Establishing Precedence Clauses in Cross-Border Earn out Agreements
Explicit precedence clauses in cross-border earn-out agreements prevent accounting schedules from overriding core legal risk allocations and governing law provisions.
Working Capital Adjustments
Meaning
Purchase price mechanisms in acquisition agreements align the final cash payment with the actual net current assets of the target company on the day of closing. Through working capital adjustments, the parties compare the actual working capital at completion to a pre-defined target amount to calculate the final transaction value. This process ensures that the buyer does not pay for a business stripped of its operating assets.
It applies to transactions where working capital fluctuates between signing and closing.
Baseline Comparison
The target working capital is usually based on the average working capital of the business over the preceding twelve months to account for seasonality. When working capital adjustments are calculated, any deficit below this baseline results in a reduction of the purchase price. Conversely, any surplus above the baseline results in an increase in the purchase price.
This comparison provides a fair adjustment that reflects the actual cash requirements of the business.
Balance Calculation
Current assets and current liabilities are defined in the purchase agreement to establish exactly which items are included in the calculation. Cash, debt, and transaction expenses are typically excluded from these working capital calculations since they are adjusted separately. By defining these categories, the parties prevent double-counting of liabilities.
The closing balance sheet is prepared by the buyer’s accountants and submitted to the seller for review. This step ensures the numbers are verified against the agreed accounting policies.
Settlement Mechanism
Once the final working capital is agreed or determined, the resulting payment is made to adjust the initial purchase price. If a dispute arises over the calculation, it is referred to an independent accountant for final determination. The payment is often secured by a portion of the purchase price held in an escrow account.
This financial buffer ensures that the buyer can recover any deficit without having to sue the seller. Escrow release marks the final settlement of the purchase price adjustments. This settlement is legally binding and prevents the parties from reopening the financial accounts of the transaction, providing complete closure to the corporate deal after the post-closing period concludes.