Buyer Beware of Working Capital Adjustments

Most stock transactions have a working capital adjustment.  Some buyers love them, some buyers hate them.  Without them a seller can often game the system to their benefit.  Many seem fair at the time, but unless well-planned they can result in unexpected purchase price adjustments post-closing when no one is in a mood to revisit the deal.  We have several tips for an effective working capital adjustment:

1. 1. Know the balance sheet you will use. Reviewing the balance sheet and breaking down the components of the calculation will help your client understand the adjustment and how it will work.  Running some projected calculations will help identify flaws in the process.

1. 1. Use a known balance sheet for the adjustment. Be specific that the balance sheet used in the calculation will be prepared consistent with past practice and custom.

1. 1. When selecting the components of the working capital adjustment differentiate between operating and non-operating liabilities as well as the party benefitted by the liability. If the seller already received all the benefit of a liability, the seller should pay the liability from the purchase price proceeds and it should not be included in any working capital target calculation.

1. 1. Write strong definitions based on the specific components of the adjustment again tying those components to past practice and custom. “Trade Payables” are obviously not the same as “Current Liabilities,” but often those details are lost on the drafter.

1. 1. Provide a clear process for performing the working capital calculation and a clear process to resolve disputes. Make sure the timelines work and there is adequate time to lodge disputes.  Build in a small amount of time to negotiate a resolution so there is a chance to diffuse an escalating situation.

1. 1. Consider an escrow based on a closing day estimate if the working capital of the target is prone to significant fluctuations which may require a big payment.

1. Make sure the working capital adjustment works within the limitations of any buyer financing or intercreditor agreements. Many times a post-closing payment of any kind to the seller before a payment to the lender will violate the terms of a loan agreement or intercreditor agreement.  The adjustment then has to be carved out of those covenants.

Most deals have working capital adjustments.  A well-drafted and well-planned adjustment can protect a buyer’s working capital expectations in the deal.  However, to work effectively adequate time and attention must go into the provision.

Andrew J. Miller, JD, CM&AA^® advises buyers and seller of main street and middle market companies in private mergers and acquisitions.  He is recognized as a Certified Mergers & Acquisitions Advisor^® by the Alliance of Mergers & Acquisitions Advisors, an organization focused on the private middle market.  He can be reached at (717) 845-1524, or amiller@mpl-law.com.

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