Working capital is essential to the operations of every business, making it a critically important component in many M&A transactions. From the buyer’s perspective, the purchase price it offers typically assumes that there will be a normal and sufficient level of working capital in the business so that it will be able to operate on a day-to-day basis post-closing, and therefore wants to ensure that the seller does not extract working capital prior to closing. From the seller’s perspective, if working capital levels at closing happen to be in excess of normal levels, the buyer should pay for that excess (or, if the excess is cash, seller should be permitted to extract it prior to closing). To balance the parties’ interests, many purchase agreements include a working capital adjustment, including a provision setting a working capital “target” or “peg”, and a mechanism adjusting the purchase price upwards or downwards, based on whether the actual working capital as of closing is above or below the target.
Net Working Capital Basics
Working capital is the capital of a business that is used in its day-to-day operations, calculated as the difference between a company’s current assets and its current liabilities. In short, it is the money available to fund a company’s near term obligations.
Establishing a Target Net Working Capital
Because deviations from the working capital target can result in dollar-for-dollar increases or decreases to the purchase price in a transaction, the target number is often highly scrutinized and negotiated. In determining the target, the parties often debate what is a “normal” level of working capital, taking into consideration factors such as whether there is any cyclicality or seasonality to the business that needs to be normalized, and whether there have been any extraordinary or non-recurring items impacting working capital that should be excluded. Using a 12 month look back period is a common approach in determining target working capital. However, the appropriate mechanism should take into account facts and circumstances specific to the business at hand.
Critical Drafting Considerations
Defining what is to be included and excluded from the definition of “working capital” is critically important to avoid post-closing disputes. Best practice is to be as precise as possible by specifying in the purchase agreement that working capital will be calculated using only certain enumerated current assets/current liabilities (either listed in the definition of working capital itself, or set forth as line items in an illustrative example of the working capital calculation). To achieve even greater precision, the parties may also opt to use the seller’s general account ledger names and account numbers to minimize disputes and confusion.
Further, it is also critically important to state how each of the itemized current assets and current liabilities included in working capital will be calculated. A buyer’s preference is to provide that items will be calculated in accordance with certain standardized accounting principles, such as GAAP. However, even under standardized accounting principles such as GAAP, there are often a number of acceptable alternatives for calculating certain assets or liabilities, giving a buyer some discretion that could have an impact on the working capital calculation. As such, a seller often prefers that working capital be calculated in accordance with the target company’s historical practices, eliminating the possibility that buyer employs different methodologies in its post-closing calculation and is thereby able to claw back purchase price via a working capital adjustment. Therefore, it is critically important to carefully define which accounting principles will apply in calculating working capital, and, if both GAAP and the historical practices of the target company are to apply (a common approach), the order of precedence between the two.
To ensure a party’s interests are appropriately protected, both buyer and seller and their accountants and financial advisors, should carefully review and negotiate the provisions of any purchase agreement related to working capital, including the working capital definition, the amount of the target working capital, the illustrative working capital calculation, and the definition of accounting methodology or principles.
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