Buyer’s purchase price adjustment mechanism based upon a post-closing inventory audit survives seller challenge in court

Seller was a distributor of compressed gases and welding supplies in Indiana. Seller sold substantially all of its assets to Buyer including its stock of asset cylinders, pursuant to an October 2014 asset purchase agreement. As part of the asset purchase agreement, Buyer paid Seller $1.6 million for Seller’s assets, of which the primary assets were its asset cylinders.

Seller rented the asset cylinders to businesses in need of compressed gas for use in their operations, including restaurants or convenience stores which rented carbon dioxide cylinders for soda fountains that must then be refilled on a regular basis. As a result, a critical factor in determining the appropriate price for the sale of Seller’s assets was the number of asset cylinders that could be transferred.

The sales price was based in part on Seller’s representation that there were approximately 6,500 cylinders. Buyer and Seller could not ascertain a precise count of the cylinders that would be transferred at the closing because many cylinders were “out in the field” with customers. Therefore, the asset purchase agreement provided that Buyer would conduct a post-closing audit of the cylinders.

The agreement purchase agreement further called for a purchase price adjustment based upon the post-closing audit of the cylinders. The purchase price would be increased if the audit found more than 6,500 cylinders at the rate of $125 per cylinder; or decreased at the same rate to the extent the audit found less than 6,500 cylinders.

Buyer’s risk that the Seller’s cylinder inventory was between 5,300 and 6,500 cylinders was secured by Buyer holding back $150K of the purchase price. Buyer had to complete the audit by April 15, 2015. The audit took longer than planned and Seller orally agreed to extend the audit and it was completed on May 22, 2015, before expiration of the extended deadline.

The audit found that Seller had under 4,700 cylinders; well below the Seller’s representation of approximately 6,500 cylinders. Furthermore, Buyer’s $150K holdback of the purchase price protected Buyer for part of the shrinkage, leaving Buyer exposed to a loss of about 700 cylinders at $125/cylinder (that is, the difference between Buyer’s loss down to 5,300 cylinders and the number of cylinders the audit said Buyer purchased from Seller; approximately 4,700 cylinders).

As a result of the audit Buyer kept the $150K holdback. Seller sued Buyer in an Indiana federal district court for the $150K holdback. Buyer counterclaimed saying that it should not only keep the $150K of held back purchase price but Buyer was also entitled to receive damages for the additional 600-cylinder shortfall computed at the rate of $125/cylinder. The trial court agreed with Buyer and Seller appealed.  Seller also lost on appeal.

This case is referred to Arc Welding Supply Co., Inc. v. American Welding & Gas, Inc., No. 18-1546, United States Court of Appeals, Seventh Circuit., (Decided February 14, 2019).

Comment. Purchase price adjustments are commonly used. In this case the real unknown at closing was the number of Seller’s cylinders; cylinders being a major value factor for the business. An inventory audit after the closing helped determine the correct purchase price.  And securing the risk that Seller’s inventory level representation and warranty was optimistic with a Buyer $150K holdback of the purchase price helped minimize Buyer’s exposure to that risk.

By John McCauley: I help people start, grow, buy and sell their businesses.



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