Guidance on Working Capital in M&A Transactions

Guidance on Working Capital in M&A Transactions

Given that working capital adjustments are very common in merger and acquisition transactions, it is important to understand how they work and how they could impact your deals. In basic terms, working capital is the difference between current assets and current liabilities. Of course, it’s never that simple, and M&A purchase agreements typically address the components of working capital that will be included and excluded from the deal. For instance, many M&A agreements exclude cash and long-term debt. Others may exclude certain liabilities, such as income taxes.

Calculating a Working Capital Target

Sellers are typically expected to deliver a certain amount of working capital when selling a business. That is because working capital reflects the current ongoing business activity of the business. The purpose of a working capital target is to set a level of working capital that the buyer and seller agree should be included. It is, ultimately, a negotiated number based on a variety of factors, and is traditionally thought of as an adjustment to purchase price. A higher target effectively reduces the purchase price while a lower target effectively increases the purchase price.

The requirement of sufficient working capital to fund ongoing operations is often first addressed in the letter of intent. As the negotiations proceed and the seller furnishes relevant due diligence, the target, and mechanism for calculating working capital, is further negotiated. For example, a deal might include a purchase price of $60 million and require the seller’s delivery of $10 million of working capital at closing.

Sellers with excess working capital can typically distribute it prior to closing, or, if not able to do so, can either receive an adjustment at closing or in a post-closing true-up process. Sellers with a working capital deficiency either have the purchase price reduced or a correction in the true-up process.

Working capital targets are generally determined by looking at the average monthly adjusted working capital over a defined period. The most appropriate method for determining working capital can vary from industry to industry and business to business. One common variation is an adjustment reflecting seasonality in a seller’s working capital. This occurs when a company’s sales vary significantly from season to season. In addition, businesses that provide products or services prior to receiving payment may also operate with negative working capital, which must also be considered when negotiating an acquisition.

Several Key Issues

Below are several key issues that should be considered when negotiating a working capital target:

• What is the industry norm?
• What unique characteristics of the business make its working capital vary from traditional levels?
• Does inventory fluctuate significantly from month to month? 
• What percentage of working capital is determined by sales?
• Do seasonal sales impact working capital levels?
• Is the business (and its working capital requirements) growing?
• Are revenues or liabilities appropriately allocable to pre-closing or post-closing activity?

In addition to determining a working capital target, the purchase agreement must determine how it will be calculated, i.e. generally accepted accounting principles (GAAP). It must also establish a dispute resolution mechanism should the parties be unable to reach a final figure after the closing.

Negotiating Working Capital Adjustments

During the M&A due diligence process, the buyer frequently identifies issues that may require adjustments to the initial target. Negotiations can be difficult because provisions that favor the buyer are typically unfavorable for the seller. For instance, the seller would prefer to have no working capital adjustment at all. While the buyer would want the agreement to allow only a downward adjustment. To resolve such impasses, agreements sometimes define working capital as a permissible range or establish a basket where working capital is only adjusted if it is a specific amount above or below the target.

In many M&A transactions, the buyer recalculates the working capital adjustment after the transaction closes in a true-up process. The true-up adjustment is typically made on a dollar-for-dollar basis. For instance, if the target is set at $10 million and the seller delivers only $8.5 million of working capital, the purchase price would be adjusted downward by $1.5 million. 

If the seller does not agree on the buyer’s true-up calculation, additional negotiations may be needed. If a deal can’t be reached, the parties may employ the dispute resolution process set forth in the agreement.

Do you have any questions? Would you like to discuss the matter further? If so, please contact me, Jeffrey Cassin, at 201-806-3364.