Skip to Main Content

Keeping you informed

M&A Price Adjustment Clauses: Buyer Beware?

    Client Alerts
  • September 11, 2006

A Delaware court’s recent decision may have cost the buyer of a business more than $10 million in potential damages arising from the target’s allegedly misstated financial statements. OSI Systems, Inc. v. Instrumentarium Corp., 892 A.2d 1086 (Del. Ch. 2006) illustrates some of the difficulties that can arise under garden-variety post-closing purchase price adjustment clauses. The case also serves as a reminder that buyers and sellers should carefully consider the intended purpose and effect of such clauses and be certain that the agreement clearly reflects the parties’ intent.

The OSI Systems acquisition agreement contained a fairly typical purchase price adjustment provision. The purchase price would be increased (or decreased) if the target’s working capital as of the March 19, 2004 closing date ("Final Working Capital") was greater (or less) than the target’s June 30, 2003 working capital ("Initial Working Capital"). Final Working Capital would contain at least the same line items as Initial Working Capital and be calculated in accordance with the Transaction Accounting Principles (defined generally as compliant with U.S. GAAP), "applied consistently with their application in connection with the preparation of [Initial Working Capital]…." The parties would close the transaction on the basis of the seller’s estimate of Final Working Capital and, after closing, the buyer would have the opportunity to prepare its own calculation of Final Working Capital. To the extent the parties disagreed on Final Working Capital, they were to submit their differences to a mutually acceptable independent accounting firm for resolution.

The buyer’s post-closing calculation of Final Working Capital was dramatically lower than the seller’s estimate, and would have reduced the purchase price by $25.3 million, or approximately 54 percent of the total purchase price. Most of the reduction resulted from the buyer’s use of different accounting principles than those employed by the seller to calculate both Initial Working Capital and its estimate of Final Working Capital. The buyer argued that it was justified in using different accounting principles because those used by the seller were not GAAP-compliant and, therefore, did not meet the definition of "Transaction Accounting Principles" that the agreement required be used in calculating Final Working Capital.

When the buyer attempted to submit the dispute to the accountants for resolution, the seller refused to participate on the grounds that the buyer’s claim was outside the scope of the purchase price adjustment procedures. According to the seller, the buyer’s position amounted to a claim that Initial Working Capital and the financial statements from which it was derived were not prepared in compliance with GAAP, a claim which if true would constitute a breach of the seller’s representations and warranties. The seller alleged that this type of claim was not intended to be resolved by the accountants, but rather under the separate dispute resolution procedures applicable to breaches of the agreement and other contractual indemnity claims.

The parties’ arguments over the characterization of the buyer’s claims held significant financial implications because the agreement included an indemnity cap relating to breaches of representations and warranties set at 25 percent of the purchase price. If the cap applied to the buyer’s claim it would reduce the maximum recoverable amount by more than $10 million.

The court ultimately agreed with the seller, finding that the working capital adjustment provisions were intended solely to handle disputes over the calculation of the change in working capital between the Initial Working Capital date and the closing date, when measured using consistent accounting principles. Although the court based its conclusion on a close reading of the agreement, it appeared to be influenced by the magnitude of the purchase price adjustment sought by the buyer and a perception that the buyer was attempting an "end run" around the indemnity cap. "[The buyer] cannot bypass the contractual indemnification process, … and then seek a gigantic Closing Adjustment by attempting to convince the Independent Accounting Firm that [the seller’s Initial Working Capital] …was materially inaccurate and infected by improper accounting." Id. at 1095.

Because working capital adjustment provisions involve a complex web of legal and accounting principles, they can produce outcomes that are unexpected and even counterintuitive. The buyer in OSI Systems, for example, was probably surprised to learn that the seller’s alleged systematic misstatements of its working capital could not be remedied under the agreement’s working capital adjustment provisions. Many buyers expect to use the adjustment clause to test the quality of the target’s working capital, in order to ensure that they are actually getting the working capital for which they bargained.

Most sellers, on the other hand, want to limit the operation of the clause to measuring and compensating for changes over time in the target’s working capital. They will often insist on using consistent accounting principles to ensure that an "apples to apples" comparison is made, and will want to leave qualitative issues to the indemnification arena. These disparate intentions can lead to ambiguities in the agreement, which can in turn result in the sort of unhappy surprise experienced by the OSI Systems buyer. It is therefore important for each party to work closely with its legal and accounting advisors to develop a common understanding of how the mechanics of the adjustment calculation should work, and to ensure that this understanding is clearly reflected in the agreement.

OSI Systems also illustrates the more fundamental fact that disputes over these provisions occur frequently. For instance, even in circumstances where the parties agree as to which accounting principles are to be used in the calculation of working capital, the application of such principles is not an exact science. In many cases, management will be required to make estimates and judgments, which may vary among reasonable management teams and may very well lead to irreconcilable differences that resist even the most careful drafting. Accordingly, the prudent party will anticipate a disagreement and ensure that it understands, and has paid adequate attention to, the process to be used to resolve any dispute over the final adjustment calculations. In particular, the agreement should address such issues as access to the other party’s work-papers, whether a party can revise its calculations once submitted, any limits on the scope of the accountants’ inquiry and responsibility for the costs of the process.

Price adjustment clauses based on changes in working capital are common in M&A transactions, but they are not "boilerplate" that can be lifted straight from a form document. These provisions require the careful attention of the principals as well as their respective accounting and legal advisors. Without such a team effort, they can become a trap for the unwary buyer or seller.

This Client Alert is intended to inform readers of recent developments in the field of Mergers & Acquisitions. It should not be considered as providing conclusive answers to specific legal problems. For additional information, please contact Skip Smart at 704-335-9031 or or Kent Workman at 704-335-9064 or