Working Capital Adjustments

he amount of working capital (current assets less current liabilities) required to fund operations varies by owner preference (e.g. how quickly they pay vendors), by industry (e.g. seasonality or cyclicality of certain industries), and by business (e.g. how often inventory turns). A transaction can ultimately be derailed late in the process without a clear and proper definition early in the negotiations of the level of working capital to be transferred to a buyer.

DEVELOPING A WORKING CAPITAL TARGET

In an acquisition, the required level of working capital needed to support the business must be carefully assessed. Commonly an average is determined – this is called a “peg” – and is included in the purchase agreement. However, between the time a buyer initially sets an offer price and the transaction closing date, variations can arise from fluctuations (sometimes significant) in the short-term assets and liabilities of the business. Regardless, setting a peg prevents a seller from managing current assets and liabilities in their favor (e.g. by delaying payments to suppliers, collecting receivables faster, etc.) and the buyer from benefiting if there is excess working capital at the time of closing.

The peg can be determined by a variety of methods. Some of the more common approaches include:

• Using the working capital level as of the most recent financial period ended,
• Taking an average of working capital over a set historical time period (e.g. 12 months), or
• Applying a benchmark industry average working capital ratio to the seller’s operations.

EFFECT ON PURCHASE PRICE

Once a final working capital calculation is performed as of the closing date, it is compared to the agreed upon peg. If actual working capital is higher than the peg, the purchase price is increased. If it is below the peg, the purchase price is decreased. Generally, either a dollar-for-dollar adjustment or a de minimis adjustment, also referred to as a “band,” are used. The band allows for the actual working capital to deviate from the target, or peg, by a specified amount. After that range is exceeded, the change in purchase price typically takes the form of a dollar-for-dollar adjustment. Since completed financial statements are typically not available at the closing date to calculate working capital, a true-up is required within 90 days after the close of a transaction.

COMMON CHALLENGES

Unfortunately, defining working capital is more complicated than simply subtracting current liabilities from current assets. Items that should be given special attention include:

• Calculation of current asset and liability categories - It is not necessary that all current assets and liabilities are included when calculating working capital. For example, in many cases cash, short-term debt, and intercompany assets and liabilities are excluded. It is important that both parties agree in advance on which accounts will be used.
   
• Seasonality - Many industries experience seasonal business cycles which cause working capital to fluctuate significantly during the year. Acquiring a business as it is building inventory for a peak selling season may require a significant adjustment if the target working capital is based on a 12-month average. For this reason, using a specific month-end working capital value during this peak selling season might be more appropriate.
   
• Strong growth - As a company grows, it naturally requires a higher level of working capital to sustain the business. If a seller has and is expected to continue to grow rapidly, an average of historical working capital may not be an appropriate target. In this case, it would be more advisable to forecast working capital necessary to fund the growth.

Every company and industry has unique characteristics for calculating and setting a working capital target. Although some are more complex than others, there will always be a plethora of details to consider. It is important to have a knowledgeable team of advisors to assist you through the process.