Overview
Working capital is the short-term capital necessary to run a business and is typically defined as current assets minus current liabilities. Working capital is an important, complex, and potentially overlooked component of M&A transactions. The treatment of working capital in a purchase agreement can have a major impact not only on the final purchase price but also on the ability of the buyer to continue operating the company on day one without an additional capital infusion.
Kroll’s Navigating Working Capital in M&A Transactions provides a comprehensive overview of the critical role working capital plays in mergers and acquisitions. The guidebook outlines in detail the process of designing, negotiating, and implementing a working capital purchase price adjustment mechanism and highlights the key considerations for buyers and sellers at every step in the process. The guidebook also includes a detailed appendix outlining special issues associated with each of the most common balance sheet line items in working capital.
The Working Capital Adjustment and Why It Matters for M&A Deals
Most M&A transactions are negotiated with the understanding that the seller will deliver a normalized level of working capital to the buyer. To bolster this requirement, many transactions will include a working capital purchase price adjustment mechanism, which involves comparing working capital delivered at close to a target value agreed upon by the buyer and seller. If actual working capital exceeds the target, the purchase price is increased by the amount of the excess. Likewise if actual working capital falls short of the target, the purchase price is decreased by the amount of the shortfall.
The primary purposes of a working capital adjustment are:
- To ensure enough working capital remains in the business at close to support the company’s operations.
- To protect both the buyer and the seller from unexpected fluctuations in working capital prior to close.
- To deter the seller from taking actions outside the normal course of business that may impact the amount of working capital delivered to the buyer.
The structure of the working capital adjustment mechanism protects both the buyer and seller from unexpected fluctuations in working capital. If the seller delivers more working capital at close than anticipated, they receive compensation for the excess via an increase in the purchase price. Likewise, if the seller delivers less working capital at close than anticipated, the buyer receives compensation for the deficiency via a decrease in the purchase price. In addition, the mechanism discourages the seller from taking actions outside the normal course of business to extract cash prior to close.
Working capital adjustments may be capped at a certain maximum amount or unlimited. They may also be two-way (adjusting the purchase price upward or downward) or only one-way (only adjusting in one direction). It is also common for the parties to set a “basket” or “collar”, in which the purchase price is adjusted only if the potential adjustment exceeds a certain threshold (e.g., $200,000).
The working capital adjustment provides to the buyer and seller these protections within a structure that has a direct effect on the purchase price. Raising the working capital target by a dollar is functionally equivalent to lowering the base purchase price by a dollar. Unfortunately, unlike other aspects of the deal, where valuation differences between buyer and seller can be bridged with creative structures like earn-outs, the working capital adjustment is essentially a zero-sum negotiation. As a result, there is potentially a higher likelihood of disputes, both during the initial negotiations and when the mechanism is settled post-close. In addition, while a lot of time and effort is typically spent coming to an agreement on the base purchase price either through an auction process or a private negotiation, working capital tends to be an afterthought, even though the working capital adjustment can have just as much impact on the final purchase price.
Due to the unique circumstances inherent in any M&A transaction, there cannot be a cookie-cutter approach to working capital adjustments. The mechanism must be tailored to the deal. However, a few broad principles can be applied to help prevent disputes and achieve the key objectives of the mechanism:
1. Try to avoid large adjustments - Neither party is likely to react well to the prospect of having to make a large purchase price concession at the end of a process. Disputes and damaged relationships are more likely to occur when a substantial working capital adjustment occurs, even if the terms were clearly understood by all in advance. While adjustments are necessary and appropriate when working capital fluctuates in a truly unexpected way prior to close, the mechanism should be designed in a manner that reduces the likelihood of a large adjustment in either direction.
Most importantly, it is highly risky for either party to attempt to use the working capital mechanism to try to achieve a final purchase price that is materially different from the initial agreed-upon value. Basket provisions, which forego an adjustment if the total amount of the adjustment would be below some threshold, are useful in promoting goodwill between the parties and preventing either side from feeling like they are being nickel-and-dimed.
2. Be specific - Working capital disputes are more likely to arise when there is ambiguity in the purchase agreement about how the working capital adjustment will be implemented. Generally accepted accounting principles (“GAAP”) can be used as a guide, but should not be considered black-and-white. GAAP is subject to interpretation, requires estimates on the part of management, and in some cases offers multiple reporting options.
In addition, while GAAP can be a useful default in many cases, there should be no presumption that it is the right basis on which to report closing working capital. The parties might reasonably agree that some other basis more accurately reflects their interests and concerns. As such, being as specific as possible about how certain balances should be measured (including showing detailed example calculations in the purchase agreement) can prevent many disputes and help resolve disputes more predictably when they do arise.
3. Be consistent - The working capital mechanism should be designed in a manner that is consistent with the overall deal. If certain assets or liabilities are excluded from the transaction, they should also be excluded from the working capital definition. Similarly, the working capital target should be set on a basis that is consistent with how working capital will be measured at close. Any potential exposures being handled via indemnification should be excluded from the working capital adjustment in order to avoid double-counting.
4. Rely on professional advisors - Financial diligence advisors will have a deep understanding of the detailed components of working capital and can be useful in helping determine what should be included in the definition of working capital, how key balances should be measured, and how much working capital is expected to be delivered at close. While the buyer will almost always employ the services a buy-side financial diligence advisor, it can also be helpful for the seller to employ a sell-side advisor, who can help the seller navigate the complexities of negotiating a working capital adjustment and ensure the seller is fully prepared for all aspects of the working capital negotiations.
Kroll provides an array of solutions for implementing a working capital adjustment mechanism.
For more information, please contact Mark Kramer or any member of the Kroll Transaction Advisory Services team.
