The Importance of Working Capital to any Deal
We’re all familiar with working capital as a concept, but in the context of a purchase or sale transaction we move from working with the general concept (in negotiating the key deal terms) to describing exactly how it will be calculated, and when (in the purchase agreement). Properly describing what will comprise working capital and how it is calculated is always important, but is often not given enough attention.
When negotiating the letter of intent the purchaser wants to ensure that it sets a working capital target that ensures the acquired business will have sufficient working capital to be able to operate in substantially the same way as before closing. This target serves as a peg for the post-closing working capital verification. Within 60 to 90 days after closing, one of the parties is responsible for preparing and delivering to the other party a statement setting out the actual working capital of the business as of the closing date. If the working capital exceeds the target, then the seller usually receives a payment equal to the excess. If it falls short, the seller may owe the purchaser the difference. In both cases, the use of escrow arrangements can be used to provide comfort to both parties that the funds will be readily available in either scenario.
Ideally, a purchaser will have been able to conduct a reasonable amount of diligence on the target business prior to submitting its offer or starting negotiations. But if the purchaser has not been able to conduct sufficient due diligence before having to submit their offer, then the purchaser should consider whether it might be appropriate to increase the working capital target so as to provide more room to adjust the purchase price downward. In a competitive environment, there may be pressure to move quickly. The result being that working capital effectively becomes a purchase price adjustment mechanism.
It's not uncommon for parties to agree to a fairly standard definition of working capital when they want to obtain exclusivity and proceed more aggressively with their diligence. From that point on, though, the textbook definition of working capital is often modified during the course of negotiations. The parties will, and should, determine which current assets and liabilities that are being acquired will be used to calculate working capital for the purposes of their transaction. Because the purchase price in most deals is negotiated on a cash-free, debt-free basis, both parties will need to be specific about what is included in each of those categories. Are the parties intending to exclude cash on the books or cash in the bank? What about prepaid transaction advisory fees? Are outstanding but uncalled letters of credit or deferred taxes to be excluded? Does the purchaser want to assume all accounts payable? Perhaps not, if the seller has been including accounts that are not a part of operations.
Layered onto the line items to be included in the definition of working capital are broader considerations such as the purchaser's and vendor's views on how much working capital is necessary, or how seasonality or cyclical trends could impact working capital. For example, a purchaser who acquires a business with a view to aggressively growing it may feel a higher working capital target is more appropriate than the seller who desired little or no growth. The time of year that a transaction closes may also have a significant impact on working capital, and consequently the adjustment to the purchase price, to the detriment of the seller or the purchaser.
Working capital is clearly a key deal term that needs to be evaluated and discussed based on the specific attributes of any given transaction. However, there are a number of practices that should be considered when negotiating your deal:
- Clearly define each of the components forming your definition of working capital.
- Remember that the post-closing working capital calculation will have to be the same as the one used in determining the working capital target at the outset.
- Prepare or agree to an illustrative working capital calculation.
- Where possible, become familiar with what accounting practices the seller has been using or, in some cases, how the seller has exercised its discretion using such accounting practices where judgment calls need to be made.
- Decide whether GAAP or previous practices applied on a consistent basis should be determinative.
- Always have the ability to defer disputes to an independent third party expert.
Failure to spend enough time up front on deciding what working capital means to each of the parties has the potential to cause significant problems further along in execution of the transaction. It’s always worth discussing at the outset and, where possible, clearly stating expectations in your letter of intent.
Invitation for Discussion:
If you would like to discuss this article in greater detail, or any other business law matter, please do not hesitate to contact one of the lawyers in the Business Law group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.