In many M&A transactions, the purchase price agreed upon at signing may not be the price you ultimately receive.  In the middle market, one of the most common – and contentious – sources of price erosion after a deal closes results from working capital adjustments.  This mechanism is designed to ensure that the business is delivered with a mutually agreed upon level of liquidity and operational resources.  Done properly, it can be a fair way for the parties to balance the books.  Done wrong, it can significantly erode your deal value.

Below are three of the most commonly disputed aspects of working capital adjustments, and strategies for how to avoid letting a math problem wipe out your hard-earned deal value.

1.  Setting the Target

We will dive into the different hot buttons around the definition of “working capital” below, but for now, understand that “working capital” is typically defined as current assets minus current liabilities.  It is intended to reflect the company’s ability to meet its short-term obligations.  In many purchase agreements, the buyer and seller agree on a target working capital number.  Following the closing, the actual working capital is compared to the target.  If the actual working capital is lower than the target, then the seller typically has to pay the shortfall to the buyer on the premise that the buyer overpaid for the company at closing.  Conversely, if the actual working capital is greater than the target, then the buyer typically has to pay the excess to the seller on the premise that the buyer only paid for a certain amount of working capital and it should not receive a windfall for that excess.

Determining the “target,” however, is not usually as simple as averaging the revenue, profits or whatever other metric the parties look to over the last 12 months.  That approach often times ignores critical issues that can significantly impact the working capital calculation and create unintended – and many times detrimental – consequences to the seller.  Other factors, such as seasonality of the company’s business, growth trends in the relevant industry and one-off anomalies, should be closely analyzed to see how they impact the calculation of the target.  

2.  Defining Working Capital

The definition of “working capital” is critical. Without precision - and ideally an example attached to the purchase agreement – the parties are inviting post-closing disputes.  Even small definitional differences can drastically swing the pendulum on the post-closing adjustment.  Factors to be considered include:

• Deferred revenue (often a hot button in service-based or subscription businesses).  Buyers often argue that deferred revenue constitutes revenue that has been collected but not yet earned under GAAP and, as such, should be treated as a liability.  Depending on how heavily weighted the seller’s financials are with respect to deferred revenue, and how the seller conceptually views deferred revenue (as an asset or a liability), sellers would be wise to surface this issue and address it upfront to avoid arguments down the road.
• Related-party payables (can artificially inflate liabilities).  A buyer-favorable definition of “liabilities” is typically broad enough to include related-party payables as liabilities.  However, if these are included in the calculation of working capital, it can artificially inflate liabilities (and accordingly reduce the working capital number) and create an unanticipated downward adjustment for the seller.
• Intercompany balances (especially in multi-entity structures where one company may owe another for shared expenses).  Sellers should carefully analyze any intercompany balances and define its expectations as to whether these should be included or excluded from the working capital calculation.  Depending on the size of these balances, these can significantly impact the calculations.
• Customer deposits (another hot button issue in service-based or subscription businesses).  Similar to deferred revenue, the treatment of customer deposits for products or services not yet delivered can be subject to debate based on the accounting method used when looking at these deposits.
• Accrued expenses (can significantly impact liabilities).  The parties should carefully consider what accrued expenses might exist on the company’s books (e.g., accrued bonuses, commissions, etc.) and determine how those expenses will be treated.  These expenses can be significant, and they can be variable.  Before selling a business, Sellers should closely look at these amounts and determine of any are atypical or one-time expenses.  If they are, and if they will impact the working capital calculation, sellers may want to consider whether it would make sense for them to seek an adjustment for those expenses or wait a few months to sign the purchase agreement if doing so would reduce or eliminate the impact of those expenses on the working capital adjustment.

3.  Post-Closing Disputes

Most purchase agreements give the buyer and its accountants 60–90 days after closing to prepare the working capital calculation. The purpose is for the buyer to have time post-closing to look closely at the seller’s books and reconstruct the “as of closing” balance sheet.  The buyer then can compare the “as of closing” balance sheet that was provided at closing against what the buyer constructs (with the benefit of time and deeper review) what it believes was actually the balance sheet as of closing. 

To protect the seller and potentially minimize disputes, most purchase agreements include a “consistency clause” relating to the preparation of these statements.  This clause requires that the buyer use the same accounting policies and principles to reconstruct the “as of closing” balance sheet with the ones that were used by the seller when it delivered the “as of closing” balance sheet at closing.  However, if the seller does not provide specificity in the purchase agreement as to what, exactly, those policies and principles were, or if historically there was room for discretion or judgment in how the seller calculated those numbers, then that opens the door for the buyer to apply different accounting judgments retroactively and potentially use alternative approaches which may be detrimental to the seller.  For example, with the benefit of hindsight, the buyer may try to increase reserves for doubtful accounts based on post-closing collection experience, argue that pre-closing procedures were inappropriate or write down inventory as obsolete.  Buyers may even decide certain receivables should not have been recognized as of closing because the performance obligation was not “substantially complete” or due to the aging of the receivables — even if the seller historically recorded those types of receivables.  Sellers should try to reduce their expose for these types of adjustments by not only providing specificity as to how the numbers they provide were calculated but also consider attaching an example with all of the relevant details around their accounting policies and procedures to the purchase agreement.

In short, pay careful attention to the working capital adjustment.  It is often the most disputed section of the purchase agreement in small and midsized private company M&A transactions.  Handled well, it should simply be another item on the post-closing checklist.  Handled poorly, it can cost sellers hundreds of thousands of dollars.  The difference comes down to preparation — and having the right advisor in your corner.