A Guide to Acquisition Agreements - Purchase Price and Closing

This is the "business end" of the contract.  It specifies what the seller promises to sell and what the buyer promises to pay (not only cash or stock at closing, but also, as appropriate, other items, such as the assumption of seller liabilities and post-closing adjustments to the purchase price).  It also specifies when and how the parties will complete ("close") the sale.

Special Purchase Price Items

There are a few typical (but not universal) elements of the purchase price that deserve special mention:

  • Working Capital Adjustments:  The “working capital” of a business is the short-term assets it has to keep around at any given moment to stay in business.  Typical items included in working capital are cash and short-term investments (if the sale is structured as an asset sale, these are usually just excluded from the deal), inventory, accounts receivable, and pre-paid items (such as a paid-up one-year subscription to an information service).  Working capital is necessary to the long-term value of the business.  Without it, you’re out of business.  That said, it’s more an enabler of long-term value than an element of it.  Because of the peculiar nature of working capital, sellers usually want to be paid extra if the working capital happens to be a little higher than normal at closing.  Likewise, buyers are afraid that the sellers will skimp on working capital in the run-up to closing, knowing that they won’t get the benefit of maintaining it.  So the parties often agree to adjust the purchase price to reflect any difference between the working capital at an agreed point (usually the date of the last balance sheet before signing) and closing.  While the concept is easy, fights often break out over the details, so it’s worth paying attention to them.  Make sure that you understand the procedure for determining working capital and that you think it’s practical and fair.  Likewise, make sure you understand how any dispute will be resolved and that you think that’s practical and fair.  If working capital isn’t likely to vary much or the amounts involved are trivial, you should think hard about skipping the working capital adjustment.
  • Earnouts:  Buyers and sellers often have very different ideas as to the value of a business.  Frequently, the source of the difference lies in diverging projections of future performance.  In those cases, the parties often think about bridging the valuation gap by including an “earnout”: making part of the purchase price depend on how things actually work out after closing.  In theory, this is a nice solution.  Both parties put their money where their mouth is and subsequent facts determine who was right.  Unfortunately, earnouts tend to break down on the details.  When and how exactly will you measure whether things have worked out?  How does one party make sure the other one doesn’t pull tricks to skew the measurement (usually, the buyer is in control after closing so this is the seller’s problem, but if some of the sellers run the business for the buyer after closing, it can be the seller’s problem)?  If you’re going to include an earnout, you need to understand and think through every detail.  Assume that the other side will do everything it can to skew things against you and make sure you still think the arrangement will be practical and fair.
  • Escrows and Notes:  Often, the sellers insist on paying some of the purchase price awhile after closing to guard against negative surprises.  This is basically the mirror image of an earnout:  If things go worse than expected, money is deducted from the purchase price.  The money is usually put into escrow, but sometimes the buyer simply gives the seller a promissory note (an IOU) that allows the buyer to “offset” post-closing claims against the amount it owes.  An escrow is better for the seller, all other things being equal, since the money is out of the buyer’s hands.  On the other hand, escrows can be expensive.  The length of the escrow generally matches up with the time limit for making claims (discussed below), but many variations are possible.  For example, if some of the escrow covers a specific contingency, such as a pending tax appeal, it will usually match up with that contingency.  If the escrow period is long, the parties also often agree to release parts of it over the period to the escrow if the buyer hasn’t made claims exceeding the amount that would remain.

Difference Between Signing and Closing

In many deals, this section of the contract contains promises as to what will happen in the future.  In other words, no one buys or sells anything when they sign the contract.  They just promise to do that at a future "closing" if a number of conditions are met.  Most of the rest of the contract, however, is taken up with specifying the process by which the parties plan to get to closing, the circumstances in which one of them can back out, and the consequences that follow if one of them backs out in breach of the contract (or otherwise breaches the contract).

Some acquisition agreements are written to "sign" and "close" simultaneously.  Those contracts are simpler because they don’t need to control the parties' conduct between signing and closing or figure out what happens if the situation changes or someone refuses to close.  In many acquisitions, however, there has to be some time between signing and closing.  Common reasons for that delay include getting consent of shareholders, government regulators, and third parties whose contracts with the parties require their consent to the deal.