller covenants to a financial position and withholds from any liquidation or disposition of its assets. The purchaser pays additional consideration for these covenants, usually compensating the seller for the time between the reference date and closing date in the form of interest. After closing, the purchaser has recourse against the seller through indemnities provided for in the acquisition agreement.

The main benefit of the “locked-box” mechanism is purchase price certainty. It prevents any purchase price disputes brought on by PPAs or disputes related to working capital normalization, the latter of which consists of negotiations to add or remove certain terms from the definition of working capital under the acquisition agreement.

The author would like to thank Sam Zadeh, articling student, for his assistance in preparing this legal update.

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