Working Capital Adjustments in M&A

Working capital adjustments are a key component of an M&A deal, yet often overlooked. There can be situations where a purchase price is decided upon and everything seems in line, but disputes arise pre or post-closing because the working capital was not properly defined or negotiated. Without a proper foundation, this can cause significant issues. Understanding these adjustments and their implications can work to prevent unnecessary financial and legal headaches for both parties. At its core, a working capital adjustment is an adjustment to the purchase price according to the difference between a normalized net working capital (NWC) at closing and the agreed-upon target NWC. This allows the buyer to pay the same effective price regardless of fluctuations. Buyers expect the business to have enough working capital to operate without the need of heavy liquidity, while sellers want to make sure they are not leaving excess value on the table. So, if the working capital at closing deviates from the agreed-upon target, an adjustment is made. Setting the Target All of this said, both parties need to negotiate a working capital target to begin the process. Sellers usually want the target to be lower, while buyers will often push for a higher figure to avoid being left short-changed post closing. There are several approaches to setting this target. One can look at historical averages, but this can potentially be misleading if the business has high peaks and low lows. Buyers may argue for a higher target if the business has been growing, while sellers may push for a lower target if they anticipate downturn. In some cases, comparable company metrics can help establish a fair baseline that both parties can agree on. Common Pitfalls Even after determining a fair, well-defined target, some deals may still run into issues with working capital adjustments. There can be a misclassification of items, meaning that certain assets and liabilities that do not belong in the working capital calculation may accidentally be included which can lead to disputes if not properly addressed and discussed. This is why proper due diligence is important in any deal. Finally, there can be unclear definitions in the purchase agreement. Too broad of a definition can lead to disputes because of its ambiguity. Best Practices for Both Parties To avoid disputes, both parties should work to clearly define working capital terms. The purchase agreement should specify which accounts are to be included, special considerations, etc. Both parties should also agree on a reasonable baseline that establishes a fair and realistic target. It should reflect the normal operational needs of the business being bought or sold. Another tool buyers and sellers use is a post-closing review period which usually stretches from###-###-#### days but can differ depending on the deal. This period will allow for a final working capital calculation which properly adjusts discrepancies. As demonstrated, working capital adjustments are extremely important and can have significant implications in an M&A deal. A well structured adjustment mechanism will benefit both buyers and sellers and prevent future unnecessary expensive disputes. To accomplish this, there should be careful negotiations and conversations, clear contract language, and a general understanding of how the business operates. Have you ever encountered a dispute relating to working capital in a transaction? Or do you have further questions? Drop a comment below or reach out directly! If you'd like to learn more about this, feel free to check out our podcast or schedule a consultation call at deanstreetlaw.com/links