Working Capital As A Purchase Price Adjustment Tool

Working capital adjustments were originally designed to ensure that enough cash remains in an acquired business to allow it to operate in the ordinary course post-closing without requiring a capital infusion by the new parent or shareholder(s), or to compensate the purchaser or vendor in the event that there is too little or too much cash, respectively, in comparison with what is needed to support the business' ordinary course operations. This is typically accomplished by specifying a working capital "peg" (an estimate calculated based on normalized historical averages) as of the closing date. Within a 60 or 90 day period after closing, the actual normalized working capital as of the closing date is calculated and compared against the peg, and the purchase price is typically adjusted up or down accordingly.

The way working capital adjustments are being used is changing, however. With a more competitive environment for transactions and with the speed at which letters of intent and term sheets are being negotiated for transactions, we have seen additional pressure on selecting a purchase price in advance of completion of due diligence or in setting a purchase price high enough in order to win in an auction or competitive bid situation. As a result, working capital adjustments may be used as a purchase price adjustment mechanism, and particularly with respect to issues which may arise in due diligence, after the target purchase price is set or once exclusivity has been negotiated.

As working capital adjustment provisions evolve beyond their traditional purpose, either intentionally or unintentionally, the risk of dispute also rises. This article summarizes some of the issues that may arise with working capital adjustments and some issues to consider while drafting to ensure more certainty in working capital adjustments.

Calculating the Peg

"Working capital" is defined as current assets less current liabilities. Current assets are those assets which are turned into cash within a period of a year, including cash and cash equivalents, inventories, accounts receivable and prepaid expenses. In most purchase transactions, cash is retained by the seller (and thus excluded from working capital) and prepaid expenses for such purposes are often limited to those prepaids that will provide a benefit to the buyer going forward. Current liabilities are those liabilities which are due within a year and would typically include short-term debt, accounts payable and accrued liabilities or "reserves". In a purchase and sale transaction it is often necessary to ensure that the items...