When selling a business it is common for the purchase and sale contract to include one or more adjustments to the purchase price. Adjustments may occur at the time of closing or following closing or both, depending on the availability of financial information. For example, it is common for a vendor and purchaser to agree on a working capital adjustment to be completed within a 60-90 day period following closing, once closing financial statements are prepared and settled. Occasionally, depending on the nature of the business, there may be other adjustments which take place at closing or after closing. While adjustments are often the subject of much negotiation, customary adjustments such as the working capital adjustment have largely become standardized among accountants and lawyers.
The relatively recent decision of the British Columbia Court of Appeal in Close v. Weigh West Marine Resort Incorporated, 2009 BCAA 216 illustrates the need for purchasers and vendors to carefully think about customizing adjustments and the possibility of readjustment following the preparation of post-closing financial statements.
In Close v. Weigh, the vendor, Mr. Close, was selling all of the shares in his company which carried on a fishing resort business in the Tofino area. The share purchase agreement provided that on closing the purchaser was to pay the purchase price subject to three adjustments.
The agreement included what was essentially a working capital adjustment to be completed after closing using holdback funds, an assumed indebtedness adjustment, and an adjustment for one half of the cost of certain seasonal preparation costs (fishing boat motors). The latter two adjustments to the purchase price were to be made on closing.
The seasonal preparation cost adjustment called for an increase to the purchase price equal to one half of the costs actually incurred by the target company in connection with buying new boat motors for the upcoming season. On closing, using information provided by the vendor’s accountants, the purchaser prepared a statement of adjustments which included an upward adjustment to the purchase price for newly purchased boat motors. After closing, upon receiving financial information for the working capital adjustment, the purchaser discovered that the vendor had received substantial trade-in credits for last season’s boat motors but failed to apply those credits to reduce the seasonal preparation costs of which the purchaser paid half.
At summary trial the judge found that the words “actually incurred” in the seasonal preparation costs clause meant that the costs to be taken into account and shared by the purchaser were the net seasonal preparation costs after deducting trade-in credits received by the target company. While that seemed a fair result, the Court of Appeal did not agree.
Relying on the legal doctrine of merger, the Court of Appeal held that the adjustment to the purchase price on account of seasonal preparation costs was merged on the closing of the transaction, and it was not open to the purchaser to seek a readjustment of it after closing unless such readjustment related to a breach of a representation, warranty, covenant or agreement contained in the agreement (which expressly survived closing) or unless there was a mutual mistake in making the adjustment. The Court of Appeal found there had been no such breach or mutual mistake. Rather the dispute between the vendor and the purchaser was over the meaning of seasonal preparation costs and whether the trade-in credits were to be included. The Court of Appeal also pointed out the purchaser itself had prepared the statement of adjustments used to close the transaction.
The purchaser could have avoided this result if it had drafted an appropriate seasonal adjustment clause that expressly accounted for trade-in credits.
- Due diligence results (particularly financial due diligence results) should be carefully considered when drafting adjustment clauses. Presumably the vendor in the Close v. Weight case had received trade-in credits in prior years. That fact should have been discovered during the due diligence process and factored into the seasonal preparation cost clause.
- Do not assume working capital and other adjustment calculations will be standard or made in accordance with GAAP. Often there will be a need to modify standard adjustment clauses or GAAP calculations in connection with certain items or practices discovered in financial statements. Accountants and financial advisors should be considering such modifications during the due diligence process.
- Use examples to illustrate adjustments. Running through examples will often raise issues that were not previously considered.
- Consider a post-closing readjustment clause or a post-closing mutual undertakings to readjust if financial information will not be complete and final on closing.
- If you want finality on closing, make that clear in the adjustment clause in order to invoke the doctrine of merger.