The concept of working capital, while familiar to most people involved in running a business, is often misunderstood in the context of a purchase price adjustment mechanism in an acquisition agreement. This mechanism can be an easy way to lose significant value in a deal if it is not structured and negotiated properly. This article will walk through the basic elements and common misconceptions of working capital adjustment mechanisms to examine ways a buyer or seller can use those mechanisms to improve its pricing position and, additionally, to protect against a potential adverse shift in value.
What Is a Working Capital Adjustment Mechanism?
Working capital is the difference between current operating assets and current operating liabilities, but can be thought of as the capital needed to run a business day to day through holding inventory, and extending credit to customers, for example. A working capital mechanism is typically included in an acquisition agreement to prevent the seller from stripping this capital from the business at or prior to closing to the point where a buyer would need to infuse additional capital to fund operations post-closing, effectively increasing the purchase price.
A buyer of a private company typically bases its bid price on the enterprise value of the business on a cash free, debt free basis, “assuming a normal level of working capital.” This “normal” level of working capital (typically the average working capital that is required to generate the EBITDA that served as the basis of the enterprise value in the buyer’s bid, or sometimes, the working capital projected to exist as of the closing) will be a point of negotiation and essentially an element of the overall purchase price. The amount determined to be “normal” is often a fixed amount included in an SPA as the “target working capital,” and the seller will pay the buyer if the working capital delivered at closing is less than this target amount, while the buyer will pay the seller additional consideration to the extent working capital at closing exceeds the target working capital.
Often target working capital is based on the average working capital of the business in the past twelve months. There are two main reasons a twelve month average is typically used. The first is because a full year average will remove any effects of seasonality. Secondly, the EBITDA number underlying a buyer’s bid is usually measured in the trailing twelve months so it makes sense that there would be a match. If a company is growing rapidly and bids are based on forecasting EBITDA, then the target working capital should ideally be based on the forecast average working capital over the same period. Because forecast net working capital is often not available, it is common to see buyers apply a growth rate expected to be achieved in EBITDA to historical working capital when calculating the working capital target. If, in the case of a growing business, forward looking earnings are priced but historical working capital (where working capital is positive) is used to set the target, this target will typically be lower than expected in the future, thus the normal level of working capital set in the price could be artificially low, hurting the buyer.
Some believe that if closing working capital exceeds the target and the buyer pays an additional post-closing adjustment, then the buyer is somehow losing out. However, because the buyer is receiving more working capital than expected (which can be used to generate earnings which will convert to cash), there should be no net change in the equity value paid at closing.
Also, we would argue that it does not actually matter when closing occurs in a seasonal business as long as intra-month working capital has been considered when setting the target. For example, if a business is sold in a peak period (and working capital is therefore greater than the target), while the buyer will pay additional purchase price for the excess working capital, the buyer will also receive this cash back from the business as the additional working capital unwinds and converts to cash. Conversely, if closing occurs at a trough in the seasonality cycle, even though the Buyer will likely receive a cash adjustment in its favor, it will still need to infuse additional cash in the business to build the working capital back up as the year progresses.
So how can buyers and sellers be aggressive with working capital?
First, by setting a target that is not the true normal level of working capital. Buyers will of course always push for a higher target, and sellers will push for a lower target. One way to move the target away from an average is by making normalization adjustments for one time or non-recurring working capital items, or by excluding certain current assets or liabilities.
Second, by changing the way working capital is calculated under the acquisition agreement at closing as compared to how working capital may have been calculated by the business in the past (and in calculating the target). This could be done up front through careful drafting and negotiation of the working capital definitions and related accounting principles in the acquisition agreement. Or it can be done on the back end when the buyer is preparing the post-closing working capital statement. For example, a buyer could adjust working capital amounts (e.g., increase judgmental reserves, etc.), while still staying within the confines of the SPA, to come up with a lower closing working capital amount if the acquisition agreement employs broad and flexible accounting policies. Acquisition agreements frequently include as a baseline standard that “closing working capital shall be prepared in accordance with GAAP,” as GAAP is a well understood concept. However, GAAP only provides guidelines, which are subject to an individual business’ interpretation. For example, with respect to “allowances for doubtful accounts,” GAAP simply states that a company must have a reserve for debts it does not anticipate collecting, but GAAP does not set out how this reserve is to be calculated. An aggressive buyer could determine that the reserve has historically not been adequate and increase it on the closing balance sheet thus reducing closing working capital and leading to a price adjustment in the buyer’s favor.
In response, we frequently see sellers proposing very specific and detailed accounting policies for the calculation of the closing statement, in particular working capital. Instead of making accounting policies simply “in accordance with GAAP” sellers will go on to say “consistent with past practices” and will often include a separate exhibit of specific accounting policies to be used when preparing the closing statement. These specific accounting policies are sometimes set out as a hierarchy that include: (1) specifically listed accounting policies; (2) to the extent not specifically listed in (1), all the accounting policies, methods and procedures utilized in the preparation of the most recent audited financial statements; and (3) to the extent not included in (1) or (2), in accordance with GAAP. In addition to this, sellers can include a detailed illustrative example of how working capital should be calculated, which will go to the trial balance account level of detail to show which accounts should be included. Even though this exhibit may add several pages to an agreement, setting out such detail enables the seller to exert significant control over the preparation of the closing statement, even though the buyer is usually the party actually preparing it. Additional detail and definition also reduces the risk of post-closing disputes.
Working capital adjustment mechanisms are often a difficult point of negotiation for both buyers and sellers in the context of acquisition agreements, in part because they lie at the intersection of corporate finance, accounting and law, but a well advised buyer or seller can take advantage of the adjustment mechanism to support its pricing model and optimize any potential value shifts that may result. This requires close coordination among the accountants, attorneys, internal finance staff and the deal team.