An issue that often arises when bedding down transaction documents is what happens to a variation in net assets at the time of settlement. That is, what if the vendors siphon money from the business at the last minute by selling stock, PP&E or just taking cash straight from the bank?
Private equity firms generally value businesses on their forecast maintainable earnings. So, in theory, they should only be concerned with whether the business has the assets needed to support the forecast maintainable earnings. In practice though, this is a very subjective measure and private equity firms don’t like the idea of vendors using such tactics to shift value; it’s a matter of saving face.
A remedy is to apply a dollar-for-dollar net asset adjustment to the purchase price based on any variation to an agreed net asset figure. But creating an additional source of purchase price uptick creates an additional channel for price manipulation. So, in typical private equity style, the preference is to limit the adjustment to the downside (and not reimburse the vendors for any net asset change on the upside). But, as you can imagine, owners rarely welcome this.
For the sake of fairness, I believe the best net asset adjustment solution is to ensure there’s an effective earn out condition attached to the deal (to align interests at least in the first year) and include a downside dollar-for-dollar net asset adjustment with a lower trigger (that allows the business to operate as usual). If the vendors sell assets from the business at the last minute, they risk lower earnings in the current year and hence a reduction in their ear nout. Even in this case, the downside net asset adjustment trigger will limit them. This is a relatively complex solution, but possibly the fairest.