The working capital adjustment is a key component of purchase agreements and is often a feared and misunderstood term in merger and acquisition (“M&A”) transactions. A significant amount of company value can be gained or lost if this mechanism isn’t carefully structured and negotiated to consider the Company’s unique working capital situation. Having a strong understanding of accounting, along with detailed knowledge of the Company’s accounting and operations, is crucial for effectively negotiating this provision.
At the end of a successful M&A process, the Company valuation is agreed upon by the seller and the buyer, and the main terms and conditions of the sale are outlined in the Letter of Intent (“LOI”). The buyer plans to acquire the assets necessary for the Company’s ongoing operations. One of those assets includes the working capital required for the business’s future operations.
The Net Working Capital adjustment assures the buyer that, at closing, the purchased company will have sufficient working capital to operate without requiring a large immediate capital injection. Since a typical M&A sale is on a cash-free, debt-free basis, the calculation of the working capital to be delivered must be adjusted to exclude the cash and debt balances and any deal-related items to determine the net working capital value.
Furthermore, the working capital adjustment is a dynamic calculation that also helps credit the seller for any extraordinary company operating performance after the valuation is agreed upon in the LOI, up to the closing date, which is typically several months later.
It is important to understand that, in general, neither the buyer nor the seller should benefit from the net working capital adjustment related to the purchase price. Working capital is simply one of the assets included in an M&A deal based on the agreed-upon company valuation, and this adjustment ensures that an appropriate amount is provided at closing. However, buyers and sellers need to be aware of potential issues and pitfalls to ensure a fair working capital provision is negotiated as part of the deal.
Working Capital Basics
The starting point is understanding the Company’s accounting-based working capital components and identifying the needed adjustments to create an accurate picture of working capital over the past several years. Additionally, in preparation for an M&A deal, we believe it’s essential to produce a Quality of Earnings report that focuses on reviewing the Company’s financial information from a deal perspective, including the working capital components and the related deal adjustments required to determine a net working capital adjustment.
The following exhibit describes the usual components of working capital in accounting.
Working Capital Components
- Accounts Receivable (related A/R reserves)
- Inventory
- Prepaid Expenses
- Cash & Marketable Securities*
- Accounts Payable
- Accrued Expenses Relative to Employees (including wages, vacation, bonus, payroll taxes, etc.)
- Accured Rents & Utilities
- Other Accrued Expenses
- Deferred Revenues
- Short Term Debt & Current Maturities of Long-Term Debt*
*Accounts that are included in “Accounting Working Capital” but excluded in the “Net Working Capital.”
The accounting working capital information is then adjusted for deal-related items. First, companies are sold on a cash-free and debt-free basis, meaning that all cash, short-term investments, debt accounts, and accrued interest are removed. Second, any deal-related items, such as accrued attorney fees and accrued deal bonuses, etc., should be eliminated from the working capital calculation and included elsewhere in the deal documents, typically on the closing funds flow statement.
Another key aspect of preparing net working capital adjustments involves timing and updating accrual valuations, such as vacation accruals, bonus accruals, and other accounts that are not frequently adjusted but are typically reviewed periodically throughout the year. These accruals should be examined and updated to reflect accurate values as of the closing date. Note that sometimes, buyers prefer to exclude payroll-related accruals from working capital adjustments and treat them as debt-like liabilities, thereby including them in the seller’s retained debt balance. Although the impact of either approach is the same at closing, we believe payroll accruals should be included in the working capital adjustment to ensure they are accurately reflected during the true-up procedures explained later.
Additionally, receivables and inventory should be carefully reviewed, and any uncollectible receivables and obsolete inventory should be reserved for, written down, or written off in preparation for a sale. Based on our experience, these kinds of adjustments can catch sellers off guard, so it is best to address them early.
Work closely with your deal team to develop your formula for the net working capital mechanism and justify the calculation. Also, gather your net working capital data by month for at least the past 12 to 24 months so it can be used to establish the net working capital target.
The Net Working Capital Target
As previously discussed, working capital is a key asset that a buyer typically expects when purchasing a company. The buyer expects a reasonable amount of working capital, enough to run the business without needing an immediate infusion of additional funds. This level of working capital will serve as the target.
Using the working capital data collected over the past 12 to 24 months, the seller typically starts with a 12-month average of working capital. This amount is then compared to each individual month to see if it is above or below, and by how much. If the business shows a seasonal pattern, a shorter average period can be used to ensure the working capital target matches the quarter or period when the closing will occur. Additionally, if the Company is experiencing strong growth, the seller should be cautious when setting the target. The seller should provide a working capital measure that reflects past growth but not future growth. To handle higher growth situations, the working capital target may be based on a shorter timeframe, such as the last six months, to capture more recent growth; however, the seller should exercise caution. These cases require a thorough understanding of the Company’s working capital dynamics and a carefully negotiated target.
The target is crucial for adjusting net working capital and is key to developing a fair adjustment. Careful analysis and clear justification are necessary to successfully negotiate an appropriate target with the buyer.
The Typical Net Working Capital Procedure
Preparation is the initial step in establishing a working capital adjustment mechanism. Gathering monthly historical working capital data helps identify the Company’s working capital trends. Conducting a Quality of Earnings analysis provides additional insight and increases the credibility of the data and calculations.
All excess and outdated inventory, along with accounts receivable experiencing collection difficulties, should be addressed promptly to avoid issues during the M&A process.
Once the deal moves to the management meeting phase, it’s important to give potential buyers a detailed overview of the working capital accounts, allowing them to perform their own analysis. It’s also useful to discuss working capital issues during the management meeting to help guide potential buyers’ analysis and to clarify the seller’s stance on the working capital adjustment.
After management meetings, the instruction letter for the LOI should specify that a net working capital provision be included, and that the buyer clearly outlines the accounts, calculations, and approach to reaching a working capital target. At this stage, actual working capital figures will still be subject to due diligence, but the mechanism can be defined. This allows any issues related to this part of the agreement to be addressed before the LOI is accepted. The net working capital provision is an important detail in the LOI and can greatly influence the selection of potential buyers. Once the buyer is chosen, the LOI, including the Net Working Capital adjustment, is finalized during due diligence and incorporated into the Purchase Agreement. Besides the working capital adjustment mechanism, the Purchase Agreement generally specifies a working capital escrow that will be released after reviewing the working capital post-closing in the true-up procedures.
At the transaction closing date, since the Company’s financial information is usually a modestly adjusted trial balance, the seller prepares an estimated closing balance sheet that includes the working capital accounts. Using the terms and formula from the Purchase Agreement, the adjusted working capital balance is compared to the target. Any excess above the target results in additional cash to the seller, while any shortfall is deducted from the cash owed to the seller. This represents the initial adjustment to working capital.
The purchase agreement typically states that the initial working capital adjustment will be reviewed or “true-up” within 60 to 90 days after closing. By that time, the books and records are settled, making the actual working capital adjustment clearer. The true-up amount is compared to the closing value, with any shortfall deducted from the working capital escrow and any overage added to it, which is then returned to the seller.
If disputes occur during the final working capital adjustment, the purchase agreement typically delineates provisions that involve external resources to resolve the issue through arbitration.
Potential Issues and Pitfalls in Working Capital Adjustments
The working capital adjustment is not meant to manipulate the purchase price. When establishing a working capital adjustment, it’s important to understand its purpose. It is not intended to extract more value from the buyer or to reduce the price paid to the seller. Instead, it ensures that a stable level of working capital is maintained at closing, allowing the business to operate smoothly at the agreed valuation. Although there may be gray areas in how the adjustment is applied, these can be fairly resolved if both the buyer and seller respect the purpose of the working capital adjustments.
Working capital definition and adjustments require careful attention to the accounts included and their accurate valuation. In the accrual area, ensure that vacation, bonus, and other payroll accruals are current through the closing date. Review inventory and address excess, stale, out-of-date, or damaged items. Confirm that accounts receivable are collectible and that bad debt reserves are adequate. Identify and eliminate all shareholder- and deal-related short-term liabilities and assets. Ultimately, working capital should only include the accounts and amounts necessary for the buyer to operate the business smoothly after closing.
Seasonality and setting the right working capital target are important. While a common approach for determining the working capital target is using the 12-month average balance, some seasonal businesses need a different method. Companies like retailers and agricultural businesses, which experience volatile working capital cycles, should review several years of monthly data and set a target at the closing date that reflects their seasonal patterns. The main goal of this adjustment is to ensure that the working capital amount matches what the Company needs to support its operations at the closing date.
Companies with large deposits and deferred revenue transactions. Sometimes companies collect deposits or advance payments for future services or products. These companies receive cash upfront and record a liability for the future delivery of those services or products. Typically, this liability appears in short-term liabilities and working capital accounts. Since M&A transactions are usually conducted on a cash-free, debt-free basis, the seller retains the cash collected and leaves the buyer with the future obligation; clearly, this results in an unfair outcome for the buyer.
There are several ways to address this issue. Deferred revenue can be treated as a debt-like item and added to the obligations retained by the seller. Alternatively, the buyer and seller could agree on a cash reserve to cover future obligations. In any case, understanding the situation thoroughly and applying the correct accounting practices will help facilitate a fair negotiation.
Generally accepted accounting principles (“GAAP”) and deviations. The primary accounting method for adjusting working capital will be GAAP, applied consistently with the Company’s historical practices which is documented in the purchase agreement. However, there are instances where multiple GAAP treatments may apply, or the selling company uses a different accounting methodology. In such cases, these deviations should be carefully documented in the purchase agreement and supported by examples to ensure full GAAP deviation transparency.
Purchase agreement documentation should thoroughly record all provisions and details related to the working capital adjustment. Since this involves a financial and technical business matter, it may not be properly documented by the legal team in the agreement. The M&A advisor and the seller’s CFO must ensure that all details are accurately included in the purchase agreement. It is also recommended to list the actual working capital account names and their chart of account numbers as an exhibit to avoid confusion on what accounts are included. Additionally, including sample calculations as an exhibit can help clarify how the adjustment will be made.
Avoid manipulating the working capital adjustment system. The seller provides a business that is free of cash and debt to the buyer. As a result, the seller keeps the cash and is responsible for paying off debts at closing. Knowing this, the seller might try to game the system and collect accounts receivable faster or delay payments to vendors to generate more cash or reduce debt before closing. If the target is set correctly, the working capital delivered at closing will be lower due to a decreased balance of receivables or an increased balance of payables, meaning any cash produced or saved through these tactics will be offset by a negative working capital adjustment to the seller. Again, working capital adjustments are meant to ensure that neither the buyer nor the seller benefits unfairly but instead are used to establish an appropriate amount of working capital at closing. So, sellers should not try to game the system.
What about a large sale occurring between the LOI and the deal closing? Sometimes, a seller may make a significant sale after agreeing on a purchase price in the LOI. The seller might reasonably expect the buyer to compensate them for this substantial one-time sale since it wasn’t included in the original valuation. However, a properly structured working capital adjustment should already provide a mechanism to account for this extra value.
If the working capital target is set correctly, at closing, the seller will provide the buyer with working capital that reflects normal operations. A large sale after the LOI can cause a noticeable increase in accounts receivable, a decrease in inventory for the cost of goods of the large sale, and potentially an increase in accrued wages payable for overtime hours incurred for the large sale. Overall, the net effect of these changes in account balances is that the seller receives a positive working capital adjustment, capturing the contribution margin due to the extraordinary sale after the LOI but before closing.
Conclusions
Remember, the working capital adjustment aims to provide enough working capital for the next owner to operate the business without needing a large new investment. Although working capital adjustments may seem confusing and intimidating, they don’t have to be. A basic understanding of accounting and the seller’s business is all that’s needed to create an effective mechanism.
Anthony Dolan is a Managing Director at Prairie Capital Advisors, Inc. He can be contacted at 630.413.5587or by email adolan@prairiecap.com.
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