When a business is sold, sometimes an adjustment to the purchase price is needed to make up any difference between available working capital at the time of closing, and the working capital needed to maintain day-to-day business operations. Such an adjustment is commonly referred to as a working capital adjustment.
When a business is purchased, the buyer must ensure that the business is capable of maintaining its every day operations following the transfer of ownership. All businesses require a certain amount of working capital to operate, and often times the amount of working capital available after a transfer of ownership is inadequate. In this case, the purchaser needs to infuse cash into the business – effectively raising the purchase price of the business. To offset this potential additional cost, the buyer often identifies a working capital target expected to be present at the time of closing.
The required working capital is usually calculated at the letter of intent (LOI) stage of the buying process and may be refined during the due diligence process.
Working Capital Adjustment Formula
Working capital is defined as Current Assets less Current Liabilities, where assets include cash and cash equivalents, inventories, prepaid expenses, and accounts receivable. Liabilities include short-term debt, accounts payable, and accrued liabilities.
But calculating a working capital adjustment isn’t as simple as calculating working capital. Estimating an agreeable and effective working capital provision can be somewhat challenging. To do this, we need to understand a working capital target.
Working Capital Target
As mentioned earlier, working capital target is an estimate of the amount of working capital that will be available on the day of closing. The amount is calculated using normalized historical averages for the closing date. Once the sale has closed, the purchaser must deliver a finalized calculation of the actual working capital that was available on the closing date. Before closing, the buyer and seller will agree on an acceptable time frame to produce the calculation (usually 60, 90, or 120 days). This allows the most accurate calculation, as the sale process is complete and the buyer has time to have its CFO and/or auditors review all numbers.
The difference between the working capital target and the actual working capital on the day of closing (if any) will determine the amount of the working capital adjustment. In some cases, the working capital at closing may actually be more than the target working capital, in which case the working capital adjustment may be payable to the seller, instead of the buyer.
Issues with Working Capital Adjustments
Working capital adjustments are complex, as they can vary dramatically depending on a particular situation. Both the purchaser and the seller will need to think about a number of issues pertaining to the sale, including what (if any) assets and liabilities should be excluded from the working capital adjustment formula, the appropriate and fair amount of working capital required to run the business, the consistency of the calculations, and the consistency of accounting standards.
In the event a dispute arises between the purchaser and the seller regarding the working capital adjustment, a third party (usually a judge, expert, or arbitrator) will be called upon to help settle the dispute. In the event the purchaser, seller, and third party cannot come to an agreement, the case may go to court for litigation.
Successful Working Capital Adjustments
In order to have a smooth, timely, and agreeable working capital adjustment, the purchaser and seller should come to some basic understandings and agreements in the early phases of a transaction process. This includes an understanding of the definition for any accounting terms used in the working capital equation (and what assets and liabilities may be excluded) along with a reference balance sheet.
Additionally, the purchaser and seller should make some decisions about:
– What accounting standard will be applied? Will GAAP or previous financial reporting standards be followed?
– Will the statements be audited or reviewed by a CPA firm?
– In the event of a dispute, will you work with an expert or and arbitrator?
The definitions, computation, and dispute methodology related to the working capital adjustment are equally important to the business seller and buyer. So communicating about this important deal term early in the acquisition process is always a good practice.