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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.
I am in the process of calculating the working capital adjustment for a business I acquired. At the time of closing, the seller had a significant amount of work in progress in anticipation of receiving a change order for an ongoing contract. This change order was issued several weeks after closing. My question is should the WIP that was undertaken as a business risk be included as an asset for the adjustment calculations? Should the value of the change order be included on the seller side of the calculations?
First, congratulations to you for your recent business acquisition!
I am not certain what you mean by “the WIP that was undertaken as a business risk”. It’s the business risk part that’s confusing me.
If that’s an important part or point to your question, please explain further.
If not, then here are my thoughts:
Work In Progress (WIP) typically has two parts — inventory and labor and when recorded is a current asset. The labor portion that’s being captured is also an asset because the expense was incurred and paid, it’s just not invoiced yet (pending receipt of the change order) so it’s also sitting on the Balance Sheet as a current asset.
Typically a current asset is part of the working capital computation for a business sale, unless its exclusion was negotiated by the seller and buyer. So the question you asked about the whether the asset should be included, I would say ‘yes’.
As for the change order that was received after the sale closing which takes WIP off the balance sheet (credit to the Asset account) and records the WIP costs (materials and labor) as an expense on the income statement. The change order is recorded as income on the Income Statement and Accounts Receivable on the Balance Sheet.
If WIP was agreed to be part of the Working Capital calculation, then the buyer ‘owns’ that asset post-closing. It’s just like any other current asset in Working Capital. As for the change order received post-closing, in this case it would belong to the buyer as well and shouldn’t increase or decrease the Working Capital (target) computation. The buyer is being paid for the WIP he acquired at the closing.
Let me know if this makes sense or not!
All the best…
How is the adjustment treated from tax perspective. Is it added/deducted from the purchase price and thus considered an adjustment to the taxable capital gain pertaining to the sale of shares?
The Working Capital Adjustment is treated differently for tax purposes depending on whether the deal is a stock transaction or an asset transactions.
In a stock transaction, the adjustment increases or decreases the price which is paid for the stock transfers to the buyer.
In an asset transaction, the purchase price for the assets transferred to the buyer is adjusted.
All the best…
The LOI should contemplate a working capital adjustment and either set forth the target working capital number or state that it will be determined based on an average or historical levels. Reach out if you would like to discuss further.
When a buyer prepares their Letter of Intent, should they include the working capital adjustment in the offer?
I am a business broker and featured adviser with EXIT Promise, and have negotiated several Letters of Intent(LOI) with this adjustment. It is in the best interest of buyer and seller to included this in the LOI as it can be a significant dollar amount. You do not want to get far along into the time and expense of due diligence and negotiating the sale contract and not have an agreement on the working capital. In some cases, the buyer and seller can be far apart on what the amount should be, so it is best to address this early. When my client is the seller, we typically determine how much working capital should be included in the sale price before the business is put on the market. If we receive a LOI from a buyer without the working capital adjustment, we submit a counter offer with the adjustment. I hope this helps.