Working Capital Adjustments

The M&A Clause that can change your purchase price

By Delzad Kutky

Working capital adjustments are among the most common purchase price adjustment mechanisms in mergers and acquisitions (M&A). They can help buyers and sellers arrive at a fair price while accommodating the uncertainty that exists in the time between signing a purchase agreement and closing a transaction. However, a working capital adjustment is more than an accounting calculation. The purchase agreement determines the rules of the calculation, and those rules can materially affect the final purchase price.

For a business owner buying or selling a company, understanding those rules is critical. For accountants advising clients on M&A transactions, understanding how the accounting calculation interacts with the purchase agreement can help identify issues before they become post-closing disputes.

What Is Working Capital?

Working capital is commonly described as a business’ current assets minus its current liabilities. It provides an indication of the resources available to support the business' ongoing operations.

In an M&A transaction, however, the accounting concept is only the starting point. The purchase agreement typically determines which assets and liabilities are included in “Working Capital” for the purposes of the transaction. For example, accounts receivable, inventory, accounts payable, accrued liabilities, prepaid expenses, taxes and deferred revenue may be treated differently depending on the terms of the agreement and the nature of the business.

This distinction is important because two parties can look at the same balance sheet and arrive at different working capital amounts depending on the rules they apply.

What Is A Working Capital Adjustment And How Does It Work?

When a business is sold, the buyer generally expects to receive the business with a level of working capital sufficient to operate in the ordinary course after closing. The seller, meanwhile, generally expects to receive the negotiated purchase price without being required to leave behind more working capital than the business reasonably needs.

To address this, the purchase agreement may establish a target working capital amount based on the business’ historical performance, growth, seasonality and expected operating requirements. The Working Capital actually delivered at closing is then compared with that target. If the business is delivered with less than the agreed target, the purchase price may be reduced. If it is delivered with more, the purchase price may increase, depending on the terms of the agreement.

For example, suppose Company A is being sold for $2 million, with a target Working Capital of $300,000. After closing, the buyer calculates Working Capital at $200,000. If the calculation is consistent with the purchase agreement and is not disputed, the purchase price would be reduced by $100,000.

The important question, however, is not simply whether the calculation is mathematically correct. It is whether the accounting methodology, including the assets and liabilities included in the calculation, follows the terms agreed to in the purchase agreement. Consider a situation where the balance sheet says the corporation has $500,000 of receivables. However, $100,000 relates to accounts that are 120+ days old. Is that $100,000 really working capital the buyer is receiving? A well-drafted purchase agreement should address exactly how working capital is calculated to avoid a situation like this where a dispute is likely to arise.

A target should also reflect the business' circumstances. A simple historical average may not be appropriate for a rapidly growing or highly seasonal business. For example, a retailer's working capital requirements immediately before the holiday season may look very different from those during a slower period.

What Should I Look Out For In My Working Capital Adjustment Clause?

Working capital adjustments are a frequent source of post-closing disputes. Some important issues to consider include:

1. Working Capital Calculation:

The agreement should clearly identify what is included and excluded from Working Capital. Issues can arise over aged accounts receivable, obsolete inventory, prepaid expenses, customer deposits, deferred revenue, taxes and unusual or non-recurring liabilities. Simply relying on “current assets minus current liabilities” may leave too much room for disagreement. For example, an aged receivable may appear as a current asset on the balance sheet but may have little practical value to the buyer.

2. Alignment in Accounting Methodology:

The purchase agreement should establish how Working Capital will be calculated and the accounting principles that will apply. The methodology should be consistent with the parties' negotiations and, where appropriate, the business' historical accounting practices. Otherwise, the parties may reach different conclusions using the same underlying financial information.

3. Setting the Target:

The target is just as important as the calculation itself. Buyers and sellers should consider historical results, recent growth, seasonality, changes in the business and the level of working capital actually required to operate the business in the ordinary course. A poorly established target can create a significant adjustment even when both parties agree on how Working Capital should be calculated.

4. The Closing and Post-Closing Process:

The agreement should clearly establish who prepares the closing statement, when it must be delivered, how long the other party has to review it and how disagreements are raised. These provisions can be particularly important because one party may initially control the preparation of the calculation.

5. Dispute Resolution:

A well-drafted clause should establish a practical process for resolving disputes, including who will make the final determination if the parties cannot agree. Clear procedures can help avoid turning a disagreement over accounting methodology into expensive litigation. In many cases, the purchase agreement will require unresolved disputes to be referred to an independent accountant or other agreed decision-maker, and define the scope of that person's authority.

For Buyers And Sellers

If you are buying a business, consider whether the target represents the working capital the business actually needs to operate after closing and whether unusual assets or liabilities could distort the calculation.

If you are selling a business, consider whether the target is achievable based on the business' actual operating history and whether the adjustment mechanism could unexpectedly reduce your sale proceeds.

For Accountants Advising M&A Clients

Working capital adjustments sit at the intersection of accounting and contract interpretation. An accountant may be responsible for preparing or reviewing the financial calculation, but the purchase agreement determines the rules under which that calculation is performed.

It is worth addressing these issues before the purchase agreement is signed, when there is still an opportunity to negotiate the definition, target and methodology. SorbaraLAW's corporate and commercial lawyers can work with buyers, sellers and their accounting advisors to identify potential working capital issues early and structure an adjustment mechanism that accurately reflects the transaction the parties have negotiated.