Working Capital Adjustments: Ensuring That The Price Is Really Right

Working capital adjustments have evolved. No longer are they merely a means of addressing the pricing challenge posed by cash-flow volatility in the target business. Today they are used to determine the final purchase price. The first half of this post addresses the calculation of working capital and suggests some key questions to ask when drafting these clauses. In the second half, we look at issues relating to disputes arising out of working capital adjustments and provide a list of best practices when negotiating these clauses.

The Evolution of Working Capital Adjustments

Historically, the purpose of the working capital adjustment was typically to ensure that the acquired business came with just enough cash to carry on with its ordinary-course operations in the immediate post-closing period. In this form, working capital adjustments are a two-way street: in addition to ensuring that the purchaser does not have to inject new capital to the business just to keep it running, they also help to ensure that the purchaser does not receive an unbargained-for windfall if there happens to be an excess of cash in the business at the time of closing. By allowing the parties to "wait and see" how much working capital the business actually has at the time of closing, rather than forcing them to try to agree on an estimate of that amount in advance, the working capital adjustment mechanism also had the advantages of reducing transactional costs and allowing some transactions to move forward than might otherwise have stalled over this issue.

The efficiency and potentially broader applicability of this approach did not go unnoticed. Parties to transactions soon began to use working capital adjustments to deal with other types of transactional uncertainty. In today's competitive deal environment, where purchase prices are often established before due diligence is complete (e.g. during an auction process), working capital adjustments often function as a means of determining the final purchase price, rather than merely as a means of adjusting the price up or down to compensate for mostly minor deviations in the cash position of the target business at the time of closing.

Calculating Working Capital

Definition

"Working capital" is broadly defined as current assets less current liabilities:

"Current assets" are those assets which are turned into cash within a period of one year. Examples include: Cash and cash equivalents;[1] Inventories; Accounts receivable; and Prepaid expenses (often limited to those that are of ongoing benefit to the buyer). "Current liabilities" are those liabilities which are due within a period of one year: Short-term debt; Accounts payable; and Accrued liabilities or "reserves". While the formula can be stated simply as "current assets less current liabilities", capturing the parties' exact intentions with an effective working capital provision can be a challenge.

The working capital target

The working capital target, a central concept in the working capital calculation, is an estimate typically based on normalized[2] historical averages for the date of closing. After closing (usually within a specified period, e.g. 60 or 90 days), the purchaser must produce a finalized calculation of the actual working capital on the closing date, which will be normalized in the same manner as the target. The difference, if any, between this finalized calculation and the target will generally determine the amount of the working capital adjustment as well as its beneficiary.[3] Working capital adjustments are usually, but not always, two-way adjustments and sometimes have a band or minimum that must be met before an adjustment is payable.

Questions to ask

Working capital calculations can be complex, in part because they need to reflect the particular situation to which they are going to be applied. Drafting an effective working capital provision will therefore typically require counsel and their clients to think carefully about questions such as the following:

What should be excluded from the working capital calculation?

It is important to ensure that items are not included under "current assets" and "current liabilities" if they were intended to be dealt with separately elsewhere in the purchase agreement. Suppose, for example, that in an asset purchase transaction, the buyer is not assuming accrued employment obligations, such as vacation pay, at closing. In that case, those items should not be listed as "current liabilities" for working capital purposes, as the seller could otherwise end up "compensating" the buyer for obligations that the buyer hasn't actually assumed. The same will often be true of ongoing litigation costs and accrued tax liabilities where these are dealt with independently in the agreement.

In short, understanding the interaction of the "working capital" definition with other provisions of the agreement will often be an important prerequisite to a successful agreement (the Brim Holding...