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Working Capital Adjustments in M&A Transactions

Posted by Ryan M. Newburn | Apr 09, 2021 | 0 Comments

If you are in the middle of a merger and acquisition (M&A) transaction or you simply need a better understanding of the working capital components of your M&A agreement, consider reaching out to an experienced business attorney at Newburn Law to get answers to your working capital adjustments questions.

What Is Working Capital?

In M&A transactions, complicated financial determinations need to be made in order to ensure the legal and financial expectations are assured of both companies. One of the more difficult determinations is how to calculate and “true-up” the working capital of the acquired company.

For example, when Company A acquires Company B, the assets minus the liabilities of Company B form the basis for Company B's “working capital”.

Assets include items like:

  • Cash and accounts receivable
  • Inventory of any finished goods, raw materials, or works in progress
  • Short term advances and investments
  • Prepaid expenses

Liabilities include items like:

  • Accounts payable (including Invoices for said raw materials or goods)
  • Unpaid taxes or declared and undistributed dividends
  • Accrued but unpaid expenses (including HR expenses like accrued vacation benefits)
  • Short term debt

The net working capital (adjusted assets minus adjusted liabilities) of Company B may also be called operating liquidity, which represents the amount of capital needed to keep the business operations moving forward once the sale to Company A is complete.

Why Working Capital Adjustments Matter

Working capital adjustments in M&A transactions effectively represent purchase price adjustments, and any effective changes to the purchase price prior to the consummation of the transaction effects the relative economics between the buyer and the seller.

For example, say Company A agreed to purchase Company B for $10 million. At the time the agreement was entered into, Company B had $2.5 million in positive working capital, including $2 million in a bank account. Just prior to closing the transaction, the owners of Company B liquidated the bank account and distributed all $2 million. Company A thought it was buying a company worth $10 million that had $2 million in the bank. The owners of Company B thought they were selling their company for $10 million. Instead, Company A purchased a company for $10 million that was only worth $8 million ($10 million less the $2 million taken out of the bank account). Conversely, the owners of Company B received $12 million for the sale (the $10 million from Company A plus the $2 million taken out of the bank account).  

Benefits of Working Capital Adjustments For the Buyer

Working capital adjustments ensure buyers purchase a business that has sufficient working capital for successful ongoing company operations. In addition, such adjustments can ensure the buyer is receiving adequate value for the purchase price.  

For the Seller

Working capital adjustment ensures sellers get a fair price for their company. While the example above shows how a missed capital adjustment can work in a seller's favor, the opposite can just as easily be true. If we took the example above and changed it so that the balance in the bank account went from $2 million to $4 million (due to increased sales for example), the owners of Company B would have sold a $12 million company for only $10 million.

In either situation, the purpose of working capital and any adjustments therein is to protect the deal value and keep the operations of the acquired company running smoothly after the deal has closed.

When to Make Working Capital Adjustments

There are many situations where the buyer wants enough financial liquidity to keep Company B operating, in which case both companies will negotiate a target figure or working capital “peg.” This figure represents the amount of money the buyer and seller agree that Company B should have at the close of the transaction in order to keep the company moving forward and generate revenue.

The peg amount can be calculated in a myriad of ways depending on how the company is to be operated moving forward. The most common peg amount is the net working capital Company B had for the previous fiscal year. These financial determinations can often involve complex calculations and specific legal language. Consider visiting with an experienced business attorney at Newburn Law to help ensure your financial and legal rights remain protected. 

Calculating the Peg

One common methodology for calculating a peg is to use the normalized net working capital for the last 12 calendar months prior to entering into the transaction agreement. However, the time frame can be adjusted between the buyer and the seller to be longer or shorter than such 12-month period. Regardless of the time frame, the buyer and seller, or Company A and Company B in our example, have opposing interests when it comes to setting the peg. Buyers want the highest possible peg and sellers want the lowest possible peg. In most M&A transactions, the peg serves as one of the most heavily negotiated items because the mathematics of the net working capital can have significant financial implications for the parties after the deal is closed.

Adjustments to working capital in M&A transactions can take place in two key scenarios:

Scenario 1

In the first scenario, where working capital exceeds the peg at the closing of the transaction, the buyer (Company A) ends up paying a higher purchase price. For example, if the net working capital at the peg rate is $2 million, and the net working capital at the close of the transaction is $3 million, the excess net working capital represents the difference between these two prices ($1 million).

In this scenario, the buyer (Company A) pays a higher incremental purchase price of $1 million because the seller (Company B) provided a net working capital at the close of the transaction that was higher then the peg.

Scenario 2

In the second scenario, where working capital is lower the peg at the closing of the transaction, the buyer (Company A) ends up paying a lower purchase price. For example, if the net working capital at the peg rate is $2 million, and the net working capital at the close of the transaction is $1 million, the lower net working capital represents the difference between these two prices ($1 million).

In this scenario, the buyer (Company A) pays a lower incremental purchase price of $1 million because the seller (Company B) provided a net working capital at the close of the transaction that was lower than the peg.

Net Working Capital Adjustments

Other net working capital adjustments include definitional adjustments, due diligence adjustments, and pro forma adjustments.

  • Definitional adjustments take place when you include things like accrued interest or lines of credit which would otherwise be excluded from net working capital figures.
  • Due diligence adjustments take place after the walk-through of accounts typically related to non-recurring or non-operating items like bonuses.
  • Pro forma adjustments include situations where retroactive impacts are calculated and adjusted on an as-if basis.

Contact a Business Attorney To Help Guide You Through Working Capital Adjustments in M&A Transactions

If you currently need help understanding the working capital adjustments in your agreements, consider contacting an experienced business attorney who can answer any questions you have about various adjustments or help you negotiate the terms of this important business transaction. Our experienced attorneys can provide insight into these working capital adjustments and help answer your legal questions. Contact Newburn Law for your free consultation today

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.

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