In a typical company acquisition, the target company can be thought of as a profit-generating system. The presence of working capital is a necessary condition for the proper operation of this system.

When the target company’s working capital changes before the deal completes, working capital adjustments to the purchase price ensure that the buyer and the seller receive the fair value of this system to maintain operations and profits – which results in adjustments to the purchase price.

Therefore, it’s vital to answer the following questions in any transaction:

  • What does “working capital” mean in that transaction and for that business?
  • What is the normal or average level of working capital for the company that is sufficient to maintain day-to-day operations?
  • What financial position will the company be in at the time that the deal completes?

Working capital isn’t the usual accounting definition.

When valuing a target, an interested buyer will assume that a typical net operating working capital level will exist to sustain the company’s current level of revenue when acquiring a company. The buyer will expect that the company is delivered to it with a specified net working capital sum in addition to the fair market value of the company’s capital assets – and this combined total supports the total enterprise value of the company.

The typical accounting definition of “working capital” is the difference between current liabilities and current assets (such as cash, accounts receivable, unpaid customer bills, etc.). This metric evaluates a company’s short-term financial health, operational effectiveness, and liquidity. Positive working capital often has room for expansion and capital investments. Conversely, a company with obligations that exceed its assets (negative working capital) is more likely to struggle to grow or pay back creditors and may be at risk of insolvency.

However, during the negotiations, savvy parties tend to employ definitions that are particularly advantageous to their respective positions.  For example:

  • Do we average the working capital of the business over a 12-month period?
  • Are there unique factors in the business that can influence this working capital average, such as one-time events, seasonality effects, or other periodic impacts to the seller company’s level of working capital?

There are innumerable ways to define and interpret each current asset and liability in the context of a transaction. In addition, purchasers and vendors may hold divergent views regarding the treatment of working capital items for the purposes of the transaction. So, as a first step, the buyer and seller must first agree on the contractual definition of working capital and hardwire it in the sale agreement.

What is a working capital adjustment?

A working capital adjustment is a transaction-related modification to the purchase price depending on the agreed working capital of the target company on the completion date.

It usually occurs between 90 and 120 days after completion of the deal when all financial information up to completion date is available and gives the parties sufficient time to analyse this information to form an accurate picture of working capital.

It works like this:

  • If working capital at completion of the deal is insufficient, the buyer will need to contribute additional funds to support operations, which raises the effective purchase price for the buyer. To avoid the buyer losing value, the way it plays out in a sale agreement to is that, if actual working capital at completion is less than the agreed target for working capital, the purchase price is adjusted downward because there is a shortfall between the working capital delivered by the seller and target level of working capital.
  • On the other hand, if actual working capital at completion is more than the target, then the seller is handing additional value to the buyer. Here, the purchase price is adjusted upward because the seller has delivered a higher-level of the working capital than the target amount.
  • If there is a shortfall – the seller pays back some of the completion funds to the buyer.
  • If there too much working capital – the buyer pays that difference to the seller.

Take Aways

In an M&A deal, parties must ensure they understand:

  1. the methodology used to determine working capital;
  2. the amount of net operating working capital required to maintain current profit levels; and
  3. how these figures can be manipulated.

Our experience has taught us that a well-written purchase price adjustment clause in the agreement, with plain language and adjustment procedures, is crucial for avoiding post-transaction disputes.

Given that price is unquestionably the most crucial variable in a transaction and that the working capital adjustment can influence price, it follows that the working capital adjustment merits special consideration.